Buy Today, Tax Tomorrow

Uncle Sam wants your money again as tax season is now upon us. That means time for Americans to tally up their tax bills and pay up. And while the time for serious tax planning for the current filing season passed at the end of 2007, you can still do a few thing to lighten your liability, like making a tax deductible contribution to an individual retirement account.

Forbes.com recently called up some market pros and asked them this question: What are the best funds for your IRA? That's an admittedly broad question since the answer depends on what you already own and what your time horizon is.

The limits to what you can kick into your IRA have been lifted. In 2008, you can now exclude up to $5,000--$6,000 if you're 50 or over-–from your taxable income. That amount will grow tax-deferred until you withdraw it, at which time it's taxed at your marginal income tax rate.

"However much you can put away is worth it," says Daniel Wiener, portfolio manager and editor of the newsletter Independent Adviser for Vanguard Investors. "You don't know what the future holds in terms of Social Security, and you don't know what it holds in terms of taxes, but you certainly do know that it makes a lot of sense to put away as much tax-deferred money as you can. Get that money working for you as early as possible."

In his newsletter, Wiener advises his readers to remember that every additional dollar they add to a tax-deferred account is a dollar that can grow on itself, and its gains, for as long as they keep it within the tax-sheltered wrapper.

Granted, that $5,000 annual maximum might not seem like an impressive chunk of change. But consider what it can become. Let's say you started today making monthly contributions to hit that $5,000 limit–-which works out to $416.67 per month-–and you did this every month for the next 30 years.

Assuming an 11.6% annualized return, the historical average for large-cap U.S. stocks, you will enjoy a portfolio value of $1.25 million by 2038. Factor in an inflation drag of 3.0% on those returns and you still have more than $687,000 in capital.

So where should you put your money to work?

For the young investor, Christopher Davis, Morningstar fund analyst, says to look for a solid core holding, one that is well diversified across the different market sectors, and generally focuses on larger companies.

"One great solution for many investors getting started is some kind of all-in-one, fund-of-funds," Davis says. He likes T. Rowe Price Personal Strat Growth fund (TRSGX).

"The funds it invests in are good, with good managers at reasonable price tags," Davis says. "This fund does all the work for you."

For that same relatively young investor, Wiener likes another big shotgun: the Vanguard Global Equity fund (VHGEX).

"It instantly gives you access to a bunch of terrific asset managers and access to the world's economy because it's a global fund," he says. "You get access to the U.S. and foreign markets. Also, the managers have a value, mid-cap orientation. You won't have some big growth whipsaw hitting your IRA. It's a great fund."

Another fund for investors looking to play the global growth story is the WisdomTree International MidCap Dividend Fund (nyse: DIM).

"There are two key benefits of DIM," says Ron Rowland, editor of All Star Fund Trader. "First, its unique focus on international dividend paying stocks, ideally positioned between large and small stocks. Second, DIM is screened by a fundamental overlay that focuses on earnings and dividends. It's not a pure market cap schematic."

Rowland notes that this fund has a low expense ratio of 0.58%, and has produced a cumulative return of 27.9% since June of 2006, vs. 21.6% for the MSCI EAFE Index.

For older investors, it gets a little trickier. Wiener in fact thinks VHGEX works just as well for a 50-year-old investor. "If he is just starting out then I like Global Equity as well," he says. "That person has to catch up."

But it's harder, Wiener says, to say what funds a 50-year-old investor who has been in the game for a long time should include in his IRA because you first have to know what he already owns.

Plus, other considerations quickly come into play for more seasoned investors: Do they work at a company where they have a 401(k)? Do they have big loans, mortgages? A spouse who works?

Morningstar's Davis points out that conventional wisdom holds that investors should hold stocks in taxable accounts and bonds in tax-protected accounts, like IRAs. The idea there is that bonds throw off a lot of income, which is taxed at high ordinary income tax rates. But Davis argues it might make more sense to put those stocks in an IRA.

"You have to live on the returns you're earning on an after- tax basis," Davis says. "So what good does it do if you fritter away those after-tax gains to the tax man?"

An example of such a high turnover, aggressive fund, Davis says, is CGM Focus (CGMFX). Turnover at this fund, analysts points out, is incredibly high, which generates a big capital gains tax liability. But the fund also produces impressive results: five-star CGM, over the last 10 years, has generated a 24.67% annualized total return.

As important as tax considerations are, though, they shouldn't dominate your investment strategy, says Wiener. Buy a fund, he says, only if it's a solid, wise pick in its own right.

"If you have a choice between two funds and you would buy them anyway, then put the least tax-efficient one in the IRA," he says. "But don't use tax efficiency as a way to choose a fund for an IRA."

There are more important questions to think about before tax considerations, Wiener says, like the manager, his track record and the needs of your portfolio.