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3 ETFs for an IRA

Income-producing ETFs are great choices for tax-deferred accounts.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. It's IRA season. We have until April 18 to contribute to an IRA if we want the contribution to count toward 2021. Joining me today to share a few exchange-traded funds that are good picks for an IRA is Ben Johnson. Ben is Morningstar's global director of ETF research.

Hi, Ben. Nice to see you today.

Ben Johnson: Hi, Susan. Thanks for having me.

Dziubinski: Let's talk a little bit first about why an investor would want to put an ETF in an IRA considering that ETFs are often thought of as pretty tax-efficient vehicles in and of themselves?

Johnson: Well, it's a terrific question, Susan. And I think it's important to understand that if you as an investor have arrived at the point in sort of your tax-location strategy, your tax-optimization strategy, where you're mulling putting ETFs into an IRA, you've done a lot of the heavy lifting already. There are any number of different steps that you've probably already taken to make sure that you're paying as few pennies in taxes on your investments as you possibly can. So, if there are opportunities to locate ETFs, which to your point tend to be far more tax-efficient than mutual funds, in a tax-deferred wrapper, it is largely going to be a strategy where you're trying to shield some of the income that they might be throwing off from regular taxation given that ETFs, in the majority, tend not to pay out any taxable capital gains distributions, and if they do, they tend to be much smaller than what we see, certainly in recent years, being spun off of open-ended mutual funds.

Dziubinski: You bought three ideas with you today to share with investors. Your first one is Schwab US TIPS ETF (SCHP), which focuses on Treasury Inflation-Protected Securities. Seems like a timely idea. Tell us a little bit about why you think this is a good idea for an IRA, who it might be best for, and why today.

Johnson: Well, first and foremost, SCHP boasts many of the same benefits that we tout for any broadly diversified, low-cost ETF that represents the investment opportunity set in its particular corner of the market and is backed by a solid parent. So, SCHP ticks all of those boxes. Broad diversification sweeps in the entirety of the U.S. Treasury-Inflation Protected Securities market. It does so for very low fee, charging just 0.05% per annum. It's got the backing of Charles Schwab. The team that manages the portfolio has done a terrific job of providing high-fidelity tracking of that benchmark index. These are all winning traits either inside or outside of an IRA.

Now, why now? Inflation is a timely topic. Certainly, we've seen it recently hit levels as high as it's been in many investors' lifetimes, highest in decades. So, the way that TIPS work is that the taxable component, or a meaningful portion of the taxable income thrown off by this fund, is likely going to come into the form of those inflation adjustments. And if those inflation adjustments are larger than the market might anticipate, you could see the tax profile of this portfolio shift pretty dramatically. Generally speaking, TIPS funds are kind of fence-sitters when it comes to tax location. They might be just as well placed in a taxable account as a tax-deferred one. But if you're worried about inflation and potentially inflationary surprises, it might be time to take a look at putting a TIPS fund like SCHP in a tax-deferred setting.

Dziubinski: Ben, your second idea is Fidelity High Dividend ETF (FDVV), and that invests in high-yielding stocks. So, again, seems like to be a very good fit for an IRA. What do we like in particular about this ETF and why now?

Johnson:
Well, what we like about Fidelity High Dividend is its unique approach to building a portfolio of stocks that are paying above-average dividend yields that balances current income with a bit of risk mitigation. So, it looks on a sector-by-sector basis at the highest-yielding stocks within a particular sector. So, it's immediately focused on current income. But what we know about reaching for yield is that it courts risk. So, to help to try to mitigate that risk, first and foremost, it's looking at yield on a sector-by-sector basis. So, it's not pulling the portfolio in the direction of any given sector that might, for whatever reason, be sporting above-average yields or persistently have higher-than-average yields--a sector like real estate, for example.

The second measure that it takes is it looks at the stocks within that particular sector that have the lowest coverage ratios that are going to, in all likelihood, be least able to continue to support their current dividend payouts, and it eliminates those from the portfolios. So, what you get is a sector-neutral approach, an approach that screens out dividends that might be at risk. It's got a very low fee, a sensible strategy, and again a solid parent which, as I alluded to before, are three great traits that we look for in all of the ETFs that we choose to rate. This particular fund carries Morningstar Analyst Rating of Silver.

So, to your second question on the "Why now?" this might be an ETF that investors would consider parking in a tax-deferred account to shield that yield. So, its current yield is around 2.7%, which is more than double the current dividend yield on the Vanguard Total Stock Market Index ETF (VTI). Now, granted, dividends are taxed at lower rates than regular income might be, but to take it back to my initial comments, if you're really looking to eke out every last red cent of tax efficiency that you can to protect every last penny from the taxman, you may want to consider putting FDVV in a tax-deferred account.

Dziubinski: And then, Ben, your last pick today is Vanguard Real Estate ETF (VNQ), which again, another strategy that throws off some income, seems like a good fit for an IRA. Tell us a little bit about that ETF in particular.

Johnson: So, at the risk of sounding like a broken record, Susan, Gold-rated Vanguard Real Estate fund boasts broad diversification, covering the entirety of the opportunity set within the real estate sector, not inclusive of just REITs but also nontraditional real estate categories like timber and towers as well. And because it has a healthy slug of REITs in the mix and because of the way that REITs have to manage their income streams, throwing them back out the door to investors as a pass-through, that income is taxed at a higher rate than qualified dividend income, and it's coming out at a yield right now that is around 2.5%. So, this is another play where if you're going to consider putting this fund, which we think is a solid option for exposure to the U.S. real estate sector, you're putting it in a tax-deferred account chiefly as a means of shielding that yield from the taxman.

Dziubinski: Ben, thank you for your time today and for these ideas for an IRA this year. We appreciate it.

Johnson: Thanks for having me, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

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