Everything In Its Place

One of these days I will surely get around to writing The Best Investing Book Ever that will aid novices (or the simply disinterested) in how to navigate the investing world. And when I do, one of the first chapters will be about asset location.

If you are a regular reader of this blog (many thanks), you surely have come across my musings on asset allocation and diversification. Asset location is a closely related topic, but just different enough to warrant its own chapter.

Visualize the street that you live on. Likely there are a variety of houses and apartments. These different homes each have their own characteristics and specific advantages and disadvantages. Some you enter cheerfully, some you avoid (like the creepy neighbor’s house).

The different “money homes” you would find on your typical investing street would be a bank account, an employer retirement account, a retirement account not associated with a particular employer, and a brokerage account. Your money will be spread amongst several of these “homes” and depending on your financial goals, it really does matter which one you choose.

Let’s start with your workplace retirement account, your 401(k), 403(b) or TSP. For money that you do not need until your 60s, this is the place to be because of the tax advantages. But what if you decide that you don’t want to work quite that long? While there are a few exceptions to the “can’t touch until you are 59 ½ years old without a penalty” rule, a better option for early retirees is to assign some of their retirement savings to a different home.

That better location would be a “plain” brokerage account, an account with the investment firm of your choice. By “plain,” I mean “taxable;” the dividends, interest, and capital gains that you earn on your investments is reported each year on your income tax return and taxed accordingly. But what you give up in tax advantages, you gain in flexibility. There are no restrictions on when you can access the funds.

I am struck by the number of people I encounter who are tremendous savers within their retirement accounts but have given scant or no attention to non-retirement account investing. You have heard of “house rich and cash poor”? Meet “IRA rich and brokerage account poor.” Similar to the person who has put everything into an illiquid house investment, in a bid to tax-optimize to the nth degree, some people “over-invest” in retirement accounts (or even wonky insurance contracts, the creepy neighbor’s house), depriving themselves of the flexibility they need to fund pre-retirement needs (or wants).

Is an IRA a nicer house than a 401(k)? That is a popular question, and of course it is completely unanswerable. Is a single-family home better than a condo? It really depends on which single family home and which condo, doesn’t it?

On the surface, a workplace retirement account and an IRA may look very much alike (like a condo and a co-op, to keep the real estate analogy going). But the rules that govern them are quite different. You may assign your money to live in one or the other…or both.

Putting aside the tremendous power of automatic payroll deduction in supporting your retirement plan, the first reason why you would favor your 401(k) over an IRA is to capture the employer match if there is one. The second reason is that the amount of money that you can contribute to an IRA each year is quite small, typically $7000. For someone seriously saving for retirement, that’s not going to do the trick. Your typical 401(k) annual contribution limit is $23,500. The third reason is that you cannot make contributions to an IRA account at all if your income is too high.

Putting all that aside, there are reasons why you may still choose to send your retirement savings to live in an IRA “home”:

• You do not have a workplace retirement plan. (Duh.)

• You have hit the limit of how much you can contribute to your workplace plan and want to save even more for your retirement years.

• The investment choices at your workplace are extremely poor. And by “poor” I mean high fees (expense ratio).

Still, there are those pesky IRA contribution and income limit hurdles to overcome. The aforementioned brokerage investment account addresses those two problems handily, but it’s really not a useful solution for the issue of poor 401(k) investment selection. No matter how stinky your workplace investment fund options are, the tax benefit will outweigh it. If you are not eligible to use an IRA, hold your nose until you reach the maximum workplace account contribution limit. Better to lobby your HR department to choose a better 401(k) plan administrator. But if you are eligible to use an IRA, then you may consider splitting your retirement account savings between these two homes, 401(k) and IRA.

Attentive readers will note that I have come to the end of this story without delving into the Roth versus traditional retirement account decision, which is certainly an important part of the asset location story. Luckily, I have a response for that here!

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