Can You Own ETFs in an IRA?
ETF investments within an IRA may provide many advantages, as distributions from these funds don’t become immediately taxable and you may avoid certain load charges and commissions associated with mutual funds.
However, when selecting investments for an IRA portfolio it’s essential to understand how ETFs and mutual funds differ in terms of their operation.
Taxes
An ETF, or Exchange Traded Fund, is a basket of stocks, bonds and commodities traded as one unit and purchased and sold through one transaction. They typically offer greater tax efficiency than mutual funds in an IRA account.
ETFs tend to trade near their NAV throughout the day while mutual funds have specific trading windows.
ETFs that hold securities that generate capital gains often don’t realize those gains until the shares are sold and distributed back to shareholders; once investors realize them, taxes may apply according to individual income tax rates. Furthermore, shareholders also receive dividend distributions from ETFs that can either qualify or disqualify depending on how long they’ve held their shares with the fund.
Investors should carefully consider all operational nuances and fees when choosing between ETFs and mutual funds for their IRAs, including front-end and back-end sales fees, management fees and any load charges that may apply.
Fees
ETFs resemble mutual funds in that both offer professionally managed portfolios of stocks and bonds, yet each has unique operational differences.
ETFs offer lower investment minimums and intraday trading capabilities than mutual funds; additionally, their expense ratios tend to be much lower – something which could significantly impact long-term returns.
As an ETF investor, your management fees are deducted directly from its net asset value (NAV), meaning every dollar that goes to fund management instead of your investments is lost forever.
ETFs offer more than management fees – in addition to capital gains distributions each year depending on their underlying holdings’ performance. Distributions are taxed as ordinary income in the year they’re received unless placed into a tax-deferred account such as an IRA; federal and state taxes also apply, including Medicare’s 3.8% Net Investment Income (NII) tax for high income investors.
Liquidity
ETFs offer an attractive investment option for your IRA; however, you should take note of trading commissions, liquidity concerns and other potential factors which could impede its returns. Furthermore, be sure to regularly verify account statements from self-directed IRAs in terms of verification – this can include consulting an independent professional valuation service or researching tax assessment records.
Investors should seek ETFs with high returns over long time horizons and low risk levels to build a reliable retirement portfolio at reduced costs. A good example is Schwab U.S. Dividend Equity ETF SCHD, which tracks an index of high dividend-paying stocks such as Broadcom AVGO and Texas Instruments TXN.
Fidelity Total Bond ETF FBND, which tracks US government and corporate bonds, has outshone the Bloomberg US Aggregate Bond Index over 10 years after fees.
Diversification
As with any type of investment, diversification offers tradeoffs. It can help reduce the impact if one of your investments suffers a large loss; but this may lead to lower short-term returns.
ETFs are an increasingly popular option for IRA investors looking for an diversified retirement portfolio at an economical cost. Investors should carefully assess fees, history and holdings of an ETF before making their selection.
ETFs may also be considered more tax-efficient than mutual funds due to their in-kind creation and redemption processes that minimize capital gains distributions to investors. ETFs also disclose their holdings daily for transparency purposes and may not impose sales loads such as front-end and back-end fees that might limit initial investment amounts in mutual funds. As with any investment decision, however, your individual circumstances and investment goals must be taken into consideration before selecting an ETF for your IRA account.
Categorised in: Blog