Investing - Which Accounts to Use?

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Taxable account, traditional IRA, 401(k)/403(b), Roth IRA – where do you put investment money? Plus HSA. Get it wrong and you can pay a lot of additional income tax, higher Medicare premiums, or miss out on an employer match. Understand this puzzle now, before it’s too late.

I’ve talked about pieces of this in past posts. This is an attempt to cover all of the issues together.

I’ll talk about five types of accounts:

• Taxable account – an ordinary brokerage account with no special tax rules.
• Traditional IRA (TIRA) - an individual retirement account with pre-tax or nondeductible contributions and tax-deferred growth. A rollover IRA is just a traditional IRA created by rolling over funds from a 401(k).
• 401(k) - an employer run pre-tax retirement account (401(k), 403(b), and similar plans).
• Roth - an after-tax account, including Roth IRA, Roth 401(k), Roth 403(b), etc.
• HSA - a health savings account

Taxable Account

You fund this with after-tax money. There are no annual contribution limits or withdrawal restrictions.

If you hold investments that generate only long-term capital gains and qualified dividends, those amounts are taxed at long-term capital gains rates when realized (when you sell or when the fund distributes gains). If you use stock ETFs, most of the equity income will be qualified dividends (taxed at long-term capital gains rates) once you’ve held the ETF long enough to meet the holding-period.

But if you use bond mutual funds or ETFs, the dividends are generally taxed as ordinary income (interest). And if you use stock mutual funds, especially those with active management, you’re likely to get capital gains distributions every year. Heavy redemptions by other shareholders, common in a down market, can force the fund to sell holdings and generate taxable gains for remaining shareholders.

Dividends are taxable in the year they are paid, even if you automatically reinvest them. When you later sell shares to raise cash, you owe tax only on the capital gain, not on the entire withdrawal. If you are making withdrawals from a taxable account, turn automatic dividend reinvestment OFF to prevent unnecessary taxable events.

Use index funds in a taxable account. This reduces yearly capital gains taxes by reducing turnover. It also reduces your chance of needing to sell a fund due to poor performance, and therefore the capital gains on any growth of the fund.

These taxes are not penalties, they are just taxes paid earlier. Each taxed dividend or distribution increases your cost basis, so you’re not taxed again on that same amount when you sell. In a taxable account, you only owe tax on gains because the account was funded by after-tax money. Brokerages will let you choose which shares to sell so that you can choose higher cost basis shares with less gain, but this takes some effort.

Traditional IRA (TIRA)

Traditional IRA contributions must be from earned income. They may be tax-deductible depending on your income and whether you are covered by a workplace retirement plan.

Withdrawals from a traditional IRA are taxed as ordinary income, regardless of whether the underlying investments produced interest, dividends, or capital gains inside the IRA. So you can reduce your taxable income in the year of deductible contributions, but you pay tax when you withdraw the money. Your tax rate may be higher or lower in retirement, depending on your situation.

Traditional IRA (and 401(k)) withdrawals count as income for Medicare purposes and can push you into higher IRMAA brackets, increasing your premiums.

Withdrawals before age 59 1/2 are generally subject to a 10% early-withdrawal penalty on top of income tax.

Required minimum distributions (RMDs) from traditional IRAs and 401(k)s generally start at age 73 (depends on your birth year). The initial RMD percentage is roughly 4% and rises with age.

Given all this, it is not clear that a TIRA is better than a taxable account. It depends on your situation and unknown future situation.

401(k)

A pre-tax 401(k) is taxed similarly to a TIRA. Contributions reduce your current taxable income and withdrawals are taxed as ordinary income. But it has some advantages over a TIRA.

Your employer may offer contribution matches in a 401(k). The match will more than make up for the tax disadvantages of a 401(k).

Many 401(k) plans offer a fund called a stable value fund. This gives bond-like returns but ensures that the yield does not fall below a specified minimum. These were designed to help reduce risk in retirement. They are typically available only within employer plans.

The yearly contribution limit for a 401(k) is about three times as high as the TIRA limit.

