Should You Hold ETFs in an IRA?

ETFs trade like stocks throughout the day and tend to be more liquid than mutual funds; however, their net asset value may experience fluctuations which affect their discount and premium ratios.

Selecting ETFs or mutual funds in an IRA depends on an investor’s goals, preferences, and investment objectives as well as costs, taxes, and liquidity considerations.

Cost

One of the primary differences between ETFs and mutual funds is cost: ETFs typically have lower expense ratios than mutual funds, making them a more cost-effective choice for your IRA.

ETFs offer high liquidity, enabling investors to purchase or sell shares throughout the day at market prices. This flexibility can help if you want to make tactical adjustments to your portfolio; however, be careful of overtrading; overtrading is often responsible for underperformance for newer investors and can result in subpar returns over time.

ETFs also pay out dividends to shareholders, which are considered taxable income but can be reinvested via dividend reinvestment plans (DRIP) into an IRA to reduce tax liability. Investors should research each ETF’s history, management team and holdings carefully to make sure it fits with their investment goals before determining if holding it in an IRA or regular brokerage account would best meet them.

Taxes

ETFs may offer advantages when it comes to tax efficiency in an IRA; however, the difference may not always be noticeable and will ultimately depend on who manages and trustees your IRA account.

ETFs are known for being highly tax efficient, which can save on brokerage commissions and lower your taxes significantly. But that benefit doesn’t apply to assets with frequent capital gains distributions such as bond ETFs (VCRB, FBND and IUSB).

To determine which ETF should be included in your IRA, first establish your investment objectives: Are you seeking growth through capital appreciation of assets, current income or some combination? Next, assess your risk tolerance. Older investors nearing or in retirement should favor income-oriented ETFs that offer low to moderate volatility while younger investors might tolerate more aggressive growth ETFs with greater levels of volatility. Once this decision is made, carefully examine each ETF’s fee structure and trading liquidity before selecting one for inclusion.

Liquidity

Consideration should be given to the liquidity of a portfolio when investors need access to cash quickly. Liquidity refers to how easily an investment can be sold for cash without impacting market value; lacking it could mean not raising enough funds for unexpected expenses such as unexpectedly replacing an air conditioner unit, for instance.

ETFs tend to be less costly and trade throughout the day, making them more liquid. However, ETFs don’t always trade at their net asset value (NAV), so investors must be wary of implicit costs such as bid/ask spread.

Before investing in an ETF, determine your investment goals and risk tolerance, then select an investment strategy that aligns with them, such as growth or income strategies. Some ETFs offer leveraged returns which may increase returns but increase losses as well. Lastly, try finding one with a low expense ratio to save on fees.

Investing

The process for investing ETFs in an IRA will depend on your goals, preferences and investment options; however, there are several key points you should keep in mind.

Some ETFs follow specific indexes such as the S&P 500, Russell 2000 or Nasdaq Composite while others specialize in particular sectors, asset classes or regions of the world. When selecting an ETF to invest in you should also take your risk tolerance and time until retirement into account.

ETFs typically feature lower expense ratios compared to mutual funds, offering you potential long-term higher returns in retirement savings. Furthermore, their structure helps minimize capital gains distributions that might lower tax liabilities when withdrawing funds in retirement.

Fidelity Core Total Bond Market ETF (FBND), for instance, tracks the Bloomberg US Aggregate Bond Index and charges annual fees of 0.36%. Each year after fees, gains are distributed on a mark-to-market basis – so at year’s end you’ll receive a Form 1099 K reflecting your share of realized capital gains in your portfolio.