Which assets don't belong in an IRA.

Americans have billions of dollars invested in individual retirement accounts. How this money is managed can make the difference in securing a safe and comfortable retirement. But not all investments and activities are appropriate in IRAs for tax, legal and investment reasons. If CPAs help clients make the right decisions about which assets to include, over a lifetime the amounts available for retirement will increase significantly. To help CPAs advise clients on IRA investments, this article discusses activities IP.As should not engage in because of potential tax penalties, describes investments that generally should be put in an IRA as well as those--because they already are tax-advantaged--that should be held outside.

PROHIBITED ACTIVITIES

A number of activities and investments could have adverse tax consequences if undertaken in an IRA.

Borrowing. Internal Revenue Code section 4975(c)(1) prohibits borrowing from an IRA by the owner or the owner's beneficiary. If it occurs, the IRA ceases to be tax deferred as of the first day of the taxable year in which the transaction takes place. As a result, the entire fair market value (net of any tax basis) becomes taxable income subject to regular income tax and to an additional 10% premature withdrawal penalty tax unless an exception under IRC section 72(t)(1)(A) applies.

There is a limited opportunity for IRA owners to "borrow" from an IRA without penalty. If funds are withdrawn and subsequently redeposited into the same IRA or into another qualified IRA within 60 days, the transaction is considered a rollover, not a loan. No adverse tax consequences will result.

Under IRC section 408(e)(4), pledging an IRA as security for a loan, instead of actually borrowing from the account, also is a prohibited transaction, but the penalty is less severe. Only the portion pledged becomes subject to regular income tax and to a possible 10% penalty. Unlike when actual borrowing occurs, the account does not lose its tax-deferred status.

Collectibles. IRAs should not hold investments in so-called collectibles--such as works of art, rugs, antiques, metals, gems, stamps, alcoholic beverages, musical instruments and coins (except certain U.S. Treasury gold or silver coins). If a collectible is placed in an IRA, its cost to the IRA is viewed as a constructive distribution to the owner. This amount is subject to regular income tax and possibly to the 10% premature withdrawal penalty. To prevent the cost from being taxed again when the item is withdrawn from the account, any amounts included in income when the collectibles were put in the IRA are not included in income when they are distributed.

Unrelated business taxable income (UBTI). UBTI generated by IRA investments is directly taxable to the account. An IRA generates UBTI when it directly owns a sole proprietorship or an interest in a partnership or S corporation. An IRA also has UBTI if it makes leveraged investments (unrelated debt-financed income). Such income is generated, for example, when stock is purchased on margin or money is borrowed to acquire real estate. IRC section 514 explains the UBTI calculation formula.

If an IRA generates more than $1,000 of UBTI, the fiduciary is required to file form 990-T on the account's behalf. The applicable tax rates are the same as those for trusts. If a return is required, the fiduciary must obtain an employer identification number and make quarterly estimated tax payments.

INVESTMENTS THAT WORK BETTER OUTSIDE IRAs

Income on IRA investments compounds tax deferred until it is withdrawn--usually at retirement. Then, all distributions are taxed equally regardless of source. That means certain tax-free, tax-deferred or tax-sheltered vehicles are better maintained outside IRAs.

Municipal bonds. Municipal bonds or municipal bond funds should always be held outside IRAs. Because interest is exempt from federal income tax (and also may be exempt from state and local taxes), the yield compared with that of taxable bonds of comparable risk is lower. Since investors receive no greater tax advantage by having municipal bonds in an IRA rather than taxable bonds and the latter earn a higher yield, investors are always better off buying taxable bonds for IRAs.

U.S. savings bonds. Like municipal bonds, series EE savings bonds are tax-advantaged, and investors earn lower yields compared with similar fully taxable investments. A cash basis taxpayer is allowed to postpone declaring the interest on these bonds until the earlier of redemption or the maturity date--30 years from when they were issued. As a trade-off, however, the EE bond yield is only 85% of the market yield on five-year Treasury securities if the EE bonds are held at least five years. Therefore, an investor should acquire higher yielding Treasury securities for an IRA instead of EE bonds.

