A Guide To Investing Ira Funds In Taxable Accounts

Individual retirement accounts (IRAs) are a great way to save for retirement, offering tax advantages and a wide range of investment options. There are two main types: traditional IRAs and Roth IRAs, each with its own benefits and tax implications. Understanding these differences is crucial for effective financial planning and making the most of your IRA.

In this article, we will explore the key features of traditional and Roth IRAs, including tax treatment, contribution limits, and investment strategies. We will also discuss the importance of factors such as time horizon, risk tolerance, and asset allocation in maximising the potential of your IRA funds. By the end, you should have a clear understanding of how to invest your IRA funds in a taxable account and make informed decisions about your retirement savings.

Understand asset allocation

Understanding asset allocation is a crucial step in investing your IRA funds in taxable accounts. Here's a detailed explanation:

Asset allocation refers to how your money is divided and allocated among different types of investments. On a broader level, it involves allocating your funds across major categories like stocks, bonds, and cash. However, a more granular view considers the allocation within these categories, such as large-cap versus small-cap stocks or corporate bonds versus municipal bonds.

For example, if you invest $10,000 in an IRA account, with $6,000 in stock funds and $4,000 in bond funds, your asset allocation is 60/40. It's important to understand that stocks, also known as equities, typically offer the highest returns over time but come with higher risk. On the other hand, bonds and other fixed-income investments are relatively safer and help balance out the risk in your portfolio.

When allocating your IRA funds in taxable accounts, it's essential to consider tax implications. Tax-efficient asset allocation involves placing tax-friendly investments, such as stocks, in taxable accounts due to their lower capital gains and dividend tax rates. This strategy allows you to defer taxes and capture tax losses on poorly performing investments.

On the other hand, fixed-income investments like bonds, which generate regular interest payments taxed at higher ordinary income tax rates, are better suited for tax-deferred accounts. Additionally, tax-efficient investments like index funds and exchange-traded funds (ETFs) are also recommended for taxable accounts.

By strategically allocating your IRA funds across taxable and tax-deferred accounts, you can optimize your after-tax returns and enhance your overall investment portfolio.

It's worth noting that the optimal asset allocation may vary based on factors such as your financial profile, tax laws, investment holding periods, and the underlying securities' tax and return characteristics.

Think about risk tolerance

When it comes to investing your IRA funds in taxable accounts, it's important to carefully consider your risk tolerance. This will help you determine the appropriate asset allocation and investment strategies for your portfolio. Risk tolerance refers to the degree of risk an investor is willing to take on, given the potential volatility in the value of their investments. It's influenced by various factors, and understanding your risk tolerance will help you make informed decisions about your investments.

Age is often seen as a factor in risk tolerance, with younger investors having a longer time horizon and being perceived as more risk-tolerant. However, it's important not to make decisions solely based on age. People are living longer, and even older investors can remain aggressive investors. Additionally, those with higher net worth and more liquid capital may have a greater risk tolerance than those who are more financially constrained.

To assess your risk tolerance, consider your investment goals and your level of investment experience. If you're saving for retirement or a child's education, you may want to be more cautious with your investments. On the other hand, if you're using disposable income to earn extra money, you may be open to taking on more risk. Your investment experience also matters—it's generally prudent to approach new types of investments with caution.

There are risk tolerance assessments available online, such as surveys and questionnaires, that can help you evaluate your comfort with risk. Additionally, reviewing historical returns for different asset classes can provide insights into the volatility of various financial instruments.

It's worth noting that your risk tolerance may change over time as your financial situation, goals, and market conditions evolve. Regularly assessing your risk tolerance will help ensure that your investment strategies remain aligned with your comfort level and financial objectives.

Consider mutual funds

Mutual funds are a popular choice for IRA investments because they are easy and offer diversification. They are also professionally managed and tend to be more diversified, low-cost, and convenient than investing in individual securities.

