Stocks ? Part VIII: The 401K, 403b, IRA & Roth Buckets ? jlcollinsnh

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.

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. ?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 won?t 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 Required Minimum Withdrawals.

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 Required Minimum Withdrawals.

- 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 Required Minimum Withdrawals.

- 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?Required Minimum Withdrawal.
• 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.??? ?Gold Star. ?While you have to contribute money you?ve already paid tax on, that money then grows tax-free and it remains tax-free on withdrawal. ?This is something very special?and it is what makes the Roth far and away my favorite of these tools.

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.

Finally, lets talk a bit about withdrawal strategy. ?Except for the Roth, all of these have 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.

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