Getting more for your money

Travis Gallton, BridgeTower Media Newswires

When planning for retirement, investors are bombarded with complex decisions that could affect their financial goals. Most are widely known, such as the importance of asset allocation (i.e., your composition of stocks, bonds, and alternatives). Additional important obstacles include your comprehensive investment plan, year-end tax planning strategies, budget planning, and re-balancing toward target allocations.

One of the largest unknowns, however, is the constantly changing U.S. tax code. As most know, the Tax Cuts and Jobs Act of 2017 (TCJA), just became effective this year and lowers all income tax brackets. I am constantly being asked by family and friends, 'Should I be saving in my 401k, a personal account, a traditional IRA or a Roth IRA?' The answer is not simple, because taxes matter when it comes to retirement. However, knowing what that tax rate will be in the future is, at best, a guess. A quick refresher is needed on the different types of savings vehicles for retirement accounts before diving into the answer above.

First, the employer-sponsored 401k, 403b and 457 plans are where pre-taxed dollars (up to $18,500 in 2018) are deposited and allowed to grow tax-deferred until you reach the age of 70 ½ or retirement. Key to note with these plans is that individuals must take required minimum distributions (RMDs) at 70 ½. Both RMDs and other withdrawals are subject to federal income taxes.

Next, a traditional IRA is an account that lets your earnings grow tax deferred again until you reach the age of 70 ½, when you are subject to RMDs. Withdrawals are subject to federal income taxes. Your income will dictate whether your contribution is deductible that year, and there is no maximum income limit. In addition, individuals cannot make contributions to traditional IRAs after age 70 ½.

Another form of IRA account is called a Roth IRA. Roth IRAs offer tax-free growth and tax-free withdrawals. They are not subject to RMDs and there is no age limit on making contributions. The contributions are made post taxes. There are income restrictions on contributions, but investors earning over the income limits can still use these accounts by a process called "back door Roth IRA conversions."

Last, a personal or joint account is one where contributions are made after taxes and also where the account holder pays investment taxes on interest, dividends and capital gains. The primary upside with these accounts is that the holder(s) can withdraw funds at any time with no penalty (unlike IRA's with the 59½ age restriction). In addition, you're taxed only on gains of your investments.

Now that we've reviewed the basic types of investment accounts that are available, let's get back to the main question at hand: which types of accounts should be used to save for retirement?

There is total merit to having investments within multiple types of accounts, known as tax diversification, because of the reduction in tax risk. Indeed, numerous studies have shown that it's optimal for investors to have both taxable and tax-deferred accounts, as doing so hedges against potential changes in the future. To illustrate how many changes have occurred over the years, one study found that "the marginal rate for married taxpayers with inflation adjusted income of $100,000 has changed 39 times since the introduction of income taxes in 1913."[1]

If an individual is saving in traditional accounts, they're expecting lower future tax rates when they intend on making withdrawals. Alternately, if an individual is saving in Roth accounts, higher future taxes benefit you as your withdrawals are tax free.

To answer the question of the article, first and foremost you always want to contribute and maximize your company's 401k up to at least their match. Second, in the earlier stages of your working life, (i.e., 25-35 years old) you want to contribute to a Roth IRA. The rationale being that for most, your income (and thus your effective tax rate) is likely to be lower in the earlier career years, which make it advantageous to pay the taxes on income today and make contributions to a Roth IRA that grows tax-free.

In fact, a recent study by David Brown, Scott Cederburg, and Michael O'Doherty looked at this very issue of finding the optimal location for investors' savings towards their retirement assets. In sum, their research and models proved that most could follow this simplistic rule "households should allocate (Age + 20%) of their retirement savings in traditional accounts with the remainder in Roth vehicles subject to investment limits."[2]

In the same line of importance of having both types of accounts for retirement, asset location or placement of your asset allocation among them is equally important. Again, because Roth IRA contributions have already been taxed, the earnings and qualified withdrawals will be tax free. The most suitable investments are those then with higher taxability, such as real estate investment trusts, high dividend stocks, and high yielding bonds. Investments that are not efficient for a Roth IRA, but more suitable for personal accounts would include growth stocks, municipal bonds, and cash type assets.

As always, it is best to speak with your financial professional to help you determine which types of accounts and which asset mix will help you reach your financial goals.

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Travis M. Gallton, CFA, is a senior equity portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY 14534, (585) 586-4680.

[1] Brown, David, Cederburg, Scott, and O'Doherty, Michael. Tax Uncertainty and Retirement Savings Diversification. November 2016.

[2] Brown, David, Cederburg, Scott, and O'Doherty, Michael. Tax Uncertainty and Retirement Savings Diversification. November 2016.

Published: Mon, Mar 26, 2018

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