The stock market goes up and, as we’ve learned, it goes down. Despite the volatility, stocks have been excellent long- term investments for many decades, and there’s no reason to think that the future will be different. Regular investing in equities, through bull and bear markets, probably should be part of your strategy for building an investment portfolio you can tap in retirement.
Many people do virtually all of their investing in 401(k) and similar employer-sponsored retirement plans. They often roll those accounts into IRAs, continuing the tax deferral. If you’re in that category, you’ll do your stock market investing inside your retirement account; you can decide what portion to allocate to equities.
Mixing your money
On the other hand, you may have both a tax-deferred retirement account and a taxable investment account. That is, in addition to your retirement accounts, you might have one or more accounts with brokerage ﬁrms or mutual fund companies where any investment income is taxed each year. In that situation, where do your stocks belong? Individual circumstances may dictate the decision.
Example 1: Jim Morgan is 33 years old with no plans to retire for at least 35 years. With such a long time horizon, Jim invests mainly in equities, where he expects the greatest long-term returns. Jim invests his 401(k) contribution in the stock market and also holds stock funds in his taxable accounts.
Other investors, especially those closer to retirement, may prefer to hold a mix of stocks, bonds, and other asset classes. Investors with such a diversiﬁed portfolio as well as taxable and retirement accounts must decide where to hold their stocks.
Example 2: Barbara Owens, age 50, has a 401(k) account, a traditional IRA and a brokerage account. Her desired asset allocation is 50% in equities and 50% in ﬁxed income. Barbara can choose among these accounts for holding her stocks.
The case for holding stocks inside a retirement account is straightforward: They have higher expected returns. Morningstar’s Ibbotson subsidiary reports that large company stocks historically have returned around 10% a year for patient investors. If Barbara contributes a maximum $24,000 to her 401(k) in 2015 and puts that money into stocks that return, say, 9% per year, that contribution would grow to around $96,000 in 16 years. Invested in bonds that earn, say, 6% a year, Barbara’s $24,000 contribution would grow to about $60,000 in 2031, which is when she plans to retire, roll her 401(k)into an IRA and start taking distributions.
Naturally, Barbara would rather have $96,000 in her IRA than $60,000. Keep in mind that diﬀerence is from one year’s contribution. If Barbara keeps investing her 401(k) money in stocks, year after year, and stocks approach historic norms, her retirement fund would be much larger than it would be with bonds. To keep her desired asset allocation and moderate portfolio volatility, Barbara can contribute to bond funds in her taxable brokerage account.
If projected returns from stocks are higher than they are from bonds, why not hold your stocks in tax-deferred territory? In a 401(k) account or an IRA, the higher returns can be compounded without an annual reduction for income tax.
However, holding stocks in a tax- deferred retirement account means giving up some key tax advantages. Under current law, stock dividends taken in a taxable account usually are taxed at only 15%; some taxpayers owe 0% on dividends, whereas a 20% tax rate applies to investors in the highest tax bracket. The same bargain tax rates apply to long-term capital gains realized in a taxable account. What’s more, investors can take capital losses in taxable accounts—losses that can provide valuable tax advantages.
In a 401(k) or an IRA, taking capital losses won’t provide any tax beneﬁt. Moreover, any distributions from such retirement accounts will be taxed as ordinary income, at rates that now go up to 39.6%. (The tax rates mentioned may actually be higher, because of various tax code provisions.) What could have been bargain-taxed stock dividends and long-term gains may be transformed into fully taxed IRA distributions.
Today’s tax rates are meaningful, but what really will count are the tax rates in eﬀect in the future, when you draw down your portfolio for retirement income. Perhaps you’ll have a low tax rate then, without earned income, so paying ordinary income tax on IRA distributions
won’t be terribly painful. Alternatively, ordinary income tax rates may be much higher in the future, so the IRS’ share of your stock market gains could be greater when you withdraw those proﬁts from your IRA.
No one has a crystal ball about future personal income and tax rates. Nevertheless, you should keep the tax aspects in mind when you decide whether to hold your stocks and stock funds in a taxable or tax- deferred account. Our oﬃce can help you crunch the numbers, so you can make informed decisions.