Funds Made for Your IRA

Tax season is upon us, so let's talk about picking a mutual fund for your IRA. Your search begins with your investment plan. Review it annually to see if you lack a sector or need to beef up an asset class. As you begin to narrow the field with fundamental criteria, remember this: Some funds have "IRA!" written all over them.

A matter of timing

When a fund realizes capital gains by selling stocks or bonds at a profit or receives interest or dividends, any amount above the fund's expense ratio must be paid out to shareholders, who are then taxed on that income. Some funds are much better than others at shielding shareholders from taxable income and capital-gains payouts. And some investors make it a habit to steer clear of "tax-inefficient funds," those that pay out a substantial portion of each year's gain as taxable income.

When you're choosing a fund for an IRA, though, you can ignore this issue. The attraction of IRAs and other tax-sheltered accounts, of course, is that the profits aren't taxed right away. Instead, they compound until you actually withdraw the money from your account. Only then do you pay the tax.

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That means some funds you might avoid in a taxable account are suddenly back on the menu when you're investing in your IRA. Here are four examples -- each representing a different asset type -- that present tax problems in taxable accounts but can be terrific inside a tax shelter.

At T. Rowe Price Global Stock (symbol PRGSX), manager Rob Gensler's turnover has exceeded 100%, so shareholders are quickly taxed on their gains. Now the good news: The fund hasn't been discovered yet because Gensler took over in 2005, following his outstanding run at T. Rowe Price Media & Telecommunications. At Morningstar, we made it a Fund Analyst Pick a year after Gensler took the helm because we liked his previous record. The fund has only $400 million in assets, so Gensler has flexibility to pursue his strategy of finding growth companies with sustainable competitive advantages in the U.S. (roughly 50% of the portfolio) and abroad. He runs a fairly focused portfolio, so be prepared for some bumps. The fund returned a category-beating 23% in 2006.

Pimco StocksPlus D (PSPDX) employs a clever strategy: It invests in index futures but tries to beat the underlying benchmark (Standard & Poor's 500-stock index) by using a bond overlay. The core idea is to choose bonds that will beat the LIBOR rate, which is priced into futures contracts. Succeed by more than the fund's 1.03% expense ratio and you'll beat the index (and any traditional index fund tracking the index). Since its 1993 inception, the Pimco fund has virtually tied the S&P 500 on an annualized basis. The catch is that nearly all the yearly returns come as taxable income. So this one is for IRAs and 401(k)s only.

Arbitrage funds, such as Merger (MERFX) and Calamos Market Neutral Income A (CVSIX), can produce solid returns that have a very low correlation to those of the market. For example, during the bear market of 2000Ð02, Merger posted calendar-year returns of 18%, 2% and -6%, and Calamos returned 10%, 8% and 7%. These funds are Òmarket neutralÓ because they try to capture inefficiencies that have little to do with the market's direction. For example, Merger buys shares of companies about to be acquired. It profits from the spread between the price just after the announcement and the price when the deal closes. The difference is the risk premium that the deal won't go through. Although this makes Merger a good diversifier, arbitrage leads to lots of capital gains and income. Save this fund for your IRA. The same advice goes for Calamos Market Neutral Income, which does convertible arbitrage -- that is, it buys undervalued convertible securities and shorts the stocks of the issuing companies.

Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.