Solving The Investment Account Puzzle: ROTH, Traditional, 401(k), Taxable—Arggh!

By:  Richard Hitchcock CFP®

When it comes to investing and trying to save for the future, consider how the normal family goes about it.  At first, there is usually a major effort to open a savings account at a bank or credit union (almost always just cash). After that mile stone is accomplished, then comes an IRA with a small yearly contribution. At work, a 401(k) (or something similar) is opened. Then, the contributions are put in with some available investments chosen, maybe, by talking to fellow employees.  

Over the years, this pattern continues.  It’s good because savings and investments are being made. It’s bad because there is little comprehensive overall coordination between the accounts. So, what should happen?

Investment accounts should be coordinated according to:

An overall risk profile

A risk profile is a type of measure of how comfortable one is with wide fluctuations in account values. A person with an aggressive risk profile is more comfortable with wide value swings than a conservative investor.  It is important to know what type investor one is because it helps one “stay the course” throughout market cycles.  It is also important to make sure the overall allocation of portfolios reflect the risk profile of the investor.

Quite often we see investors who have 401(k) type investments at work which are allocated in ways not reflecting the overall investment risk profile.  There is the tendency to have too much of a good thing or too much of the same thing.  It is important to put each account side by side to see the total investment picture.  It is then easier to see if the risk being taken is appropriate to the individual’s risk profile.

Tax Efficiency

Across the complete spectrum of investment possibilities, there are some investments that have different tax considerations.  Some investments may generate interest and dividends, some generate capital gains, and some (such as oil and gas partnerships) report on K-1s (a bit harder for the average person to use on their federal and state tax forms).

While we all want to be good, law-abiding citizens, we also want to minimize the taxes we owe.  It should be important to know which accounts hold the dividend and interest paying positions (IRAs for example) and which accounts hold positions that generate capital gains or losses and use K-1 reporting (taxable, non-qualified accounts.)

Ultimate distribution flexibility

As a family approaches retirement, the prospect of using and living off one’s accumulated assets becomes a big part of their retirement.  At that point, having flexibility as to types of income streams will be very helpful.  For example, having non-qualified accounts may help in high value purchases (Example: it would be challenging to take money off an IRA, pay the tax and then go buy a car.  It would be a 20% more expensive car!).  Having the choice of distributions from Roth IRAs vs Traditional IRAs will be important.  Other investment vehicles exist that have the possibility of distributions, which are partially tax free.

In short, it is important to consistently look at the full range of accounts to make sure the various types make sense for a particular goal in retirement.

Beneficiary maximization

Different types of accounts mean different possibilities once a beneficiary inherits the account.  Regular taxable accounts offer the possibility of stepped-up cost basis. Roth IRAs offer tax free distributions. Traditional IRAs, although taxable, have distributions that may be “stretched” for many years over the live(s) of beneficiaries.  It is important, not only to the original owner, but also to the entire estate, that appropriate account types are used to maximize beneficiary possibilities.

The term “Stretch IRA” is a marketing term used to describe an IRA that is set up to extend the period of tax-deferred earnings beyond the lifetime of the individual who created the account.  The accounts are typically designed to last over multiple generations.

The Roth IRA offers tax deferral on any earnings in the account.  Withdrawals from the account may be tax free, as long as they are considered qualified.  Limitations and restrictions may apply.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs.  Their tax treatment may change.

Additional considerations include: the fact that many investors have a collection of accounts, 401(k) or 403(b), 457, traditional IRA, Roth IRA, taxable accounts, etc. Some accounts may be getting new contributions, while other accounts may be closed for new contributions. For couples, the number of accounts in a consolidated portfolio can double. Developing a coherent portfolio across all of these accounts that implements one’s desired asset allocation becomes even more complicated.

And, remember as always, the opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

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