In Part IV we looked at some sample portfolios built from the three key Index Funds I favor, plus cash. Those four are what we call investments.
But in our complex world we must next consider where to hold these investments. That is, in which bucket should which investment go? There are two types of buckets:
1. Ordinary Buckets
2 Tax Advantaged Buckets
Now at this point I must apologize to my international readers. This post is about to become very USA centric. I am completely ignorant of the tax situation and/or possible tax advantaged buckets of other countries. My guess is, that at least for western style democracies, there are many similarities and possibly you can extrapolate the information here into something relevant to where you live. Or you might post a country specific question in the comments below. The readership of jlcollinsnh has been growing quickly and there are a lot of savvy investors on board who may well be able to help.
Here in the USA the government taxes dividends, interest and capital gains. But it has also created several Tax Advantaged Buckets to encourage retirement savings. While well-intentioned, this has created a whole new level of complexity. Volumes have been written about each of these and the strategies now associated with them. Clearly, we haven’t the time or space to review it all. But hopefully I can provide a simple explanation of each along with some considerations to ponder.
The Ordinary Bucket is, in a sense, no bucket at all. This is where everything would go were there no taxes on investment returns. We would just own what we own. Easey peasy. This is where we’ll want to put investments that are already “tax efficient.”
There are several variations of Tax Advantaged Buckets, and we’ll look at each. These are the buckets in which we’ll want to place our less tax efficient investments. In general this means investments that generate dividends and interest.
Let’s look at our four investments from Part IV:
Stocks. VTSAX (Vanguard Total Stock Market Index Fund) pays around a 2% dividend and most of the gain we seek in in capital appreciation. Ordinary Bucket.
Real Estate. VGSLX (Vanguard REIT Index Fund) REITs (Real Estate Investment Trusts) invest in real estate and this is also a play for capital gains. However REITS also tend to pay dividends, VGSLX in the range of 3-4%. Tax Advantaged Bucket.
Bonds. VBTLX (Vanguard Total Bond Market Index Fund) Bonds are all about interest. Tax Advantaged Bucket.
Cash is also all about interest but, more importantly, it is all about ready access for immediate needs. Ordinary Bucket.
None of this is carved in stone.
There may be exceptions. Proper allocation should trump bucket choice. Your tax bracket, investment horizon and the like will color your personal decisions. But the above should give you a basic framework for considering the options.
Before we look at the specifics of IRAs and 401Ks, this important note:
None of these eliminates your tax obligations. They only defer them.
Fix this in your brain. We are talking about when, not if, the tax due is paid.
You’ll pay tax anytime you withdraw your money and once you reach age 70 1/2 you’ll be faced with RMDs (required minimum distributions)
There are many, many variations of 401K and IRA accounts. If you are self-employed or work for the government, for example, each has its own variation. We’ll look at the three basic varieties here. The rest are branches from these trees.
401K/403b. These are buckets provided by your employer. They select an investment company which then offers a selection of investments from which to choose. Many employers will match your contribution up to a certain amount. Both your and your employer’s contributions are tax deferred, reducing your tax bill for the year. All earnings are also tax deferred. The amount you can contribute is capped. In general:
- These are very good things. (but not as good as they once were. See Part VIII-b) I always maxed out my contributions.
- Any employer match is an exceptionally good thing. Free money. Contribute at least enough to capture the full match.
- Unless Vanguard happens to be the investment company your employer has chosen, you may not have access to Vanguard Funds. That’s OK….
- …Most 401k plans will have a least one Index Fund option. Look for that.
- When you leave your employer you can roll your 401k into an IRA preserving its tax advantage. Some employers will also let you continue to hold your 401k in their plan. I’ve always rolled mine.
- Taxes are due when you withdraw your money.
- Money withdrawn before 59 1/2 is subject to penalty.
- After 70 1/2 money is subject to RMDs.
IRAs are buckets your hold on your own, separate from any employer.
– Deductible IRA. Contributions you make are deductible from your income for tax purposes. In general, you’ll want to use these if you are in a high tax bracket and are looking for a deduction to lower your immediate tax obligation. Just like an 401K.
- All earnings on your investments are tax deferred.
- Taxes are due when you withdraw your money.
- Money withdrawn before 59 1/2 is subject to penalty.
- After 70 1/2 money is subject to RMDs.
– Non Deductible IRA. Contributions you make are NOT deductible from your income for tax purposes.
- All earnings on your investments are tax deferred.
- Taxes are due on any dividends, interest or capital gains earned when you withdraw your money.
- Taxes are not due on your original contributions. Since these contributions were made with “after tax” money they have already been taxed.
- Those last two points mean extra record keeping and complexity in figuring your tax due when the time comes. A bad thing.