Roth

A Roth IRA is truly tax-advantaged. Contributions are after-tax and must be from earned income.

You can also fund a Roth via a Roth conversion, moving money from a TIRA (or from a pre-tax 401(k) to a Roth 401(k)) and paying ordinary income tax on the converted amount.

After age 59 1/2 (and after the account has been open for five years), qualified Roth IRA withdrawals are tax-free and do not count toward IRMAA. Roth IRAs also have no required minimum distributions during your lifetime.

Assuming a growing stock market, it’s usually best to do a TIRA to Roth conversion early in the year to catch a full year of tax-free growth.

Put your high growth investments in your Roth to take advantage of tax-free growth.

Direct Roth IRA contributions are limited by your modified adjusted gross income (MAGI). But TIRA conversions to Roth are not.

Your employer may offer matches to Roth 401(k) contributions. The match is usually pre-tax to a separate pre-tax 401(k). Or it may be after-tax to your Roth 401(k), depending on the plan.

BEST TO CONSULT A TAX EXPERT AT THIS POINT

If all of your TIRAs are near 100% pre-tax, and you make a deductible contribution, you can convert some or all to a Roth and pay income taxes at that point.

If all of your TIRAs are near 100% after-tax, and you make a nondeductible contribution, you can convert some or all to a Roth, paying taxes only on any earnings in the TIRA.

And if you can roll the pre-tax part of a mixed TIRA into a 401(k) (depends on your specific plan), then you are left with a near 100% after-tax TIRA.

The Roth usage decision is often described as a guess on pay taxes now or pay later. This will be a guess on government tax law and your tax bracket. But it leaves out a more important issue - in a Roth, asset growth can be withdrawn tax-free. In a TIRA or 401(k) when asset growth is withdrawn it is taxed as ordinary income.

HSA

This is funded with pre-tax money (does not have to be earned income). You must have an HSA eligible high-deductible health plan (HDHP) and not be on Medicare. The fund growth is untaxed. And any payments for healthcare (including Medicare and COBRA premiums but not other insurance premiums) from the account are untaxed. If you need the funds for other purposes and are over 65, you can withdraw and pay income rate tax on it. Under 65 add a 20% penalty. There is a yearly contribution limit and you cannot contribute if you are on Medicare, but you can continue to use the funds . Start contributing early.

This is tax free medical payments (not tax-deferred). Do not miss out.

My Takeaways

Use index ETFs in a taxable account to minimize unwanted distributions and need to sell due to poor management. Do not use a DRIP (automatic reinvestment) if you need the dividends for income - withdraw whatever you need before reinvesting to prevent an unneeded tax event.

TIRAs and 401(k) are good places for assets with income rate tax on distributions (CDs, bonds, money market) because there is tax deferral but no income vs capital gains tax rate issues.

Roths are a good place for assets that are expected to return better than inflation (stocks) because the growth is tax free.

Favor Roth's over TIRA and 401(k)s to minimize IRMAA Medicare payments.

Favor Roth's over TIRA and 401(k)s to avoid higher taxes due to wealth
accumulation.

Contribute to your Roth 401(k) or 401(k) at least to maximize employer match.

Look ahead starting at age 59 1/2, and earlier is better, make a plan for converting rolling 401(k)s to TIRAs and Roth 401(k)s to Roth IRA, and converting TIRA to Roth. The plan may be "do nothing", but if you wait too long, it will likely cost you in taxes.

Taxable accounts may be preferred over TIRA and 401(k) because long-term gains and qualified dividends are taxed at the capital gains rate instead of the ordinary income rate. But after retirement a TIRA is still convertible to Roth, while contributions to a Roth from a taxable account are not allowed without equivalent earned income.

Taxable accounts may be preferred over any tax advantaged account because the money is available for use at any time of life, penalty free.

Max out your HSA for best tax-free medical.

Investing - Investment Areas of ETFs

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The number and investment areas of ETFs have exploded in the last few years. This is an overview of the ETF areas in common use. When choosing, also consider fees and liquidity (smaller funds can be harder to trade).

