We hear that question all of the time.
Consider these three concepts: a 401(k), an individual IRA, and a taxable investment account.
So let’s begin with a 401(k). The 401(k), or any other type of retirement savings through your employer, is an exceptional vehicle if managed for its purpose. The 401(k) is a vehicle for long term retirement savings. The benefits are many: tax efficient (your savings can get invested before taxes), usually comes with an employer match, has multiple investment choices and the investment grows tax deferred. Some plans even offer a ROTH or after-tax option – a great benefit for those who would be otherwise ineligible. Given these facts, here’s a good way to think through how to manage your 401(k). Select an investment model you believe is appropriate for your age and risk profile (e.g. Conservative, Balanced, Growth, and Aggressive). Continue to invest regularly through your payroll contributions as this will help with the volatility, you’ll be buying low and high – also known as dollar cost averaging. The fear of investing can be minimized simply by investing regularly. Given that predicting volatility is difficult at best, being consistent and investing on a regular basis minimizes the impact.
Another key takeaway is to make certain your investments stay within the parameters you intended. If you chose a balanced portfolio with a certain percentage allocation, for example – 30% stocks, 30% bonds, 20% cash, and 20% real estate – be sure to make certain the percentages stay where you intended. This requires a regular rebalancing of the account to match your original goals. Rebalancing is crucial as it takes the positions that are high – profits – and buys the positions that that are down – buying low and selling high. This is the primary objective of most investors. Your goals will change as you get older however; rebalancing should be done at least annually and, if available, more often. Just be consistent.
Next let’s discuss an individual IRA: There always needs to be context on an Investment and an IRA is no different. Look at the account first from its tax status. For a Traditional IRA, all the income (gains and dividends) is tax deferred and distributions that you take from the account are taxed as income. What does this mean? Given all else is equal, the income producing assets should be held in the IRA as interest and dividends are also taxed as income. Defer and accumulate! If you plan on doing long term buying and selling regularly, all things being equal, this should be done outside of the IRA. In today’s world, long term gains are treated better outside of an IRA because the long term capital gain rate is lower than income tax rates.
The same asset allocation and rebalance principles apply to IRA’s as well. The allocation will change when the IRA moves from accumulation to distribution.
This brings us to the third concept, a taxable investment account and managing investments during or close to Retirement: this requires another essay. Look for it in the upcoming weeks.
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