Not all savings accounts are created equal. Each retirement savings vehicle has different incentives:

  • Traditional IRAs and 401(k)s provide a tax deduction upon contribution, grows tax-free, but must have taxes paid on distribution
  • Roth IRAs offer tax-free growth and tax-free distributions with no upfront tax benefits
  • Health Saving Accounts (HSA) have triple tax benefits: tax deduction, tax-free growth, and tax-free withdrawals if used for qualified medical expenses
  • Taxable brokerage accounts do not have guaranteed tax-deferred growth but have favorable capital gain and qualified dividend tax rates

All in all, every account has unique features that change how you should build your portfolio within that account.

In this article, we will not discuss the benefits of saving in each account. Instead, we’ll focus on how you should structure your portfolio after you have already chosen where to save. These decisions are completely independent of each other. Please check out the Waterfall Approach to Retirement Savings for a greater focus on where to save.

Asset allocation

The most controllable factor that you have in regards to your portfolio is asset allocation. Your asset allocation determines the level of risk of your portfolio given a hundred years’ of historical data. In general, there are three main asset classes:

  • Stocks
  • Bonds
  • Alternative investments

Stocks consist of domestic and international stocks of all different sizes. Bonds include government and corporate debt of various maturities. Lastly, alternatives are “the rest”, e.g. commodities and real estate.

The general rule of thumb is that the average investor has a 60% allocation in stocks and a 40% allocation in bonds throughout their total portfolio. Does this mean that each account should have this exact allocation? Absolutely not.

Allocation by account

Allocations should always be set by account but within a total portfolio context. Since every type of account offers unique advantages, each account allocation should be tailored to benefit from those advantages. Tilting account asset allocations towards being riskier or less risky than the overall portfolio can boost after-tax growth. For example, consider the following risk assessments:

Roth IRA — this account should have the highest degree of asset risk due to the perpetual tax-free growth and lack of Required Minimum Distributions during the life of the Roth owner. In the standard 60/40 allocation, this account should lean towards 80% stocks and 20% bonds or riskier. This risk allocation will boost the performance of the account compared to the rest of the portfolio. The effect of this over the long-run will be to increase tax-free income faster than taxable income which in turn makes your retirement nest egg last longer.

Health Savings Account — next on the risky list is the HSA. This account falls below the Roth IRA only because it is not guaranteed tax-free income unless utilized appropriately. However, it still offers tax-free distributions for all current and accrued qualified medical expenses which make it advantageous to grow faster than the rest of your portfolio. Consider using a similar risk allocation as the Roth IRA. 

Taxable Brokerage — capital gains and qualified dividend tax rates are why the taxable brokerage has the next best advantage for growth. While it does not have full tax deferral, the tax rates to access the money are always lower than the Traditional IRA as long as you hold onto assets for more than one year. This account should not be as risky as a Roth IRA or an HSA but still have a higher allocation to stocks than the 401(k) or Traditional IRA. Another unique advantage that no other account has is that you can benefit from an asset falling in value inside the brokerage account. Due to this, we generally recommend holding counter-cyclical assets (investments that tend to go down when the market goes up, and vice versa) to benefit from this trend. Counter-cyclical assets generally include certain business sectors, precious metals and real estate. This is the only account where you can benefit from holding tax-exempt bonds as well.

401(k) and Traditional IRA — if you are going to take more risk in the above accounts, there has to be an account where you offset that risk in order to achieve your target asset allocation. A 401(k) and Traditional IRA is the perfect account for less risky assets. You receive all the tax benefits for these account upon contribution. After that point, the account is now a future tax burden to you as you will have to pay your ordinary income tax rates on any distributions. You are also forced to start taking distributions once you reach 70 ½. The goal is to intentionally grow this account slower by keeping a higher allocation of taxable bonds (which pay interest that will be tax-deferred) and a lower allocation of stock.

Other considerations

It is generally never advisable to go 100% in stock or 100% in bonds for any account allocation. Both of these strategies reduce account level diversification and doesn’t allow for intra-account rebalancing if the asset class that you are holding goes down in value.

Conclusion

Short-term investment performance is dependent on forces outside of your control. Long-term investment performance can be improved by taking the appropriate amount risk in a diversified way. Schedule a time to chat with us if you are interested in developing a tax efficient growth plan for your investments.

Written by Garrett Gould

Garrett Gould is a remote financial planner who specializes in long-term tax management. He is the co-owner of Halyard Financial and advises individuals, families, and small business owners throughout the nation. Garrett is an Enrolled Agent with the IRS who has passed all three of the CFA exams and has been creating financial plans for several years. Garrett is located on the Upper West Side in New York City.