Consider Tax Managed Funds instead of IRAs?

Investors who are saving for retirement through non-deductible IRAs might want to consider tax-managed mutual funds instead. At least that's the conclusion of an article by Murray Coleman over at Marketwatch, "Tax-managed funds outperform non-deductible IRAs."

Coleman highlights one of the tax inefficiencies of non-deductible individual retirement accounts: earnings are taxed at ordinary income rates, which can be as high as 35%, instead of the more favorable 15% on qualified dividends and long-term capital gains. In an non-deductible IRA, the taxes are deferred until the taxpayer begins making withdrawals, or the money is rolled over into a Roth. Even taking the tax deferral into account, investors may come out head by using taxable accounts.

The advice in the article sounds good -- except for one little bit of tax timing that's pretty crucial. Starting with the year 2010, investors will be able to convert their non-deductible IRAs into Roth IRAs. That's the year that the income limitation on Roth conversions is removed. So a common tax strategy is to save as much as possible in a non-deductible traditional IRA, and then convert those funds into a Roth IRA. Using this strategy, investors will pay tax only on the earnings accumulated in their IRA at the time of the conversion. Earnings inside a Roth IRA are tax-free. This tax strategy was made possible under the Tax Increase Prevention and Reconciliation Act of 2005.

So what would I do with these research findings? I would consider tax-managed funds for taxpayers who aren't eligible to contribute to Roth IRAs after the crucial year 2010. Until then, I think it makes more sense to bulk up on non-deductible IRAs, so taxpayers can convert their savings into tax-free Roths. However, this is primarily a tax strategy, designed to shift as many assets as possible into a Roth IRA. Investors should also do some basic research on the tax efficiency of their mutual funds before making any financial decisions. This article from Morningstar offers five tips for Making Your Portfolio More Tax Efficient. Investors may also want to consult with an investment advisor.

More information:

• Tax Deduction for Traditional IRAs
• What You Need to Know About a Roth IRA
• Remember to File Form 8606 for Nondeductible IRAs
• Understanding Tax-Managed Funds (from Fool.com)
• IRS Publication 590, Individual Retirement Arrangements