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Diversifying your Nest Egg Account Types

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In past articles, we have emphasized the importance of investment diversification.

Such diversification refers to your overall investment portfolio and is important at two levels:

  • Macro allocation – Choosing a ratio of stock-related investments to bond or cash-related investments that is appropriate for your goals, risk tolerance, and investment time horizon. 
  • Asset class allocation – Ensuring that holdings are properly allocated among common domestic and foreign investment asset classes within the broad stock and bond categories. 

Diversification does not mean having similar accounts spread out over multiple financial institutions. Doing so generally results in substantial duplication and normally does not achieve the desired allocation benefits.

There is another diversification factor of high importance that is often neglected – diversifying across account types – pre-tax, after-tax, and tax free.

Pre-tax accounts typically consist of 401(k)/403(b)/457 employer plans and various forms of IRAs. Contributions generally are tax-deductible, and earnings and growth are tax-deferred. Income taxes are paid when distributions are made.

After-tax accounts include savings and checking accounts, non-IRA CDs, and investment accounts. Here, income taxes have already been paid on the principal, but taxes are then paid annually on the interest and dividend earnings and on gains realized from sales of securities.

Finally, tax-free accounts are represented by one of the greatest gifts ever given to the American taxpayer by Congress – the Roth IRA and Roth 401(k). For assets held in such accounts, none of the generated income or capital gains on securities sales is taxable, as long as some simple timing and age rules are followed.

Note that I am ignoring, for the sake of keeping this discussion simple, deferred annuities and tax-free municipal bonds which are variations on this general theme.

Except in unusual circumstances, I typically encourage clients to approach retirement with a mix of all three types of accounts.

To appreciate the value in doing so, it is important to understand some of the pros and cons of each type.

Pre-Tax – Pros: immediate tax deduction for contributions; tax-deferred income and growth; easy, disciplined way to save for retirement; employers often offer match contributions for employer plans; first $20K/year of distributions not taxed in NYS; can be left to heirs.

Pre-Tax – Cons: distributions taxed at ordinary rates; required annual distributions starting at age 70-1/2; 10% penalty for distributions prior to age 59-1/2, with a few exceptions; required distributions can have negative income tax consequences – taxability of Social Security at lower income levels and phase-out of itemized deductions and personal exemptions at higher levels; can also trigger additional 3.8% Medicare tax at higher levels; annual contributions limited by ceiling dollar amount; no step-up in basis at death; non-spouse heirs required to take annual distributions.

After-Tax – Pros: always under the owner’s control; highly-flexible; favorable federal tax rates for long-term capital gains and qualified dividends; can be gifted to spouse, family, charity; no annual contribution ceiling; can be left to heirs; full step-up in basis at death.

After-Tax – Cons: contributions not tax-deductible; annual interest/dividend income taxable; income taxes also generated by regular account rebalancing and changes in the investments including securities sales;

Tax-Free – Pros: no income taxes ever, if simple rules are followed; reasonably-flexible; no required annual distributions; easy, disciplined way to save for retirement; no tax or penalty associated with removing principal, regardless of age or timeframe; can be left to heirs; heirs can continue accounts tax-free.

Tax-Free – Cons: contributions not tax-deductible; dollar ceiling on annual contributions; non-spouse heirs required to take annual distributions.

When a client is accumulating assets, I usually suggest the following order of priority in setting money aside for retirement:

  • First, max out a traditional 401(k) up to the company match, if any.
  • Second, max out a Roth IRA (2014 - $5,500 plus $1,000 if age 50 or older) or contribute like amount to a Roth 401(k) if available. Note there are income limits to making Roth IRA, but not Roth 401(k), contributions.
  • Third, allocate additional savings dollars among pre-tax, traditional 401(k) and Roth 401(k), if available, accounts. 

What is an appropriate allocation for the third step? It depends on individual circumstances. There is no standard rule of thumb.

The idea is to have a reasonable mix to take advantage of the “pros” and not be disadvantaged by a preponderance of the “cons”. For example, it is not unusual to find a retiree with most of his/her assets in a pre-tax form – not a particularly good situation.

As we always advise, be sure to partner with a trusted financial planner to determine the account-type allocation strategy best for you.

This material is provided for general information purposes only and is not a recommendation or solicitation to buy or sell any particular security, product or service. Past performance is not indicative of future investment results. Any investment involves potential risk, including potential loss of capital. Before making any investment decision, please consult your legal, tax and financial advisors. Non-deposit investment products are not bank deposits and are not insured or guaranteed by Canandaigua National Trust Company of Florida, or any federal or state government or agency and are subject to investment risks, including possible loss of principal amount invested. 

Posted by Kelly Hohman at 02/09/2015 09:55:22 AM 

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