How to select investments for your retirement accounts

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Often, when investing in a retirement account, people end up inadvertently titling their overall risk profile in their combined accounts into either too much risk or too little risk. They can also end up not fully utilizing the tax advantages inherent in their qualified-retirement accounts.

You want to invest prudently in all of your investment accounts, as you will need your money to grow over your lifetime. But how do you decide which types of investments should go into your retirement accounts vs. your taxable accounts?

It is best to start by deciding on the contents and weightings of your overall investment portfolio. It is advisable to first talk to a financial planner to make sure you map out how long your money will be invested, and when you plan to start taking money out of your accounts. Establishing the appropriate risk profile of your overall portfolio is probably the most important decision you have to make. Then, you and your planner can decide on your diversification allocation across a variety of asset classes and styles of investment.

Such investment categories should include a variety of domestic and international stocks and bonds as well as an allocation to short-term low risk savings. Small amounts of nontraditional asset classes, such as real estate investment trusts and commodities, can also help balance out the risk and return of your overall portfolio. Only after you have decided on the contents of this total portfolio and your investing time horizon, should you then move to the next step of allocating the investments across the different types of accounts.

In your retirement accounts, all current investment income will be able to grow tax-deferred. However, if those investments were in your normal taxable accounts, each year you would lose as much as half of your income in taxes. The types of investments that generate a lot of current taxable income should generally go into your individual retirement account and 401(k) accounts, where those gains can grow tax-deferred for years. What kinds of investments are generally best-suited for your retirement accounts?

-- Corporate and government bonds, including related bond funds, as well as long-term certificates of deposit, where the interest income would otherwise be taxed each year

-- Stocks and stock funds that you may actively trade: They would be subject to short-term high rate taxes in your taxable accounts. But in your qualified retirement accounts, your gains can grow without being taxed until you withdraw your funds after retirement.

-- Real estate or REIT funds

As to your regular taxable accounts, it is often best to put investments that already have natural tax deferment built into their structure. What kinds of investments are these?

-- Municipal bonds (as the income is not taxed by the federal government)

-- Stocks or stock funds that are held primarily for appreciation: As long as you hold them in the long term, you won't be taxed on the appreciation portion until the stocks are actually sold.

-- Money market funds and other short-term accounts: After all, the interest income is so little it doesn't make economic sense to use up your tax-deferred account allotment for such a small-return investment.

Since you are limited in how much you can put into tax-deferred accounts, you want to make sure to take full advantage of these accounts. However, there are other factors that can influence the allocation across your taxable and tax-deferred accounts. For instance, it is generally advisable to leave your money in as long as possible, growing in your tax-deferred accounts. But depending on your age, you will eventually be required to make withdrawals from these accounts. In order to make sure you have proper liquidity, in your later years, you will likely keep a larger portion of lower risk assets in these accounts, as your risk profile becomes more conservative (even if it is marginally not as tax-efficient).

You may ask what do I do with stocks or equity funds that pay dividends? Since qualified-dividend income is often only taxed at 20 percent or less, tax considerations are not as critical as keeping the overall risk profile of your personal portfolio in a proper range. You can have dividend producing stocks and funds in both your taxable and tax-deferred accounts. One example could be that if you have already filled up your retirement accounts to the maximum amount allowed, then, having dividend-oriented stocks and funds in your taxable account is fine, as after all, the taxes will be less than on ordinary income.

Dividends are generally subject to some tax, however. If you still have extra room in retirement accounts after investing according to the above recommendations, then it is okay to put dividend-income stocks and similar funds into your retirement accounts as well. At least that way you are making sure to take advantage of the full allotment of the tax deferral in your retirement accounts.

Remember, tax minimization is important but it is not the only driver. Here are many other factors that go into deciding on your investments and allocations to accounts. Such considerations include:

Your personal liquidity situation. The money that gets invested into the retirement accounts has to stay there until you reach retirement age or else you will have to pay a penalty to the Internal Revenue Service. So, it is wise to first build up an emergency fund in your bank account, so that when you can invest in a retirement account, you will be able to leave that money in the account until after retirement. At the same time, as soon as you have enough short-term emergency money set aside, it is very important to start funding your retirement accounts as soon as you can. Look at qualified-retirement accounts as a gift from the government as your taxes are deferred; but only if you take advantage of this gift in a timely fashion.

Estate and inheritance taxes for your spouse and beneficiaries. Often times, people are only paying attention to income taxes without also looking into other taxes that can affect their estate later on.

Before closing, let me emphasize that each person's requirements can be quite different, and it is difficult to cover all personal and family tax and investment scenarios. Tax regulations are both complex and constantly changing, and often contain subtle details that can escape even sophisticated investors. It is definitely worth reviewing your investment plan with a financial advisor, a tax accountant and even an estate attorney before you execute your long-term investment plan. Indeed, I have seen more money lost over the years by people focusing too exclusively on just the income-tax impact and overlooking the risk level of their investments.

Tim McCarthy is the author of "The Safe Investor," released in February 2014, and former chairman and CEO of Nikko Asset Management Co. He has also worked at other large financial institutions such as Fidelity Investments and Merrill Lynch.

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