In the Asset Allocation series I advised choosing non-correlated investment classes for your portfolio; that is assets that don’t go up or down at the same time. I also recommended some specific asset classes. But you don’t invest in asset classes. You buy specific things. You buy shares in a mutual fund, common stock shares, bonds, gold coins, rental houses, government or corporate bonds. And, you buy them in specific types of investment accounts.
In this series, “Structuring Your Portfolio”, I will introduce various types of portfolios suitable for average people. From the very simplest portfolio structure to fairly sophisticated structures for people who enjoy the process of investing and want to make a hobby of it.
I can not make you a professional. I’m not a professional investor myself. Mostly, I’m a self-taught hobbyist amateur. Because I’m self-taught (lots of books, lots of free newsletters, and lots of trial and error) and a hobbyist, I think I can help you get started and help you improve your investing skills and your results.
Before deciding what to buy we should think about where our financial assets will reside. Even this bit can get complicated, but for most people the choices come down to these:
1. 401k (or equivalent) account administered by your employers
2. Traditional IRA accounts administered by a bank or brokerage company
3. Roth IRA accounts administered by a bank or brokerage company
4. Taxable accounts administered by a brokerage company
5. Bank accounts administered by a bank
6. Real assets administered by you
Each of these possible homes for your investments has certain advantages and disadvantages; characteristics largely created and defined by the federal government. The key features of each investment account type are described below. There are many minor features of each type that I’m not going to cover, so these descriptions are not comprehensive.
401k plans are “tax deferred”. A percentage of your overall (before taxes) wages or salary is deducted from your pay every payday. You choose the percentage and you choose which of the limited number of investment options your payroll deduction buys.
Tax deferred means that you don’t pay income tax on the amount you contribute to the 401k account. You also don’t pay income taxes on any capital gains (increases in the value of the investments you bought) as long as the value stays in the 401k account.
In the end, you do pay income taxes on the money you withdraw from your 401k account – that’s the deferred part.
Traditional IRA Accounts
Traditional IRA’s are also tax deferred. Money you contribute up to the legal limit (currently $5,000) is tax deductable. Since your employer is uninvolved in your IRA the money is reported as income on your W-2 form, but you deduct it from your gross income when you file your income tax (Form 1040). If you withdraw money before you are 59 ½ years old you will be taxed at your normal rate plus 10% of the amount withdrawn early.
You neither report as earnings nor deduct the gains as long as the money remains in the IRA account. But, like the 401k, you pay income taxes on the money as it is withdrawn from the account. If you withdraw money before you are 59 ½ years old, the same 10% tax penalty applies as in the case of an early 401k withdrawal.
Roth IRA Accounts
Roth IRA’s are tax free instead of tax deferred. Contributions to your Roth cannot be deducted from your income tax for the year you made the contribution. But once money is in the account it will never again be subject to income tax even when it is withdrawn.
Taxable accounts are not protected from income tax in any way. You may choose to purchase specific assets that have certain tax advantages, but the account itself conveys no tax advantage. They are typically not covered by any federal insurance program.
Like Taxable Accounts, Bank accounts have no tax advantages. They are protected from loss up to $250,000 per account by the Federal Deposit Insurance Corporation.
Real Assets are things like gold coins, $100 dollar bills, houses, or collectables. The only tax advantage is whatever break you get on your income tax rate for a capital gain as opposed to your rate for regular income. Rather than collecting interest or dividends on these assets you frequently must pay for insurance, storage, or maintenance.
Each of these investment account types could have a place in your portfolio of assets and you can use more than one or even all of them. It depends, as most thing do, on your inclinations, your desires, your expertise, your disposition, your age, your risk tolerance, and your financial net worth.
Link to Other Topics in the Special Report: Structuring Your Simple Portfolio