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Best Investments for Retirement Accounts

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Nest EggsWhen I started working after college, it was a bit of a stretch to contribute to both my 401(k), to get my employer match, fully fund my Roth IRA, and build up a small cash cushion (I would later learn these are called emergency funds). I pushed to do it because my parents drilled this lesson into my brain as a young adult – save money today because you never know what will happen tomorrow. (I thought I dodged a bullet by avoiding the dot com boom and bust but I was later rewarded for my diligence with the largest recession since the Great Depression!)

So… what do I do with the money in my Roth IRA or my 401(k)? You will never be able to predict the future with certainty so you will never know beforehand which investments will perform the best. You will, however, know the cost of owning those investments and the cost of taxes if you pick correctly. The best we can do is have a good plan, execute that plan, and pick investments that provide the most value for the price that you pay in fees and taxes.

Tax Advantaged vs. Regular Brokerage

As you save money, you’ll start to have a mix of tax advantaged accounts and taxable brokerage accounts:

  • The 401(k) and traditional IRA represent tax deferred retirement accounts, where tax deductible contribution grow tax free and distributions are taxed at your ordinary income tax rate.
  • The Roth IRA represents tax free retirement accounts, where you cannot deduct contributions but they grow tax free and distributions are tax free.
  • Finally, there are regular taxable brokerage accounts that offer no tax benefits whatsoever but do offer the chance to withdraw your funds without rules or penalties.

Put tax advantaged investments into a taxable brokerage account and put tax disadvantaged investments into your retirement accounts. You only benefit from tax advantaged investments if they’re in a regular broker account because the tax advantaged accounts shield you from those benefits.

Example: If you buy a dividend aristocrat for the dividend yield, it’s better to buy through your regular brokerage account. Dividends are taxed at the long term capital gains rate (0% or 15), much lower than your ordinary income tax rate. If you bought it in an Traditional IRA, your dividends would be tax free initially but then taxed at the might higher ordinary income tax rate when you take disbursements (the dividends would grow tax free but you lose the initial tax benefit of dividends).

Best Investments for Tax Advantaged Accounts

The general rule is that tax advantaged investments are bad in an already tax advantaged account. Municipal bonds, which are income tax free, make terrible IRA investments because you take an investment that’s federal income tax free and subject it to income taxes. The return on munis is low because of the tax treatment, and lower risk, so you’re not getting the full value.

If you plan on generating a lot of short term capital gains (buying and selling stocks and holding them for less than a year), do so in your tax advantaged retirement account. In a regular account, you’d pay taxes each year. In a tax advantaged accounts, you would only have to pay taxes when you took disbursements, leaving a larger amount in your account to invest in. If you’re to pay short term capital gains anyway, you might as well have them deferred for as long as possible.

The disadvantage of this approach is that you in a regular account you can write-off up to $3,000 of investment losses from your ordinary income. This isn’t possible in a tax advantaged account.

Best Investments for Regular Accounts

On the flip side, the best investment for a regular brokerage account are those that are bad investments for tax advantaged accounts. Any investment that has built-in tax advantages will not be fully appreciated unless they get regular tax treatment. These include long term stock holdings (longer than a year), tax advantaged bonds (or bond funds), dividends, MLPs, Treasuries, and others.

Remember, when you are making retirement and investing decisions, tax considerations should only play a small role in the process. What you invest in and how you setup your entire portfolio is far more important than whether you invested in the right product in the right account. If you took tax advantaged dividends in a tax free Roth IRA, you would surrender only a bit of the tax advantage. If, however, you have everything else under control, then it makes sense to ensure you are being the most tax efficient.

(Photo: oakleyoriginals)

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23 Responses to “Best Investments for Retirement Accounts”

  1. billsnider says:

    Your comment that you should not let tax reasons determine the composition is an excellant one. Most people lose sight of this.

    I also go by the 100 rule – 100 minus your age equals the max in stocks and other such holdings. It gives you an upper bound number and helps to guide you to the next allocation step.

    Bill snider

  2. cubiclegeoff says:

    I never thought much about how best to us a tax advantaged account or brokerage depending on the asset. This is a good summary, although it leaves few investments to keep in your tax advantaged account. What about mutual funds? I don’t own any outside of my retirement accounts, but these may be a hassle in a taxed account because of how they deal with capital gains.

  3. zapeta says:

    I think its an important point to consider taxes in your investment strategy. However asset allocation is probably going to be a bigger factor in overall return. I think its much more important to be contributing to some sort of retirement account rather than letting tax uncertainty keep you from contributing.

    • jsbrendog says:

      exactly. as i said below that is why i am a fan of the target date funds. they give someone who knows nothing the chance to open the account and have an investment until they have a chance to better understand the market, types of funds, etc. I am not sure if i will keep it or not but if i decide not to the only issue will be laziness (my old nemesis)

      to anyone who doesnt have a retirement fund yet JUST DO IT. een if you only have a 1000 or so.

  4. NateUVM says:

    The title of this article being “Best Investments for Retirement Accounts,” I thought I might mention something outside of tax consequences for accounts based on whether they are tax-deferred or not. There is also the question of asset allocation between your traditional and Roth accounts, assuming you’ve got both…

    Given that funds in a traditional IRA or 401(k) are going to be taxed when they are withdrawn, and the funds in a Roth IRA or Roth 401(k) are not going to be, it may make sense to have your more aggressive (read: riskier, but with a higher potential for return) investments in your Roth account and your more conservative investments in your traditional accounts. This way, between the two, you will only get taxed on the account that is less aggressive and will probably have less of an overall return. The only thing to watch out for is to make sure you maintain your planned asset allocation through your contributions so that one side doesn’t take up too much of your overall retirement portfolio.

