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Investment Ideas

With tax season ending, many investors are likely scrambling to make one final IRA contribution for the 2012 tax year.

Yet despite the popularity of the investment vehicle, there is still a great question of what type of security belongs in an IRA. This problem is further confounded by ETFs, as these have various product structures, tax treatments, and other issues, each of which need to be considered for IRA investment.

What type of ETF to put in an IRA?

Most agree that muni bonds are poor choices for IRAs, suggesting that funds like (MUB - ETF report) are out. That is because these are tax-favored securities that don’t pay any federal income tax anyway, so there is less incentive to shelter these types of bonds.

Beyond that though, there is a great deal of debate on what type of asset to put into an IRA. Some believe that growth securities are better suited as they can grow tax-free in a Roth, and if you taking gains off the table in a traditional IRA (but keeping them in the account), there isn’t a tax liability.

Others believe that higher yielding ETFs should be the top holdings in your IRA instead. This is because for traditional IRAs, income payments (that are kept in the account) grow tax-deferred while Roth investors see tax-free (for the most part) dividends and income payments.

This is extremely important as it can make a huge difference over time thanks to compounding. This is particularly true given the recent hike in taxes, both in terms of dividends and ordinary income, suggesting that now more than ever is the time to consider putting solid performing income products into a tax sheltered account (see 3 Excellent ETFs for Income Investors).

And in many cases, there are high yielding exchange-traded products that pay out yield as ordinary income anyway. This type of payout is already taxed at normal (39.6% top marginal level) rates, so putting it into an IRA—either a traditional but especially in the case of a Roth—is probably a good idea.

While there are definitely a number of choices out there that fit this bill, we have highlighted three of our favorite higher yielding ETFs in this category below. Any of these make sense to us in a tax sheltered account, and especially for those who are looking to bank on high levels of income in their portfolios:

PowerShares KBW Premium Yield Equity REIT Portfolio (KBWY - ETF report)

In order to avoid double taxation, REITs pay out the vast majority of their income to unit holders. While this results in big payouts, it also makes the income taxed at ordinary rates, something that is generally a drawback, but isn’t much of an issue in a sheltered IRA account.

For this reason, it could be a good idea to look at any number of REIT ETFs on the market for broad exposure to the space. While there are a number of more popular choices like (VNQ - ETF report) or (SCHH - ETF report), for the purposes of this article we think KBWY presents an impressive opportunity (see Top ETFs for the Real Estate Recovery).

This is because KBWY follows a higher yield index for its exposure, while still staying in the equity REIT segment (in other words not venturing into the mREIT market). With this high yield, KBWY could be a better IRA choice, especially considering its 30-Day SEC yield is over 4.6%.

In terms of its portfolio, the ETF is a bit concentrated as just 34 REITs are in its basket. However, assets among these securities are well spread out, and there is a definite tilt towards small caps so growth is very possible for this potential IRA choice.

For fees, the ETF is relatively cheap at 35 basis points a year, although volume is a bit on the light side along with total assets under management. However, it is worth noting that bid ask spreads are still very tight for this fund, so total costs shouldn’t be too bad.

Credit Suisse Cushing 30 MLP ETN (MLPN - ETF report)

Some might question the pick of an MLP for an IRA. After all, MLPs can require K-1s and if enough of them are held, a declaration of unrelated business taxable income as well. However, due to the ETN structure, which is basically a debt instrument, these issues are eliminated although income is taxed at ordinary rates.

Fortunately for those in an IRA, this doesn’t really matter, meaning that MLP ETNs could be a decent fit in a tax sheltered account. While there a number of picks to like in the MLP world such as higher risk leveraged ETNs like MLPL, a more stable choice could be Credit Suisse’s MLPN.  

This note focuses on the Cushing 30 MLP index, which tracks midstream MLPs which look to be less impacted by commodity prices. Hopefully, this focus makes the fund a bit less volatile, though the income is still quite high (also read Boost Income and Growth with MLP ETFs).

In fact, levels are currently coming in above 5% in 12-month yield terms, although fees are a bit high at 85 basis points a year. Volume is spotty as well, but observed bid ask spreads have been relatively tight, so this shouldn’t be much of a concern.

And for investors who want to target MLPs in an IRA, this is one of the few viable options. Other types of securities—and especially individual MLP holdings—can suffer more burdensome tax issues, making MLP ETNs like MLPN top choices for the IRA structure.

PowerShares Senior Loan Portfolio (BKLN - ETF report)

Much like REITs, bonds are also interesting picks for IRAs for many of the same reasons. Their income is also taxed at ordinary rates, while bond ETFs do run into capital gains issues as well.

This is more-or-less irrelevant in an IRA though, suggesting that fixed income could have a decent home in an IRA structure. Particularly this is true in the junk bond ETF market as these securities pay out huge amounts of income on a regular basis (for another option see HYLD: Crushing the High Yield ETF Competition).

However, many investors are growing concerned about a bond bubble building suggesting that fixed income might not be right for all investors. Many of these worries though can be avoided by targeting shorter-duration securities such as BKLN.

This relatively new ETF focuses on the senior loan market, which is a subset of the junk bond world. However, bonds in this category are ‘senior’ to other types of debt, while they also use LIBOR for their yields.

This resetting yield feature helps to mitigate interest rate risk and greatly reduce losses that would happen in a bond bubble. And best of all, the product—despite having an average years to maturity of just over five years—has a 30 Day SEC Yield approaching 4%.

The fund also sees a great deal of interest from investors, and has actually surged up the popularity charts so far in 2013. So, the product should be easy to trade at a reasonable cost, and with the high rate of low interest rate risk income, could be an excellent long term pick for IRA investors.

Bottom Line

Investors have a number of decisions to make when it comes to their IRA, no matter if they possess a traditional or a Roth version. There are also a number of conflicting opinions when it comes to what to put in an IRA, but I like yield focused plays.

That is because the income gets to grow tax-free in a Roth IRA or tax-deferred in a traditional IRA. While this may not seem like a big deal initially, saving this tax year in and year out can really add up, and act as a huge catalyst for great returns (also see Three Great ETFs for Your IRA).

This is especially true in the case of the three aforementioned ETFs, as not only are they poised to do well in today’s market environment, but they pay out a great deal of income as well. And since their income would be taxed at ordinary rates anyway, holding them in a tax sheltered account makes the most sense over the long haul for IRA investors.

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