Exchange-traded and target-date funds, as well as Roth IRAs, are on a short list of the best developments for investors over the past few decades. Thanks to efficient design, tax-friendliness, or both, all have the potential to improve investors’ take-home returns. Yet even as these investments and investment “wrappers,” in the case of Roths, have eclipsed existing alternatives, old-fangled, less-popular alternatives can sometimes be as sensible a choice, if not an even better one.
Eclipsed by: Exchange-traded funds
Why you should consider them: Exchange-traded funds have garnered more attention than traditional index funds in recent years, thanks to the former’s widely touted trading flexibility and tax efficiency. But index funds and ETFs, especially the large, broad-market versions, have a key virtue in common: low costs. And unless an investor values the ability to trade intraday–and it’s hard to see why most strategic investors would want to do so–the fact that traditional index mutual funds are priced just once a day shouldn’t be a drawback. Finally, depending on the specific product and index a fund or ETF tracks, index funds can be just as tax-efficient as their ETF counterparts. That’s because broad-market equity index funds and ETFs share very low turnover, which contributes to their tax efficiency. Vanguard’s ETFs, meanwhile, are designed as share classes of the traditional index mutual funds; that setup allows the index funds to be especially tax-efficient because the ETFs can flush out low-cost-basis shares to pay off large, departing shareholders, among other tactics. Indeed, Vanguard 500 Index , a plain-vanilla S&P 500 mutual fund, has lower tax-cost ratios and better long-term tax-adjusted returns than its ETF counterpart that also tracks the S&P 500, SPDR S&P 500 ETF .Tax-Managed Funds
Eclipsed by: Exchange-traded funds
Why you should consider them: Here’s another category that has struggled to gain attention in recent years. Some shops, such as Putnam, have scuttled their tax-efficient equity funds altogether. It’s true that broad-market equity index funds and ETFs do a reliable job of reducing the drag of taxes on their returns (see above); low turnover means few capital gain distributions. But tax-managed funds have an important advantage relative to the index trackers: They can adjust their strategies to conform to the current tax regime. For example, if dividends were once again taxed at ordinary income tax rates (as they were before 2003), tax-managed funds could reduce the importance of dividend payers in their portfolios, whereas index funds would have no such latitude. That’s the key reason why I’ve used tax-managed equity funds in my tax-efficient model portfolios, though I’ll concede that tax-managed funds aren’t available in each and every category. I used a foreign-stock index fund for overseas exposure in my tax-efficient portfolios, for example.Static Allocation Funds
Eclipsed by: Target-date funds
Why you should consider them: Although they still account for a healthy share of mutual fund assets, all-in-one funds that maintain static asset allocations, such as balanced funds, have fallen off many investors’ radars in recent years. Accumulators have gravitated to (or more likely, been opted into) target-date funds, which feature gradually more conservative asset allocations. Such funds are the ultimate in hands-off investing, and appear to do a good job of keeping investors in their seats, helping them earn a healthy share of the funds’ returns. Tactical asset allocation funds, meanwhile, have grabbed the attention of investors seeking all-weather performance (though they’re still a small share of the fund universe and their results, in aggregate, have been decidedly mixed). That said, a static-allocation fund can still play a role in some investors’ portfolios. For example, if an investor is investing for a goal other than retirement–such as a home down payment–such funds can provide all-in-one diversification; the investor with a long-term goal can choose a more equity-heavy option, while the shorter-term investor can focus on funds with lighter equity weightings, such as those in the allocation–15% to 30% equity group. And while my preference is for discrete stock and bond holdings in retirement portfolios, the better to facilitate rebalancing, some retirees may find that all-in-one static-allocation offerings deliver the income the income they need in a single diversified package.Traditional IRAs
Eclipsed by: Roth IRAs
Why you should consider them: Roth IRAs have gained a lot of buzz since they became an option in 1997. Not only do they allow tax-free withdrawals in retirement, but as of right now, they do not carry required minimum distributions after age 70 1/2, the bane of many an affluent retiree. But amassing Roth assets isn’t the right answer for every investor, as discussed here. For investors getting close to retirement who haven’t yet saved a substantial sum, it’s a good bet their tax rate in retirements will be lower than their tax rates while they were working. Thus, it’s more beneficial for them to make a contribution to a traditional deductible IRA (assuming their income levels are below the thresholds for doing so) and obtain the tax break now than they are waiting to take tax-free withdrawals in retirement, as is the case with Roth IRAs.Moreover, most dollars in IRAs got there because employees rolled over their assets from their company retirement plans; unless the employee pays taxes to convert those traditional 401(k) assets assets to Roth at the time of rollover, or had been making Roth 401(k) contributions, those rollover assets will remain traditional IRA assets. Coverdell Educational Savings Accounts
Eclipsed by: 529 College Savings Plans
Why you should consider them: In the college savings sweepstakes, Congress has clearly given the nod to 529 college savings plans over Coverdell Education Savings Accounts. Contribution limits to 529s are much more generous and income limits do not apply; 529 investors may also be able to obtain a state tax break on their contributions while benefiting from tax-free compounding and withdrawals for qualified college expenses. Coverdell contributions, meanwhile, are limited to just $2,000 per year per beneficiary, and income limits apply to those contributions. College savers with modified adjusted gross incomes higher than $110,000 for singles and $220,000 for married couples filing jointly cannot make Coverdell contributions at all. Because of these limitations, many investor providers have stopped offering Coverdell ESAs altogether.That said, Coverdells shouldn’t be dismissed and can reasonably be used in conjunction with 529 assets. In contrast with 529s, which allow tax-free withdrawals only for qualified college expenses, Coverdell ESA investors can take tax-free withdrawals for elementary and secondary school expenses, too; many families paying private school tuition use Coverdells for pre-college educational expenses and 529s for college. Moreover, in contrast with 529s, where investors must choose from a preset menu of choices, Coverdell investors have more latitude. An investor in a Coverdell through Schwab, for example, could employ Schwab’s ultralow-cost ETFs and index funds to populate her portfolio, and would pay no ongoing account-maintenance fees.