    This isn’t to say that you should only put Bonds and cash equivalents in a traditional account and only stocks in a Roth…both still have to have a little bit of a mix. Just something to think about as a general theme between your two (or more) retirement accounts.

    • Jim says:

      I thought about talking about aggressive vs. conservative but I thought that sticking with a discussion on taxes, with only a minor note on aggressiveness (really about short term capital gains), was going to be a lot clearer for most people. I didn’t want to go in too many directions because the tax consequences is probably the largest point.

      I agree with your points, about the general theme in each account.

    • jsbrendog says:

      this is the hardest thing for me. I am currently trying to figure out the balance between the two accounts, roth and 401k. almost time to re-balance….

    • cubiclegeoff says:

      Another good point I never thought of. Might as well make the biggest gains with the least impact from taxes.

    • NateUVM says:

      There is another reason to be more aggressive, generally, with Roth accounts and vice-versa with traditional accounts…

      Traditional accounts have a mandatory minimum distribution that must start when you turn 70 1/2. So there really is a maximum amount of time that you will be able to hold your funds in those accounts. Roth accounts, currently, do not have this limitation. Probably has to do with the fact that no tax is due on the withrdrawal, so Uncle Sam has no need to have you take the funds out.

      Regardless, in that you can keep Roth funds in their account longer, on average, than traditional funds, their investment horizon can generally be longer. This would again suggest that it might be to one’s benefit to have their Roth funds allocated more aggressively than their traditional funds as there will be more time for them to recover from the vagaries of the market.

      • billsnider says:

        If you do the distribution calculation, you will find that you have to take out about 3-4% of your money per year. So it is not technically correct to say that you have to pay taxes when you turn 70 1/2. You have to pay on that amount.

        Bill snider

        • NateUVM says:

          No, of course. I did leave out that it is only PART of the traditional [Trad. IRA, 401(k), etc...] account that you need to withdraw and pay taxes, at first. But you do have to start taking it out, and the proportion you have to take out is greater each year until it’s fully withdrawn.

          Again, the point is that the investment time horizon for traditional accounts is shorter than Roths, generally, because you are never legally required to withdraw the funds in the Roth where you are with traditional funds.

          Just another factor, and I hope I haven’t made it more confusing… Sorry about leaving that out.

  5. jsbrendog says:

    just to get it open and start as soon as psosible i put my roth in a target date fund. s i learn more and become better acquainted with the system i will prob break it down and get mroe in depth. but it is mroe important just to start it up and worry about that later. the target date funds work as a good beginnner buffer.

  6. Kate says:

    I am a fan of the Roth IRA. I was lucky enough to start one when I got out of school. Unfortunately, I have not been able to contribue the full amount yearly, but at least it is there!

  7. Where assets are held is extremely important over the long run and doesn’t have to be treated as either/or in relation to asset allocation. First decide on asset allocation. Everyone agrees that this is the most important decision. Suppose it is 70% stocks/30% fixed income. Then, as much as possible try to hold fixed income in qualified accounts (IRAs, 401(k)s, 403(b)s) etc. Any interest received in the taxable accounts will have to be taxed. Therefore in the taxable accounts try to get qualified dividends, lon-term cap gains etc.
    Playing this right over the long term determines how much you get to keep – and that’s the name of the game.

  8. Great article! Put simply, one must consider both asset allocation as well as asset LOCATION.

    “Everything should be made as simple as possible, but no simpler.” ~ Albert Einstein

  9. Great points. I never really thought of this when investing in my retirement and non-retirement accounts, but it makes complete sense. I wouldn’t be surprised if lots of people are putting their retirement dollars in investments that don’t allow them to take advantage of it not being taxable.

  10. Mike says:

    I’m usually a very cautious person with my investments. However, you can’t be cautious during one of the greatest bull market runs in history. I was on a pure stock picking mode for the first couple months of the bull run and have done very well. I have just recently been selling my positions and moving them back into index funds. I’ve done much better than the “experts” that have relied on index funds during the majority of this upswing in the market.

  11. eric says:

    Tax planning is essential but I admit, something I’m not terribly excited about. It’s hard to keep everything organized but it pays off in the end (literally).

  12. Ryan says:

    I’ve just opened a Roth and have a target date fund in it. From what I understand, I can open a new Roth every year and max it out at $5k a year. Now lets say that 3 years down the road I have 3 Roths with the same target date fund, but I’ve learned a lot about investing over that period and decide I would rather lose the target date fund and build my own portfolio in my Roth. Will I be able to sell off my assets from all 3 years and replace those assets with individual stocks or will I have to just exchange the fund for a different one? Or would I just have to sell the fund in all 3 Roths and leave the cash from the sales in the Roth? I’m just a little confused as to what I can do in each Roth account once the current year for that particular account has past. Thanks for any info on this.

    • Tony says:

      Ryan:

      Not sure why you’d open multiple Roth IRAs. You open a single Roth IRA and fund it at $5k/year. You can trade stocks/funds/etc. within that account as if it were any other trading-enabled account, but I can’t see a reason on earth why you’d open more than one Roth unless one is for you and one is for your wife/spouse/partner.

  13. Ryan says:

    Thanks for the response Tony. I was under the impression that a new Roth must be opened individually each year, but what you’ve said makes more sense and clears up further questions I had. So now that my Roth is opened, I can just continue funding it over the years as long as I don’t exceed $5,000 a year in contributions…Got it! I was wondering how I was supposed to keep up with all of those accounts over the years! Thanks again.

  14. Tak Nomura says:

    I have a question for all of you. When you look at your investments since 2007 through the current period, what are your results?

    If you’re over 70.5 years old, how much have you been withdrawing during those same period?

    If you’re still investing new monies into your retirement savings, how much more did you invest during those same period?

    How were you impacted in 2008-2009?


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