Diversification: Bonds vs. cash

(Money Magazine) -- Question: Why are bonds always recommended to diversify stocks? Since bond funds are yielding no better than FDIC-insured money-market accounts, why not hold cash instead? - Ervin Mubarekyan, San Diego

Answer: First, those great money-market rates can't last. Second, unlike a money-market account, bonds have more going for them than their yields.

Looking for some answers? Send us your questions about investing. E-mail answer_guy@moneymail.com.

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What makes bonds so useful alongside stocks is that bonds not only provide steady interest income but also can appreciate in value - and often do so when stocks are falling. In part that's because the steady income they generate makes them more valuable to investors at times of crisis. A money-market account (or a money-market mutual fund) doesn't offer the chance for capital gains.

And like all good things, high money-market pay-outs will come to an end soon, thanks to the Federal Reserve's recent reduction of a key short-term rate. The best strategy, advises Richard Ferri, author of All About Asset Allocation, is to stick with intermediate-term bond funds. They offer better diversification, and today's rates notwithstanding, they historically yield 1.5 percentage points more than money funds.

Question: In your August column you suggested opening a nondeductible IRA as a way to back into a Roth IRA in 2010. Would this create tax problems with my decades-old IRA? - Marcus B. Seligman, Savannah

Answer: If by "tax problems" you mean "a surprisingly big IRS bill," you're right. Answer Guy's strategy for using new tax laws to open up a Roth - even if your high income blocks current contributions - works for new IRAs but can be costly if you have a pre-existing one.

Here's why: The taxes you pay on a traditional-to-Roth IRA conversion are based on all your non-Roth IRAs, not just the one you convert. Let's say, for illustrative purposes, you make a $4,000 nondeductible contribution to a new IRA that grows to $4,400 by the time you convert it to a Roth in 2010. If, like the August questioner, you had no other IRA, only that $400 gain would be taxable as income.

But let's say you also had $100,000 in an old IRA funded with deductible contributions. Under the IRS formula (we'll skip the math) you'd owe taxes on $4,200 of the $4,400 you convert. On the bright side, you can delay payment and split the bill over your 2011 and 2012 returns. Bottom line: Big gains and deductible contributions in old IRAs make the backdoor Roth less attractive.

--Looking for answers? Send us your questions about investing. E-mail answer_guy@moneymail.com.