Coordinating your taxable and tax-advantaged investments can create a symphony of financial success.
Rather than viewing your retirement savings as an isolated investment portfolio, consider it an integral part of your overall financial landscape. While you’ve carefully allocated assets and diversified your holdings within your account, it’s essential to recognize how your retirement plan fits into your broader financial strategy for maximum effectiveness.
Even if your 401(k) contributions are your primary focus for retirement investing, they likely won’t be your sole source of retirement income. For instance, while Social Security benefits may fluctuate over time, you can reasonably anticipate some income from that avenue. Additionally, you might qualify for a pension, whether it’s modest or substantial, and if you’re married, your spouse’s employer may provide pension income as well. You may also own property that you can sell or rent for additional income.
As you work toward other financial objectives, such as purchasing a home or funding higher education, or if you find yourself with extra funds after maxing out your 401(k) contributions, you may have the opportunity to invest for retirement outside of your 401(k) plan.
What is IRA?
If your 401(k) plan is solid, it’s generally wise to maximize your contributions. However, you may eventually reach the annual federal contribution limit. Once you hit that ceiling and still have the capacity to invest more, exploring an Individual Retirement Account (IRA) can be a beneficial option.
The primary requirement for opening an IRA is having earned income. You can contribute up to the annual limit, but your contributions cannot exceed your total earnings for the year.
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While the maximum contribution limits for traditional IRAs are significantly lower than those for 401(k) plans, they offer the same advantage of tax-deferred growth. This means you can defer taxes on earnings as they accumulate, and you won’t incur capital gains tax on profits when you sell investments within the account—though you may face transaction fees. Consequently, your account has the potential to grow more substantially than a taxable account with similar earnings.
If you’re 50 or older, you can also take advantage of annual catch-up contributions. Additionally, you may be eligible to deduct your contributions to a traditional IRA. If you do not have access to a retirement plan at work, you can deduct your contributions if you’re single. For married individuals filing jointly, income limits apply. Furthermore, you can qualify for a deduction if your modified adjusted gross income (MAGI) is below the annual thresholds set by Congress for your filing status. Based on your MAGI, you may also be able to open or contribute to a Roth IRA.
With a Roth IRA, you contribute after-tax income, allowing for tax-free withdrawals—provided you are at least 59½ years old and the account has been open for at least five years. Additionally, Roth IRAs do not have the required minimum distributions (RMDs) that traditional tax-deferred IRAs impose, giving you greater flexibility in managing your retirement savings.
A second perspective
If you and your spouse or partner have investment assets, it’s beneficial to evaluate both portfolios when determining your asset allocation. For instance, if your spouse has a defined benefit pension that will provide between 30% to 50% (or more) of their final salary—a generous figure that’s not uncommon—this could contribute significantly to your overall retirement income. With this income stream, both of you can afford to allocate a larger portion of your 401(k) and taxable investment portfolios toward equities, enhancing growth potential.
Conversely, if a significant portion of your 401(k) is invested in your employer’s stock, it may be prudent to shift your focus toward tax-exempt municipal bonds in your taxable accounts. This strategy can help achieve a better balance and provide the diversification necessary to mitigate risk.
Taxable investments
When weighing the pros and cons of investing in taxable accounts versus tax-deferred accounts, it’s easy to focus on the downsides of taxable accounts. With these accounts, you’ve already paid income tax on your initial investments, and you’ll incur taxes on any earnings your investments generate—even if you choose to reinvest them. Additionally, you’ll owe taxes on any profits realized from trades.
However, it’s important to note that long-term capital gains are taxed at a lower rate than your ordinary income tax rate, which can help alleviate some of the tax burden. Likewise, qualifying dividends enjoy this same lower tax treatment, which can be set at 0%, 15%, or 20%, depending on your adjusted gross income (AGI). Taxable accounts also offer flexibility: there are no limits on how much you can invest in a given year, and you can sell investments without penalty whenever you choose. By strategically allocating certain investments to your taxable accounts and others to your tax-deferred accounts, you can maximize the benefits of both types.
A key strategy for taxable investing is to focus on long-term growth, particularly in equities. Holding onto these investments for the long term can be advantageous, as you won’t owe any income tax on unrealized gains—regardless of how substantial they may be.
Furthermore, it’s wise to keep tax-exempt investments, such as municipal bonds and municipal bond funds, in your taxable accounts. If you hold these in tax-deferred accounts, you’ll be taxed on the interest they generate when you make withdrawals, which defeats the purpose of their tax-exempt status.
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