- Money withdrawn before 59 1/2 is subject to penalty.
- After 70 1/2 money is subject to RMDs.
– Roth IRA. Contributions you make are NOT deducible from your income for tax purposes.
- All earnings on your investments are tax-free.
- All withdrawals after age 59 1/2 are tax-free.
- You can withdraw your original contribution anytime, tax and penalty free.
- There is no RMD.
- It can be passed to your heirs tax-free and will continue to grow for them tax-free.
All of these have income restrictions for participation. These change year-to-year, here’s a current table:
In short:
401k/401b = Immediate tax benefits & tax-free growth. No income limit means the tax deduction for high income earners can be especially attractive. But taxes are due when the money is withdrawn.
Deductible IRA = Immediate tax benefits & tax-free growth. But taxes are due when the money is withdrawn.
Non-Deductible IRA = No immediate tax benefit, tax-free growth and added complexity. Taxes due when the money is withdrawn.
Roth IRA = No immediate tax benefit, tax-free growth and no taxes due on withdrawal. A better Non-Deductible IRA, if you will.
Now, if you’ve been paying attention, you might be thinking “Holy cow! This Roth IRA is looking like one very sweet deal. In fact it is even looking like it violates what jlcollinsnh told us to fix in our minds earlier: ‘None of these eliminates your tax obligations. They only defer them.‘” True enough, but as with many things in life there is a catch.
While the money you contribute to your Roth does indeed grow tax-free and remains tax-free on withdrawal, you have to contribute “after-tax” money. That is, money upon which you’ve already paid tax. This can be easy to overlook, but it is a very real consideration.
Look at it this way. Suppose you want to fund your IRA this year with $5000 and you are in the 20% tax bracket. To fund your deductible IRA all you need is $5000 because, since it is deductible, you don’t need any money to pay the taxes due on it. But with a Roth, you’d need $6000: $5000 to fund the IRA and $1000 to pay the 20% tax due on the $5000. That $1000 is now gone forever and so is all the money it could have earned for you over the years. Were you to fund your deductible IRA instead of your Roth, this $1000 could then be invested rather than going to paying taxes.
Of course, if you don’t invest that $1000, you will be better off with the Roth. In effect, with the Roth you are investing more after tax dollars.
Personally, I find it very emotionally satisfying to fund a Roth, pay the taxes now and be done with them. But it might not be the best financial strategy.
Further, because I’m the suspicious type, and the tax advantages of a Roth are so attractive, I start thinking about what might go wrong. Especially since these are such long-term investments and the government can and does change the rules seemingly on a whim. Two things occur to me:
1. The government can simply change the rules and declare money in Roths taxable. But since Roths are becoming so popular and are held by so many people this seems more and more politically unlikely.
2. The government can find an alternative way to tax the money. Increasingly in the USA there is talk of establishing a national sales tax or added value tax. While both may have merit, especially as a substitute for the income tax, these would effectively tax any Roth money as it was spent. This seems more likely to me.
OK, you now are probably thinking: No Roth for me – deductible IRA, that’s the ticket. I’ll take the immediate tax savings and let more of my money compound over time for me.
Well, it is not quite so easy. So which is better? Pay the taxes today and invest in a Roth or take the deduction today with an IRA and worry about taxes later?
In part it depends upon your age, and many readers might well be far along the path of one or the other. But let’s say you are 30 years old and have 40 years until you reach 70 1/2 and face those RMDs (required minimum distributions). A lot can happen in 40 years. Personally I’d be inclined to take the tax benefit today and let that money work for me over the decades. Hopefully, that growth will be greater than the taxes then due. (For a more in depth look, see Addendum #1)
Let’s finish with the recommendation that, whenever possible, you roll your 401K/403b accounts into your personal IRA. Usually this is only possible when you leave your employer. As we’ve already seen, employer plans are all too frequently laden with excessive fees and your investment choices are limited. In your IRA you have far more control.
Personally, I’ve always been slightly paranoid about having my employers involved in my investments any longer than I had to. The moment I could roll my 401K into my own IRA, I did. Usually, this means once I left the job.
Next, lets talk a bit about withdrawal strategy. Except for the Roth, all of these have RMDs (required minimum withdrawals) at age 70 1/2. Basically this is the Feds saying “OK. We’ve waited long enough. Time to pay us our money!” Fair enough. But for those of us diligently building FI (financial independence) there is going to be a very large amount of money in these accounts. Pulling it out in the required amounts on the government time schedule could easily push us into a higher tax bracket.
Assuming when you retire your tax bracket drops, you have a window of opportunity between that moment and age 70 1/2. Let’s consider an example.
A married couple retires at 60 years old.
