Retirement Investment Strategies for Pre-Tax and After-Tax Accounts

A good investment strategy could generate THOUSANDS of dollars more than a poorly executed one. An important component of any strategy is the types of accounts that are used. This means taking advantage of both qualified and unqualified accounts.

Qualified accounts are tax-advantaged accounts such as retirement plans or IRAs that allow you tax-deferral or tax-free growth. When qualified accounts are used in conjunction with non-qualified accounts, or taxable investment accounts, the account types can allow you to create a more tax-efficient investment strategy.

saving for retirement

Purpose of The Money

This is always the first question. If we’re talking about IRAs, usually the purpose is for retirement. Depending on when you expect to need the funds will dictate how the portfolio is invested.

If the funds are used for the same purpose such as retirement, I will suggest the entire household as a single portfolio. This allows you to take advantage of different account types like a Traditional IRA and Roth IRA.

First, you must understand the differences. It all comes down to taxes. Ask yourself:

  1. Do you want to pay tax now or later?
  2. Do you expect to be in a higher or lower tax bracket now or in the future?
  3. When do you expect to need the funds?
  4. How much risk are you willing to take?

If you can answer these questions with some clarity it will help dictate your investment strategy. There are always unknowns and assumptions (guesses) you will have to make when putting together a financial plan or investment strategy.

Retirement Account Features

The major drawback with a Traditional IRA is that you will have to pay taxes when you pull the funds out and you are subject to RMDs at age 72. The taxman wants his money so they require you to remove the funds.

This is why it helps to know your current tax situation and what it could be in the future. Sometimes it’s clear and sometimes not. Do the best you can.

A Roth IRA you get hit with taxes now, so no deduction on contributions, but the funds grow tax free for the rest of your life. When you take distributions from the account they are tax free (assuming you meet the requirements).

Distribution Strategy

You should have a distribution strategy when you go into retirement or need to withdraw the funds. Typically, there is a pecking order for which accounts to withdrawal funds from first and last. A lot of times this will be:

  1. A savings account or cash equivalents
  2. Taxable investment account
  3. Traditional IRA or other qualified plans
  4. Roth IRA

Cash is used for immediate and short-term needs like living expenses. You want to have your expenses covered in cash accounts.

Taxable investment accounts are accessed after cash accounts. You will be subject to capital gains tax when you go to sell any assets inside these accounts. This can be managed to an extent.

In both a Traditional IRA and Roth IRA you want to put heavy income-producing funds such as REITs or bond funds inside so you’re not taxed on the income. The other benefit is that you’re not subject to capital gains tax on any gains when you sell funds inside the accounts.

The Traditional IRA is typically used before a Roth IRA. This is due to the RMD requirement at age 72 forcing you to remove a certain amount of pre-tax funds in order for the IRS to get their money. If you fail to do so you will be hit with a 50% penalty on undistributed RMD funds, which can be substantial.

An Investment Strategy for Different Accounts

Due to this little IRS rule of RMDs, you will likely be using these funds BEFORE Roth IRA funds. THIS is what makes a big difference between the two accounts – TIME.

If you have been through any introductory 101 finance courses you’ve studied the time value of money. The more time you have on your side to stay invested the better off your portfolio is expected to be.

Let’s avoid getting into the details of statistical analysis, but basically the longer your time horizon for the funds the better your odds are for a successful outcome. This successful outcome can be in relation to risky assets. An example of these assets can be small-cap and emerging markets.

Asset Class Risk & Volatility

These two asset classes are inherently riskier when you are looking at their volatility, or how much they go up and down on any given day or year. That said, when you look over many many years and decades they have outperformed other areas of the stock market.

Logically this makes sense. You just do not know when this time period will be or be able to predict this. You do the best you can by being diligent and staying invested for long periods of time. This increases your likelihood of success by capturing the periods of outperformance in the riskier asset classes.

By this logic, typically you will be using your Roth IRA funds last, or you may even pass the funds on to the next generation, so you will want to place the riskier funds in this account.

Retirement Investment Strategies by Age

Many employer 401(k) plans have target-date retirement funds. These are used to make it easy on employees. You find your target retirement date based on your age and select the corresponding fund to invest your money in.

The issue with these funds is that they can become too conservative over time. Therefore, they can create an opportunity cost by not being invested more heavily in the stock market. This can significantly impact your rate of return over the long haul. This is why I’m a fan of building a more comprehensive portfolio when possible.

The concept of investing based on your age can still be helpful and dictate, to an extent, how you should be invested. As you get older and get closer to retirement or needing to use the funds, the more conservative you want to be. This is because you don’t have the time on your side to handle a large drop in the stock market and wait for it to recover.

How Much Money Do I Need In Retirement?

That said, it depends on what the need is from the portfolio. To me, this is the most important piece of the puzzle. You need to make assumptions and conservative estimates for larger expenses like long-term care. But overall you should decide on the fixed amount of income needed in retirement.

The less you need, the more risk you can take on therefore allowing you to be more heavily invested in stocks and vice versa.

If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER, at Applied Capital. Email him at [email protected] or fill out a contact form.

This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.

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