Mutual Funds and Retirement Savings

The tax law provides a variety of vehicles for retirement savings, including:

• IRAs (regular IRAs, Roth IRAs, SEP IRAs)
• 401k and 403b plans
• Keogh plans (also known as HR 10 plans)
• SIMPLE plans

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Any of these plans can be set up to permit investments in mutual funds. (If the plan is set up by an employer, the employer decides whether to offer mutual funds as an investment choice, and if so, which ones.) Often there will be a choice of several mutual funds. In choosing a mutual fund investment for your retirement savings it's helpful to understand the tax rules that apply here.

All earnings treated the same

For investments inside a retirement plan, all forms of earnings are treated the same way. Capital gains are treated the same as dividends. Municipal bond interest is treated the same as interest on a certificate of deposit.

• When the income goes in. The retirement plan doesn't pay tax when it receives the earnings. This is true for all types of earnings except "unrelated business" income. So all types of income are treated the same on the way in.
•  When the income comes out. All income is treated the same when it comes out of the IRA or other retirement plan, too. In a Roth IRA, if you meet certain requirements, all distributions are tax-free — including earnings of every kind. In other retirement plans, distributions of earnings are taxable. And they're always taxable as ordinary income.

Example: You have a regular IRA and you choose to invest it in a mutual fund. Earnings from this fund include ordinary dividends, capital gain dividends and tax-free distributions. When you withdraw the earnings from the IRA you must treat the entire amount as ordinary income.

We can sum this up in a single sentence:

Inside an IRA or other retirement account, long-term capital gains and exempt income are no better than ordinary income.

Choosing a fund

When choosing a mutual fund for your IRA or other retirement plan, tax benefits are not a plus. In fact, the presence of tax benefits may be a negative factor. It would almost never make sense to buy a municipal bond fund in an IRA. You would get a lower return than in a corporate bond fund with a similar risk profile, but you would still have to pay tax on the earnings when you received distributions.

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