- They have a 10 year window until 70 1/2 to reduce their 401k/IRA holdings.
- The 15% tax bracket is good up to 69k.
- Personal exemptions and the standard deduction are good for another 19k.
- They have up to 88k in income before they get pushed into the 25% bracket.
If their income is below 88k they should seriously consider moving the difference out of their IRA and/or 401k and taking the 15% hit. 15% is a very low rate and worth locking in. So, if they have 50k in taxable income they might withdraw another 38k. They could put it in their Roth, their ordinary bucket investments or just spend it.
There is no one solution. If your 401k/IRA amounts are low you can just leave them alone. If they are very high pulling them out even at a 25% tax might make sense for you. The key is to be aware of this looming required minimum withdrawal hit so you can take it on your own terms.
Let’s end with this, my basic hierarchy for deploying investment money:
- Fund 401k type plans to the full match.
- Fully fund a deductible IRA, rather than the Roth (but keep any Roth you have) unless you are paying little or no income tax. The reason is the money you don’t pay in taxes will compound for you over the decades.
- Finish funding the 401K to the max.
- Fund your taxable account with any money left.
One final note. We’ve touched a bit on tax laws in this post. While the numbers and information is current as of 2014, should you be reading this post a few years after publication, they are sure to have changed. The basic principles should hold up for some time, but be sure to look up the specific numbers that are applicable for the year in which you are reading.
Addendum #1
Here’s an excellent series of posts offering more detail on sorting thru the traditional v. Roth IRA question.
Addendum #2
If you are interested in how to identify the index funds from the list you plan offers, check out my conversation with Sid on Ask jlcollinsnh
Addendum #3– October 17, 2012: Health Saving Accounts (HSAs)
Some readers may have access to HSAs. These can be extraordinary useful retirement tools, in addition to providing funds to cover health care costs. My pal, The Mad Fientist, has put together a terrific review on hacking your HSA: http://www.madfientist.com/ultimate-retirement-account/?utm_source=rss&utm_medium=rss&utm_campaign=ultimate-retirement-account
If you are interested, here is my take on HSAs.
Addendum #4– March 10, 2013:
Here’s a great strategy for using IRAs and Roth IRAs at different stages of your life: Traditional IRA vs. Roth IRA _ The Final Battle
Plus there is a really cool picture of two foxes.
Addendum #5:
In the comment section under Part IX of this series reader Prob 8 posted:
“If anyone doubts JLC’s claims regarding the impact of fees and commissions on your portfolio, please check out this video from PBS:http://www.pbs.org/wgbh/pages/frontline/
It’s called The Retirement Gamble. (You’ll have to paste that into the search box to find the video.) There are interviews with Jack Bogle and all you’ll need to know to realize fees and investment advisors are hurting your portfolio more than helping.”
I just finished watching it. Very powerful stuff and I highly recommend readers here check it out.
The math on how damaging even seemingly modest 2% fees really are is nothing short of breathtaking; and even I didn’t fully appreciate just how laden with fees 401k plans have become. Yikes!
Thanks Prob 8!!
Addendum #6: TSP Plans
Buried in the comments below is a conversation with reader Enceladus. It starts July 5th, 2013 if you want to scroll down to read the full exchange. But for my thinking on TSP Plans, here is the low-down:
Hi Enceladus…
TSPs are retirement plans for Federal employees, including military personal. Think 401k for government employees. But better.
One of the cool things about writing this blog is how much I get to learn. Not having any personal experience with TSPs I did a little digging. Unlike the fee heavy cesspool too many 401k plans have become your TSP offers a nice, but not overwhelming, selection of low cost index funds. As you point out, only .027% last year.
Looking at the chart of ERs going back to 1999 the ER has ranged from a low of .015% in 2007 to a high of .102% in 2003. Seems the variation is due, to quote the site, to:
“The TSP expense ratio represents the amount that participants’ investment returns were reduced by TSP administrative expenses, net of forfeitures”
Still, even at the worst these are very low ERs. And they seem to be coming down in the last five years or so. Good deal.
Also a good deal is that the funds are index funds. The C-fund you mentioned for instance replicates the S&P 500 index. The S-fund is the small cap index. Own both in about a 75/25 balance and you’ve basically got VTSAX. The F-fund is a bond index.
To answer your question: Yep. These are a no-brainer. I’d max out my TSP right after the civilian 401k for the match. Then Roth.
As for your mix of stock v. bonds, at age 26 I’d go light on the bonds if at all. 10% maybe.
Looking at your total assets as a whole (which is the only way to figure asset allocations), I’d try for something like this:
10% in F-fund (bonds)
25% in S-fund (small cap)
65% in FUSVX/C-Fund
These are all low cost index funds and will serve you well over the decades.