Variable annuities. Variable annuities--essentially mutual funds with a modest insurance element--are not appropriate for IRAs. Because of the insurance feature, earnings from variable annuities are tax deferred. While they may make sense outside of IRAs under certain circumstances (see "Tax-Advantaged Investing: Comparing Variable Annuities and Mutual Funds," JofA, May91, pages 71-77), buying variable annuities instead of mutual funds for IRAs adds an extra layer of insurance fees in exchange for only a very modest amount of protection. These fees--known as mortality and expense risk charges--re primarily to compensate the insurer for providing a guaranteed death benefit. Investors who wish to include mutual funds in IRAs should buy them outright rather than through variable annuities, thus avoiding the extra fees.

THE BEST PLACE FOR STOCKS AND BONDS

As an investor develops a diversified portfolio, some investment vehicles will yield better results if they are held outside an IRA. All investors generally need to diversify their portfolios across three broad asset groups: equities (stocks), bonds and cash equivalents such as Treasury bills or money market funds. Within stocks and bonds, investors should diversify further. For example, within the stock category, investors should diversify among large capitalization, small capitalization and international stocks, buying individual stocks or mutual funds. Within the bond category, investors should diversify across bonds of different maturities and among such individual bond or mutual fund categories as U.S government, mortgage-backed, investment-grade corporate, high-yield (junk) corporate and municipal.

If all of an investor's assets are held in retirement plans, to ensure adequate diversification all the above categories (except municipal bonds) should be included in an IRA portfolio. If, however, an investor holds some of his or her assets outside retirement plans, he or she must decide which assets are better held inside and which outside an IRA.

In making this decision, investors should adhere to two general guidelines:

1. Assets that are expected to generate the greatest relative pretax returns should be held in an IRA. This allows more income to compound tax free. (Exhibit 1, above, shows the historical returns of the three major financial asset classes. It illustrates that stocks historically have earned higher returns than bonds and Treasury bills and thus meet this guideline better than the other asset classes.)

2. Assets whose returns are tax-advantaged should be held outside an IRA since no further tax benefit is gained by including them in the account.

Stocks. Historically, stocks have provided the greatest annual return (10.33%), consistent with their greater annual volatility (20.45%), compared with bonds and cash equivalents. Stock returns are composed of two parts: dividends and capital appreciation (increase in value). Although the dividend portion is immediately taxable as ordinary income, the capital gain portion is tax-advantaged. Net long-term capital gains are taxed at a maximum rate of 28%, and capital gains on stocks are taxed only when they are realized upon sale. (Being able to defer tax on appreciated stocks results in a greater aftertax return because the deferred tax effectively provides investors with an interest-free loan from the government.)

* Best choices to include in an IRA. Investors should include in IRAs stocks and stock funds with relatively high dividend yields. For example, investors might hold utility stocks and real estate investment trusts (REITs) since they usually pay high dividends. Stocks an investor intends to hold for shorter periods of time such as cyclicals also might be included in an IRA. Mutual funds that emphasize stocks paying significant dividends such as equity-income funds and funds with rapid turnover rates also would be logical inclusions.

* Best choices to hold outside an IRA. Stocks an investor expects to hold for several years and stock mutual funds that emphasize long-term holdings should be held outside IRAs since low turnover translates into greater tax deferral because taxable gains are realized less frequently. Also, stocks and stock funds whose returns are composed primarily of capital gains (as opposed to dividends) are best left out of IRAs to obtain maximum benefit from deferring capital gains until sale and from any favorable difference between the capital gain tax rate and the rate on ordinary income.

Outside an IRA, an investor's stock selections might emphasize growth stocks since their returns are likely to consist primarily of capital appreciation instead of dividends. Moreover, investors should purchase such stocks intending to hold them for long periods to maximize tax deferral. Among stock mutual funds, stock index funds are a logical choice since their portfolio turnovers normally are very low.

Fixed-income securities. Assuming stable interest rates, the total returns from fixed-income securities are immediately taxable interest (or dividends if held through mutual funds). Since fixed-income securities are not tax-advantaged, expected returns are the sole criterion in determining which should be placed in IRAs and which should be held outside.