Stocks (mostly capital gains rate income taxes)

    Stock Category

• total market
• value
• growth
• dividend - high dividends (for stocks), some funds screen for quality, provides income and growth
• dividend growth - growing dividends (which imply quality), provides growing income and growth
• dividend with covered calls - dividends and covered call premiums, but growth is capped

    Management Strategies

• pure index - tracks a rules based index, low turnover
• market-cap weighting - most common, largest companies dominate the return
• equal weighting - reduces large cap dominance, more rebalancing
• active management, momentum - favors stocks with good recent performance
• active management, covered call - adds income, caps growth
• active management, low volatility - tries to reduce downside, likely reduces growth, advantage if you withdraw capital for income
• active management, leveraging to increase returns - tries to amplify returns, high risk

    Market-Cap (size of the corporations, stock price times number of shares)

• large cap
• mid cap
• small cap
• total market - all sizes, if market-cap weighted then large caps dominate

    Operating Space

• total market
• technology
• healthcare
• financials
• energy
• utilities
• REIT (real estate invesment trust) - high income, tax issues
• artificial intelligence
• computer memory and storage
• computer connectivity optics
• small scale nuclear power
• semiconductors

    Geography/Currency

• US
• international, currency hedged - reduces currency risk
• international, currency unhedged - adds currency risk/reward
• global, currency hedged - reduces currency risk
• global, currency unhedged - adds currency risk/reward

Bonds (mostly income rate income taxes)

    Duration (affects volatility risk)

• ultra-short - low interest rate sensitivity, close to money market
• short
• intermediate
• long - interest rate sensitive, benefits from falling yields, falls when yield rises

   Strategies

• pure index - tracks bond index, low turnover
• active management, total return - tries to increase return by trading principal
• active management, high income - aims for high, regular payout

    Issuer/Currency

• government/treasury - low risk if you believe that the government will never default
• corporate - higher yield, riskier than government
• municipal - lower pre-tax yield, tax advantages
• international government/treasury hedged - reduces currency risk
• international government/treasury not hedged - adds currency risk/reward
• global government/treasury hedged - reduces currency risk
• global government/treasury not hedged - adds currency risk/reward

    Credit Risk

• investment-grade - lower yield, lower default risk of default
• high-yield - higher yield, higher risk of default

Thaxted

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I occasionally hear pieces of classical music that I think would make great dance tunes. I haven't succeeded in adapting any of them, most often due to phrasing issues. Contra tunes need 2/2 or 4/4 timing and 16 beat phrases. Trying to make a 24 beat, for example, phrase fit just doesn't work - it ruins the melody. And there is also tempo - it must sound right at 110-120 bpm. Waltz needs 3/4 timing, an even number of bars, and needs to work around 125 bpm.

Yesterday, I was scrolling through my Facebook feed and came across a video about someone rescuing a dog and her puppies. It was set to one of my favorite melodies. From Gustav Holst's The Planets, Jupiter, the Bringer of Jollity. This entire piece is wonderful, but what usually comes to mind is a melody from the middle.

One of many performances on YouTube - Jupiter .

I found that Holst had repurposed this melody to fit Cecil Spring Rice’s poem "I Vow to Thee, My Country", and entitled it Thaxted, a town in England where he lived for several years. This is what was used in the video.

Thaxted has been used for many songs/hymns. Perplexity AI lists eight.

I found ABC sheet music for Thaxted - not in great shape. I transposed to E minor, fixed the timing to 3/4, and added chords. ABA, 8 bar phrases. I played it at my usual waltz tempo, 125 bpm - perfect. It's a hymn, but should be good as a waltz. Perplexity AI says to emphasize the boom-chuck-chuck rhythm - sounds good.

MIDI recording

Something useful from Facebook. Wow! And a beautiful new waltz (I hope).

