"The Lord works in mysterious ways."
Uh-oh, I thought, as I read the first line of a letter from a Morningstar reader, who proceeded to regale me with an investment-related tale worthy of an O. Henry story.
A 50-something computer programmer, he was devastated when he lost his job in the financial-services industry back in mid-2008. With a mortgage and two kids hurtling toward college, the layoff obviously brought worries about what the future would bring.
At the time of his layoff, he was also panicked about his 401(k) portfolio, which included a healthy dose of stock funds as well as many shares of his employer's stock, which was quickly going from bad to worse.
Here's where the plot twist comes in: Shortly after the layoff, he had rolled over his 401(k)--the bulk of his retirement savings--into an IRA. Paralyzed by indecision over where to invest the money, he had left the assets sitting in an ultra-low-yielding, but ultra-safe money market fund. In so doing, his retirement portfolio was cushioned during the late 2008-early 2009 market sell-off, the worst since the Great Depression, which saw the S&P 500 dropping by 50%.
Even more fortuitously, he had also dumped his company stock at an opportune time. Soon after he sold the stock and rolled his money into the IRA, shares of his former company skidded from $25 a share down to about $3. He hadn't yet found a new job at the time he wrote to me, but he noted that his inaction toward his retirement portfolio had saved him far more money than he had lost in income from his job.
Yet, he didn't want to look a gift horse in the mouth. He knew how lucky he had been in sidestepping the market's troubles, but he also knew that his conservative portfolio could be left in the dust if the market rebounded. And indeed, when he wrote me in the spring of 2009, the major stock indexes were scoring huge gains each day. He wanted guidance, posthaste, on getting his portfolio invested for good.
It's easy to see why this programmer, as well as a lot of other would-be IRA investors, suffer from "analysis paralysis." Once you decide whether to invest in a traditional or Roth IRA, you then have to sort among an overwhelming array of options. You can put almost anything inside an IRA wrapper: individual stocks and bonds, money market funds, certificates of deposit, or mutual funds. Life insurance policies and investments made on margin--that is, those funded with borrowed money--are among the few mainstream investment types that can't go inside an IRA.
However, because IRAs offer either tax-free (Roth IRA) or tax-deferred (traditional IRA) compounding, it's usually a mistake to put any sort of investment that itself has tax benefits inside an IRA wrapper. Municipal bonds are a great example: You don't typically pay federal taxes on the income from municipal bonds or bond funds, but in exchange you usually have to accept a lower level of income than you'd have from a taxable bond or bond fund. For that reason, you're better off holding tax-advantaged investments such as municipal bonds and variable annuities (to the extent that you own them) in your taxable accounts, and only after you've funded your IRA and company retirement plan.
To identify the best investments for your IRA, you'll need:
Start the ClockStep 1
- Statements for all of your retirement holdings: 401(k)s, 457s, 403(b)s, and other IRAs
- Morningstar's Instant X-Ray tool
The first step in selecting investments for your IRA is to think about what role your IRA will play in your retirement portfolio. Will it take up a big share--either because you're just starting out and plan to make many more IRA investments in the future or because you've rolled over a large sum of money from your company retirement plan? If so, move on to Step 2.
If you consider your IRA to be more of a supporting player because the bulk of your retirement assets are elsewhere, either in your company retirement plan or your taxable account, go to Step 3.