There are two main types of mutual funds: exchange-traded funds (ETFs) and passively managed mutual funds. ETFs are traded on stock exchanges and are known for their tax efficiency, while mutual funds are bought and sold at the end-of-day net asset value (NAV) price. ETFs typically have lower expense ratios and no minimum investment requirements, making them more accessible to investors with limited capital. On the other hand, mutual funds can have higher expense ratios, especially when they are actively managed, and may involve more research and hands-on management.

When deciding whether to invest in mutual funds or ETFs for your IRA, consider the fees and tax efficiency of each option. Additionally, think about your risk tolerance and investment goals. If you are comfortable with a more hands-off approach and want to keep costs low, ETFs may be a better choice. If you prefer the idea of having a portfolio manager actively making investment decisions and are willing to pay higher fees, then mutual funds could be the better option.

Ultimately, the decision to invest in mutual funds or ETFs for your IRA depends on your personal financial situation and goals. Be sure to do your research and understand the risks and benefits of each option before investing.

Know when to seek professional help

If you don't have any interest in selecting investments, you might want to outsource this to a professional. There are two ways to get what amounts to low-cost portfolio management: target-date funds and robo-advisors.

A target-date fund is a mutual fund designed to work toward the year its investors plan to retire; because of that, the funds are named by year: If you plan to retire around 2050, you'd select a target-date fund with 2050 in its title. It will then do all of the work for you, rebalancing as needed and taking an appropriate amount of risk as you age. These funds are very popular in 401(k)s and tend to have higher expense ratios, but through an IRA, you can shop around for a wider selection to find a low-cost option. You don't need to diversify among target-date funds — you put all of your IRA money into the single fund.

Robo-advisors are another option. These are computer-powered investment managers that will choose low-cost funds and rebalance your portfolio, keeping it in line with your investing preferences and timeline — for a fraction of the cost of hiring a human financial advisor. To use a robo-advisor, you would need to open an IRA account at one of these companies, such as Betterment or Wealthfront. The companies charge an annual management fee to build and manage an ETF portfolio for you, based on your age, risk tolerance, and other factors — most services will have you fill out an initial questionnaire.

No matter what you do, it's a good idea to take steps to minimize all types of investment fees. Left unchecked, these expenses can quickly start to swallow your portfolio's returns. Make sure your IRA offers competitive commissions and abundant low-cost investment options.

Choose the right type of IRA for you

There are two main types of Individual Retirement Accounts (IRAs) to choose from: the traditional IRA and the Roth IRA. Both types of IRAs offer tax breaks, but each does so in a different way. Here are some key considerations to help you choose the right type of IRA for your needs:

Traditional IRA

With a traditional IRA, you won't have to pay taxes on your contributions, but you will have to pay taxes when you withdraw the money, typically after age 59 1/2. The advantage of a traditional IRA is that it gives you an immediate tax break, as the amount you put in is deducted from your gross taxable earnings for the year. However, you will owe taxes on the entire balance when you start withdrawing funds. You must also start taking required minimum distributions (RMDs) by a certain age, which is currently set at 75 for those born in 1960 or later.

Roth IRA

On the other hand, a Roth IRA is taxed differently. With a Roth IRA, you've already paid taxes on the money you contribute, so you won't have to pay taxes when you withdraw it in retirement. This means that the entire balance will be tax-free when you start taking it out. There are no required minimum distributions with a Roth IRA, and you can even leave it as a tax-free inheritance. However, there are income limits for eligibility, and you may be subject to a 10% penalty for early withdrawals, unless you meet certain exceptions.

Factors to Consider

When choosing between a traditional and Roth IRA, consider your current tax bracket and whether you expect to be in a higher or lower bracket in the future. If you're in a higher tax bracket now, a traditional IRA can provide immediate tax relief. If you're in a lower tax bracket, a Roth IRA may be more advantageous, as you won't pay taxes on the withdrawals later when you may be in a higher bracket. Additionally, think about your time horizon and risk tolerance. If you're a patient investor with a long-term horizon, you may be more comfortable with investments that have higher long-term return potential. On the other hand, if you're closer to retirement age, you may prefer more conservative investments like taxable bonds.

Frequently asked questions