The ABC -

X: 1
T: Thaxted
R: waltz
C: Gustav Holst
M: 3/4
Q: 1/4=125
K: Em
B,D||"Em" E2 EG F>D|"G"GA G2 F2|"Em"EF E2 D2|"Bm"B,4 B,D||"Em"E2 EG F>D|"G"GA B2 B2|BA G2 A2|"Em"G4 ||
dB||"Am"A2 A2 GB|"D"A2 D2 dB|"Am"A2 A2 Bd|"Em"e4 ef||"C"g2 f2 e2|"G"d2 g2 B2|"Am"AG A2 B2|"D"d4 ||
B,D||"Em"E2 EG F>D|"G"GA G2 F2|"Em"EF E2 D2|"Bm"B,4 B,D||"Em"E2 EG F>D|"G"GA B2 B2|BA G2 A2|"Em"G6||

Blog Post 101

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This is blog post 101, almost 10 years after post 1. I started with a post about smart phones, suggesting that many of the "features" were less than useful. Some these features failed in the marketplace - curved screens, squeeze control. Most of my complaints were ignored.

Glossy screens - nine years after my complaint, Samsung introduced a non glare screen, only on their top of the line, huge phone. I haven't checked it out. Thankfully, matte screen covers are much improved with a fine texture that doesn't ruin the screen resolution.

OLED screens have largely replaced backlit LCD screens, but this hasn't produced optimal always on displays (AODs). With Samsung, the AOD app widgets have limited brightness that make them very hard to read in some situations. Apple thinks that AODs belong only on their Pro models - I don't know what they can display. Motorola thinks there is no reason to have an AOD. Google has an AOD with next alarm but not time zone.

None of the main screen clocks have time zone. Software designers - THE DISPLAYED TIME IS NOT COMPLETE UNLESS IT INCLUDES THE TIME ZONE THAT IT IS REPORTING IN.

Screen bezels have been minimized. I cannot use any current phone effectively without a phone cover. The cover supplies a raised "bezel" than prevents me from constantly touching the bottom of the screen and the resulting unwanted action. It also makes the phone significantly bigger - not good.

Samsung has a "game booster" that puts an icon in the lower left corner of the screen. Accidentally touch it and you get a menu. Maybe useful for action games - I don't know. But worse than useless for word games. The game booster app cannot be removed. But you can kill its function - see Samsung Galaxy S25 in my blog.

Phones keep getting bigger. You might think that a next generation small phone would be smaller or the same as the current generation. NO. Small phones keep getting bigger.

I still have never used a voice assistant or any AI feature on a phone.

Fingerprint readers have moved to the front of the phone, under the display. These have improved a lot since the Samsung S22, but still not nearly as good as the fingerprint readers on the back as on the Pixel 4A.

Google has decided that it's okay to display Android navigation buttons on top of application information. This maximizes the app size while still giving access to the navigation buttons. They think that the buttons and the underlying app don't interfere with each other. WRONG. Shrink the app - the navigation buttons don't take that much space.

Screen brightness has gotten so severe on my Samsung phone that I have to turn the brightness down to absolute bottom. Which leaves no room for optimization - just "PLEASE DON'T BURN OUT MY EYES" mode.

I don't care about the headphone jack any more. I use first generation Apple Airpods. They fit me perfectly and connect quickly.

Android split screen and insets - still useless and annoying.

Emojis are out of control. I occasionally use thumbs up, heart, smile, frown. That's all. When selecting one, I am presented with hundreds of them to choose from. Wouldn't it be easier to use a word enclosed in brackets - for example, [smile] would cause the reader to picture a smile emoji.

Minimum volume is still too loud at times. And volume steps are often too large. There has been absolutely no improvement in this in ten years. Resources MUST be directed toward new icons and emojis [satire].

And gestures have become pests. I accidentally touch the screen and something changes. I don't know what I did and I don't know what happened, other than I've lost what I was looking at.

And - WHY TO YOU KEEP CHANGING THINGS THAT WORK? How does that help the user? How about changing things that don't work?

Investing - International

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The US is in bad shape fiscally. 39,000,000,000,000 dollars in debt, an estimated 100,000,000,000,000 in unfunded liabilities. For a population of 350 million, that's $111,000 and $285,000 per person. And only one third of the population pays any federal income taxes, so 333,000 and 855,000 per taxpayer. And if the debt magically dropped to zero, our government has no mechanism to avoid returning to the same situation in short order.

