Jim Wiandt

Tax Sheltering Index Funds

While it may seem counterintuitive, your retirement fund may well be the best place to hold the riskier end of your portfolio.

Many of us think of retirement accounts as a place for conservative assets, because we want to be certain of having a minimum of retirement funds. At the same time we often look to the high risk, high gain part of the market for short-term income. Placing your more volatile growth investments in a tax shelter over the long term can be advantageous because you save money on taxes. In addition, because your retirement account is more likely to consist of long-term investments, you decrease your susceptibility to short-term market fluctuations.

The riskier asset classes (such as technology) often also have higher long-term returns that can gain more from tax sheltering in a retirement fund. This tax savings effect is most pronounced over long periods of time and so has more relevance to younger professionals. If 20 or more years remain until you plan to draw on your retirement accounts, long-term investment in volatile growth sectors of the market will not only save you taxes but will help even out the tremendous short-term risks you face in buying and selling these stocks over the near term.

Short-term volatility often leaves even professionals in a losing position against the broader market in the near term. Even if you do manage to rapidly increase the value of your portfolio through active buying and selling, stocks that are turned over in less than a year are taxed as ordinary income, taking a large bite out of your short-term gains.

Investing in higher risk growth stocks using Roth IRA accounts can eliminate tax consequences on short-term gains, notes Eric Weir of Weir Capital Management. The downside of this strategy, he says, is that you are unable to write off any losses that your retirement account incurs.

Why choose index funds to play the more risky, high growth end of the market? For the same reason you would choose index funds in general. That is, you will reap the benefits of both lower fees and of holding a stake in stocks with a potentially explosive upside.

If you place your portfolio's higher-growth index funds in a tax shelter, you will decrease your tax bill over the long haul. In the charts that follow, you will notice the significant gain that can be reaped by sheltering your higher returning funds and using your taxable account to invest in more conservative funds.