Successful investing is about managing risk, not avoiding it.Benjamin Graham
There seems to be a lot of contridictory advice regarding investing. A lot of advice is simply presented from a particular point of view (e.g. conservative vs. aggressive) I tried to boil down all of the investment advice I have received over the years into my investment plan. My goal is to be growth oriented and reduce risk. After all, no risk, no reward. This is a living document, and if you come back in the future there may be some changes. It doesn't contain all of the advice I have received, just the pieces I feel are most important. My investment plan helps me to organize my thoughts and stay on track with my investment goals.
Death & Taxes
While death and taxes are inevitable, you can mitigate these risks by eating healthy foods, exercising and having a good accountant. There are investment strategies that can help you minimize income taxes. You can rollover your employer-sponsored tax-deferred account (e.g. 401k, 403b, 457b or pension) into a rollover IRA account without causing a taxable event and maintain your tax-deferred status. It's a lot easier to manage your portfolio with one IRA account than to have multiple accounts at different companies. When you decide to take a distribution / withdraw from your IRA account, it can go to one of three places:
- Roth IRA conversion - distribution is taxable as ordinary income, money continues to grow tax-exempt
- Qualified Charitible Distribution - distribution is non-taxable and not included as part of your income
- You - distribution is taxable as ordinary income
Depending on where you direct the money, there are different tax consequences. Preferably you want to pay taxes out of pocket, but that might not be an option. If you pay taxes from your IRA distribution it will reduce your portfolio, but in the grand scheme of things so does paying taxes out of pocket. If you are younger than 59 1/2 and you don't qualify for an exception, your distribution will be subject to an additonal 10% tax.
Since IRA distributions are taxable as ordinary income, you want to minimize the taxes you pay on distributions. The straightforward approach to this is to spread out taxes across as many years as possible and take distributions from your IRA when your tax rate is lowest. This is easier said than done. At age 72, you are required to take IRA distributions based on your life expectancy, these are called Required Minimum Distributions. (RMDs) If your life expectancy is 25 years, then your RMD is 1/25th of your IRA balance at the beginning of the year.
The next complication to consider is the longer you defer taxes, the larger your IRA grows and the more you pay in taxes. I ran the numbers and if your effective tax rate is fixed over time, it doesn't matter when you perform a Roth IRA conversion, as long as you stay invested you will end up with the same amount of money after taxes. Since the United States has progressive tax rates that increase with your income, you want to distribute your Roth conversions over time in order to minimize the taxes you pay each year. There is no way to reliably predict what your maximum tax bracket will be in the future, so you basically need to make an educated guess on when to take your IRA distributions based on historical tax rates. This is a lot to consider when taking distributions from your tax-deferred accounts.
And then one day, I had an epiphany regarding this problem.
As with stock investing, this simple goal is somewhat elusive. How do you grow your Roth faster than your IRA? The traditional answer is to hold stocks in your Roth account and bonds in your IRA account, because stocks generally outperform bonds over the long-term. However sometimes bonds outperform stocks, especially long-term bonds. There is no way to predict stock prices, however as a result of the bond investing experience with my dad, I learned that bond funds trade within a range, so you can tell when bonds are priced high or low based on where they are within the 52-week range. One of my most important investment rules is to Always maintain asset allocation. If you maintain a constant asset allocation, there will be times when portions of your portfolio lose value. The goal is to take advantage of the time when your securities are down and realize the loss in your IRA account. This effectively reduces your future RMD amount and your future taxes.
As in real estate, location is very important in investing. Tax-deferred accounts allow you to defer income and income taxes until it is needed in retirement. A Roth IRA / 401k is a special account were investment income is tax-exempt! I have put together some guidelines below on how to use these different accounts to grow your IRA faster than your Roth IRA:
- Taxable - goal is long-term capital gains, avoid short-term capital gains, avoid excess dividends, take losses on Schedule D (tax loss harvesting)
- Roth IRA / 401k - tax-exempt, buy assets with upward momentum, realize gains here, never realize losses here
- 401k / Rollover IRA - tax-deferred, buy assets with downward momentum, realize losses here
It is obviously advantageous to make money in these accounts. What is less obvious is the advantage of losing money in your taxable or IRA accounts. If you realize losses (i.e. sell) in a taxable account, you can deduct losses on your schedule D up to a maximum taxable loss of $3,000 per year. If you realize losses in your IRA, it reduces your overall future tax. While Roth IRAs are a fantastic investment vehicle because they are tax-exempt, you never want to realize a loss in a Roth account because that money is gone forever.
Using these strategies, I invest in long-term bonds in my Roth account when they are near the 52-week low and sell them when they are near the 52-week high. In my IRA account, I invest in long-term bonds when they are near the top of the range and sell them when they are near the bottom of the range. I buy or sell stocks in the account to fund the bond transaction so that I always maintain my asset allocation and am always in the market.
One optimization to this plan is to hold cash in my IRA instead of buying long-term bonds and waiting for them to decline in value. This causes me to miss dividends in the IRA account and breaks the constant asset allocation rule. Buying short or intermediate-term bonds may be a substitute. I'll have to do more research on this.
One last strategy to point out. Since the stock market is unpredictable, if you are unsure of the future direction of a security, purchase it in your IRA or taxable account. Whether the market goes up or down, you have a way to profit from either way it moves.