It is often argued that US corporations do a lot of business internationally, so there is no need to invest in foreign businesses. But that does not address the problem of a weak US Dollar (USD).

So I decided I should be investing 20% (to start) of my assets in foreign businesses. I found that many foreign corporations allow US investment through American Depositary Receipts (ADRs). An ADR certificate represents shares of a foreign corporation and trades on a US exchange (NYSE, Nasdaq, etc.) or over the counter. Most ADRs on US exchanges are sponsored by the corporation, but others are unsponsored. ADRs remove much of the complexity of owning foreign stocks directly. Dividends from ADRs are generally qualified, after a holding period, so you pay the capital gains income tax rate. It is easy and effective to invest in foreign corporations.

ADRs are traded in USD. But the price tracks the home country price via arbitrage (institutional buys and sells). You get dividends in USD at the current exchange rate. So ADRs and their dividends reflect the value in the home country currency, making them useful as a USD hedge.

For US taxpayers, in taxable accounts, many ADRs report withheld foreign taxes on dividends. You pay capital gains taxes on trades and dividend taxes as with US stocks, but you get the foreign tax credit. In a Roth IRA the foreign tax credit cannot be used, but there are no taxes on the dividends (or capital gains). In a traditional IRA, the foreign tax credit cannot be used, and you pay income tax rate on the dividends (and capital gains) on withdrawal. I prefer using a Roth for my international assets, but many investors prefer a taxable account.

There are ETFs that include ADRs that are similar to US ETFs. SCHY is an international version of SCHD. VYMI and VIGI, international versions of VYM and VIG. All with just slightly higher fees.

Since I want stable, profitable foreign corporations, I use mostly SCHY. It has been suggested that dividend growth ETFs are likely more stable than high dividend ETFs because they exclude corporations that pay high dividends to attract investors. But dividend growth ETFs don't pay high dividends, so I consider a lot of those corporations to be growth oriented. SCHY is a good compromise because it filters on quality and dividends.

Investing - Financial Mistakes to Avoid

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Co-sign a Loan? 

Do not co-sign a loan. If a lender requires a co-signer, that means that the lender thinks that the borrower cannot repay the loan. If they don't repay, the co-signer is fully responsible to repay. And the loan likely comes with a very high interest rate. Find another way to help. 

Share an Asset with an Heir? 

If you want to transfer assets on your death, do not transfer them before your death. Do not add your heirs as co-owners of your house or brokerage accounts. If you do, they may share your cost basis as well as the assets. Under current tax law, if they inherit, their cost basis in these assets generally steps up to the value of the assets at your death. This can be a huge difference in capital gains tax if/when they sell the assets.

Transfer on Death

To easily transfer assets to heirs on your death, look into "transfer on death" for house (not available in all states) and brokerages (available from most reputable brokerages and banks). Transfer on death is a direct transfer to your beneficiaries at your death, bypassing probate, wills, and trusts. It is easy to set up and easy to change. Since this covers only specific properties and assets, is does not eliminate the need for a will or trust.

Direct Transfer of 401K to TIRA

When moving assets from a 401K or 403B to a TIRA, be certain to follow the rules to avoid making this a taxable event. The easy and safe way to do this is to authorize your brokerage to request a direct trustee to trustee transfer from your employer plan to a rollover IRA (a rollover IRA is just a traditional IRA that originated as a 401k or 403b conversion).

Borrow Money from a 401K or 403B?

Borrowing money from your 401K or 403B is risky. If you don't repay the loan on schedule, the balance becomes a (taxable) distribution. And if you leave your job (including layoff) the balance must be paid off by the next tax filing (sometimes sooner), generally April 15, or the balance becomes a distribution. If this happens, you will owe income tax on it and, if you are under age 59 1/2, a 10% penalty. Read the rules specific to your loan plan carefully.

Whole Life Insurance?

