With the plethora of investment options available to individual investors, it can be hard to know where to put your retirement investment dollars. Mutual funds offer the twin benefits of giving you an instantly diversified investment portfolio, and professional management of that portfolio. Individual retirement accounts provide significant tax advantages. By putting mutual fund shares in your IRA, you can get the best of both investment worlds.
Mutual Fund Income
A mutual fund collects income in a variety of ways, depending on the type of investments the fund holds. Funds that invest in stocks might receive ordinary dividends, while funds that invest in bonds typically receive interest income. Some funds might invest in tax-free municipal bonds, while others invest in U.S. government securities that are exempt from state income taxes. Funds that buy and sell securities typically receive capital gains or losses from those trades, which might be long-term or short-term.
Mutual Fund Pass-Through
The income and any tax implications that goes with it, are typically passed through the mutual fund to the fund's shareholders on a per-share basis. Ordinary dividend income is taxable to the shareholder at his ordinary income tax rate, even if those dividends are automatically reinvested in additional mutual fund shares. Interest income is taxed as ordinary income. Passed-through interest from municipal bonds is usually exempt from federal income taxes, and capital gains distributions are taxed based on whether the trades in the mutual fund were long-term or short-term.
IRA Tax Deferral
Taxes on investment gains in your individual retirement account are deferred as long as the money remains in your IRA. That includes any distributions from a mutual fund that you hold in your IRA, regardless of how the income for those distributions was earned. You can also defer any capital gains taxes that would otherwise result from selling your mutual fund shares inside your IRA.
Withdrawals from your traditional IRA are always taxed as ordinary income, and qualified withdrawals from your Roth IRA are free from federal income taxes, regardless of how the money in the account was earned. This should influence your decision on the type of mutual fund to hold in your IRA. For example, a mutual fund that invests in municipal bonds would produce distributions that would normally be free from federal income taxes. Because you have to pay ordinary income taxes on all withdrawals from your traditional IRA, if you hold that mutual fund in your IRA you would lose the advantage of the tax free income.