Orchestrating your taxable and tax-favored investing can create financial harmony.

You might think of your retirement savings as a self-contained investment portfolio. You’ve allocated the assets within your account and made sure your portfolio is diversified. But to make the most of your plan, you also need to think of it as part of your total financial picture.

Even if your contribution to a 401(k) plan is the only active retirement investing you’re doing, it probably won’t be your only source of retirement income. For example, though Social Security may change over time, it’s reasonable to expect some income from that source. You may also be entitled to a pension, even if it’s only a modest one. And if you’re married, you may get pension income from your spouse’s employer. Or, you may own property you can sell or rent.

As you meet your other financial goals, such as buying a home or paying for higher education, or if you have money left over after contributing the maximum to your 401(k), you may be in a position to invest for retirement outside your 401(k) plan.

What is IRA?

If your 401(k) is a good one, it’s usually smart to put as much money into it as you can. Sometimes, that means coming up against the annual federal limit. But when you hit the limit and can afford to invest more, you might want to consider an individual retirement account (IRA).

The only requirement for opening an IRA is that you have earned income. You can contribute up to the annual limit but not more than you earn.

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While the maximum contribution is considerably lower than the 401(k) limits, traditional IRAs share the 401(k) advantage of tax-deferred growth. That means you postpone tax on any earnings as they accumulate, and you don’t owe capital gains tax on profits when you sell investments in the account, though there will be transaction fees. As a result, your account has the potential to accumulate more than a taxable account with comparable earnings.

If you’re 50 or over, you may also make annual catch-up contributions. You may qualify to deduct your contribution to a traditional IRA. If you’re not eligible for a retirement plan at work, you can always deduct if you’re single. Income limits apply if you’re married and file a joint return. You also qualify for a deduction if your modified adjusted gross income (MAGI) is below the annual limits that Congress sets for your filing status. Based on your MAGI, may also qualify to open or add to a Roth IRA.

You contribute after-tax earnings to your account but can withdraw completely tax-free income — provided you are at least 59½ and the account has been open at least five years. What’s more, there are no required minimum distributions from a Roth IRA, as there are with a traditional tax-deferred IRA.

Inside and Outside Your 401(k)

A second perspective

If you have a spouse or partner with investment assets, you might want to look at both portfolios when you allocate your assets. For example, if your spouse has a defined benefit pension that will pay 30% to 50% or more of his or her final salary — a generous but not uncommon percentage — that could provide a substantial amount of the basic income you need in retirement. Having that income frees each of you to put an even larger percentage of your 401(k) and your taxable investment portfolios in equities.

On the other hand, if the bulk of your 401(k) account is in stock of the company you work for, you may want to put more emphasis on tax-exempt municipal bond investments in your taxable accounts to add adequate diversification.

Taxable investments

When you compare investing in taxable accounts to investing in tax-deferred accounts, you might think first of the disadvantages. In the case of taxable accounts, you’ve already paid income tax on the amounts you invest, you pay income tax on any earnings your investments produce (even if you reinvest them), and you owe tax on any profit you realize from a trade.

But the rate at which long-term capital gains are taxed is lower than your regular tax rate, which may help soften the tax blow. Qualifying dividends are taxed at the same lower rate, which may be 0%, 15%, or 20%, based on your adjusted gross income (AGI). There’s no cap on the amount you can invest in a taxable account in any one year, and you can sell an investment without penalty whenever you wish. So if you concentrate on certain investments in your taxable accounts and on other types of investments in your tax-deferred accounts, you can take full advantage of what each has to offer.

One rule of taxable investing is to concentrate on long-term growth potential, usually in equities. It often pays to hold on to these investments for the long haul, or at least as long as they remain promising. Remember, you owe no income tax on unrealized gains — no matter how big they are.

Similarly, you’re better off keeping tax-exempt investments, such as municipal bonds and municipal bond funds, in an ordinary taxable account. Otherwise you’ll end up owing tax on the interest you receive, since all earnings on tax-deferred accounts are taxed when you withdraw them.

Investing Inside And Outside Your 401(k) by Inna Rosputnia

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