Life insurance is important if you have dependents. But be careful of what you get. It is generally agreed that "whole life" insurance is a poor value due to high fees and low return on investment. "Term" insurance is preferred, in general.

Annuity?

Annuities have their place in a retirement plan, but you must be very careful in choosing a policy. Many have a high load (sales commission) and ongoing fees and you lose control over your money and access to it. If purchased inside an traditional IRA and the annuity payments have started, distributions are taxed as ordinary income and count as the RMD for the annuity portion of the TIRA. If purchased in a taxable account, only the earnings part of the distribution is taxed (as ordinary income).

Annuity or Adviser Run Income Portfolio?

My suggestion, in preference to an annuity or an adviser run income portfolio, is an indexed dividend stock ETF, such as SCHD or VYM. These distribute mostly qualified dividends from established corporations that have a roughly 30% to 60% payout ratio. A portion of the corporate profits are given to stockholders as a qualified dividends and the rest goes to growth of the business or stock repurchase. This increases the dividends over time, likely surpassing inflation. And in a taxable account, qualified distributions get the capital gains tax rate, likely lower than the income tax rate. The fee for SCHD or VYM is .06%/year, much lower than an annuity or adviser.

Investing - Strategy and Tactics

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Strategy

 
Understand investing and why it is important. Not learning about and handling investments is a good way to end up poor. Businesses no longer have simple pension plans. The US government and Social Security are not solvent. People outlive employment by decades.

Understand taxation, especially in retirement. It is a critical element of investing.

Think of returns in inflation adjusted percents (average 2.5%, total 85%, over the last 25 years). The "wonder" of compound interest does not apply to investments that don't keep up with inflation. CDs, bonds, money market, will not grow much faster than inflation. DODIX (excellent bond fund) over 25 years, up 70%, inflation adjusted, up 12%. S&P500 over 25 years, up 696%, inflation adjusted up 430%. If you need a million dollars to retire today, plan on 1.85 million in 25 years. That's assuming a stable inflation rate.

You should initiate any investment. Letting others push your investment is ripe for them making a profit, not you. Listen to advice, evaluate it with outside sources, decide whether to use it.

Note the difference between investing and gambling - owning a share of a business (common stock) versus derivatives, futures, options, crypto coin, market timing, day trading.

Remember - investing is to earn money over decades in return for ups and downs over months.

You will make mistakes. Learn from them. Do not repeat them.

It is often suggested that you hold on to debt in favor of investing because the investing growth is more than debt interest. But - growth rates on investments are maybes. The debt interest is guaranteed and failing to keep up with the payments makes a mess.

Tactics

Bonds suppress the volatility of stock prices in your portfolio, but long term they will suppress the growth.

Dividend paying businesses, with roughly a 50% payout ratio (that's half of profits go to investors, half to growth or stock buy backs), suppress stock price volatility and add confidence to the efficacy of the businesses.

Do not use traditional mutual fund in taxable accounts. Well established indexed ETFs are far more tax efficient and are much less likely to need to be sold due to under-performance.

I prefer well established ETFs to mutual funds in tax advantaged accounts, although there is no tax advantage. ETFs have lower fees and are easier and quicker to buy, sell, and trade. But if you find a mutual fund that you like, no problem. Look for low fees, a good manager replacement strategy, a low price earnings ratio, and a stock picking strategy that you like.

After retirement, if you need money from a taxable account, turn off any automatic reinvestment. Every buy or sell is a potential taxable event. Take the money from distributions and reinvest what you don't use.

While your income is low, especially while you are young, contribute to Roth IRAs/401ks/... in preference to traditional IRAs/401ks/... A traditional IRA contribution makes a nice tax break, but you will likely end up with a much higher tax bill when it's time to use the money.

Move traditional IRA assets to Roth IRA at the beginning of the year, not the end. If you wait until the end of the year, you have missed out on a year of tax free growth. Of course you might catch a nice dip for conversion sometime during the year, but that's market timing. 

More 

Check back in occasionally if you like this, I will probably think of more to add. Suggestions are welcome.