* Best choices to include in an IRA. Within IRAs, investors should place riskier fixed-income securities such as long-term or junk bonds or bond funds since they are expected to yield higher returns.

* Best choices to hold outside an IRA. Investment-grade short-term debt such as Treasury bills and money market funds should be held outside IRAs since their returns are expected to be lower than riskier fixed-income securities.

International assets. International investments include direct investments in the stocks or bonds of foreign corporations. They also include international funds (which exclude U.S. investments) and global funds (which invest worldwide, including in the United States) that invest more than 50% of their total assets in the stock or other securities of foreign corporations.

* Best choices to hold outside an IRA. Investments in individual foreign securities or mutual funds that hold primarily foreign securities are ideally left outside IRAs to receive tax credits on the foreign taxes paid. The credits reduce the investor's tax liability on a dollar-for-dollar basis, subject to certain limits. When foreign stocks or bonds or funds owning foreign securities are held in IRAs, any taxes withheld by a foreign country merely reduce the IRAs' market value. The option of receiving a tax credit is not available.

MAXIMIZING FUNDS FOR RETIREMENT

In the final analysis, IRA owners are responsible for deciding on their own how the accounts are invested. Because of the numerous tax, legal and investment pitfalls that exist, however, CPAs can play a valuable, ongoing role in helping clients manage their IRAs in a way that maximizes the amounts available at retirement. Exhibit 2, above, provides a guide IRA investors can use to help them select the right investments.

Who Manages Their Own IRAs?

In 1994, $318 billion was held in self-directed individual
retirement accounts, representing 35% of the $917 billion
in IRAs.

Source: Investment Company Institute, Mutual Fund Fact Book

Exhibit 1: Historical Returns of Asset Classes
From 1926 to 1994

(when inflation averaged 3.13%)

                                 Average      Standard
                                 return       deviation

Large company stocks             10.33%        20.45
Long-term government bonds        5.02          7.58
U.S. Treasury bills               3.69          1.67

Source: Ibbotson Associates, Stocks, Bonds, Bills, and
Inflation: 1994 Yearbook.


Exhibit 2: IRA Investors Guide

Prohibited activities between an IRA and its owner
* Borrowing from the account or pledging it as security
  for a loan.
* Putting collectibles in the account.
* Allowing the account to generate unrelated business
  taxable income.

Investments that should always be left outside an IRA
* Municipal bonds.
* U.S. Savings Bonds.
* Variable annuities.

Investments best left outside an IRA
* Stocks with low dividend yields held for the long term.
* Stock mutual funds that emphasize long-term holdings.
* International investments.

Investments best held in an IRA
* Fixed-income investments expected to yield high returns.
* Stocks with high dividend yields.
* Stocks expected to be held short term.
* Mutual funds that emphasize stocks paying high dividends.
* Mutual funds that expect to hold stocks short term.

EXECUTIVE SUMMARY

* HOW MONEY IN INDIVIDUAL RETIREMENT accounts is invested can make the difference in securing a safe and comfortable retirement. But not all investments are appropriate for tax, legal and investment reasons. Clients who make the right investment decisions will find that the amounts available at retirement will increase significantly.

* A NUMBER OF PROHIBITED ACTIVITIES could result in adverse tax consequences, including losing the account's tax-deferred status. Borrowing from an IRA by the owner or beneficiary is prohibited. An IRA also cannot invest in collectibles such as art, antiques or stamps. If it does, the cost of the items will be considered a constructive distribution and subject to tax.

* BECAUSE INCOME ON IRA INVESTMENTS compounds tax deferred until it is withdrawn, certain investments are better held outside the account. Tax-exempt municipal bonds, for example, offer no additional advantage if held in an IRA. Similarly, series EE U.S. savings bonds and variable annuities are better maintained outside an IRA because they already are tax-advantaged.

* SUITABLE IRA INVESTMENTS INCLUDE high-yield stocks, bonds and mutual funds. Investors also might hold utility stocks and real estate investments trusts since they usually have high dividend yields.

RICHARD B. TOOLSON, CPA, PhD, is associate professor of accounting, Washington State University,, Pullman.