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.