Registered Investment Advisor specializing in Model Portfolios

SOct 5, 2004

The Four Bag Portfolio

Scott Burns
Today's Surprise Quiz: Which is more important, the asset classes in which you invest--- or the types of accounts in which you hold those investments?   Is it possible that choosing a Roth IRA over a traditional IRA can be as important as choosing between stocks or bonds?

Sadly, the investment/retirement complex offers little help. While the investment industry has done a good deal of research on portfolio construction and asset allocation, telling us we should be diversified across asset classes, etc., it offers little help on this question.

Knowing what type of account to use, however, is becoming more important every year. There are two reasons for this.

First, it is no longer safe to assume that most of us would retire to much lower tax rates than we experienced while working. If the informal and unfunded obligations of the U.S. government to pay for Social Security and Medicare benefits are $72 trillion--- about 10 times the current formal national debt--- we can't assume a lower tax burden in the future. We must assume more taxation, not less.

Second, we already know that the peculiar way in which Social Security benefits can be taxed may cause us to pay as much as 46.25 cents in Federal income taxes on each dollar withdrawn from traditional IRA, 401(k), and 403(b) accounts. Since the threshold income for the taxation of Social Security benefits is fixed, more retirees will experience this tax every year--- just as more middle income taxpayers encounter the Alternative Minimum Tax each year.

So what do we do?

We start to build a portfolio of different accounts. Here are the four important accounts:

The Imputed Income Account.   Never heard of it, did you? It's the invisible and non-taxable "income" we receive from assets we own and use. The most important imputed income assets are the house we live in, the car we drive, and other assets that provide us with benefits in service--- not cash--- that aren't taxable. We have imputed income from our home even if it is mortgaged--- but the need to generate income to pay the mortgage may create tax bills or cause the taxation of Social Security benefits.

If you are approaching retirement and still have debt outstanding, you need to shift some of your saving to debt elimination.

The Conventional Taxable Account.   We need money in these accounts to provide for emergencies and to give us flexibility with taxes. At current low tax rates on both dividends and capital gains--- a maximum of 15 percent--- there is little reason to defer taxes. Also, since a portion of every sale will be the cost basis of the original investment, we can make selective sales at minimal tax cost. Suppose, for instance, that you sell $10,000 worth of a stock originally purchased for $5,000. You'll pay 15 percent on the $5,000 gain. That's only 7.5 percent of the cash raised.

The Employer Aided 401(k) Account.   If your employer sponsors a 401(k) account and matches part of your contributions, you can view the matching contributing as a prepayment of future income taxes. We should capture the match--- but no more. Sadly, this means many qualified accounts aren't very useful. An unmatched 403(b) account, for instance, may be a tax and expense trap. Ditto, many IRA accounts.

Recent figures from the Social Security Administration show that the current average benefits received by a couple are about $16,700 a year. This means they can have $23, 650 of other income before triggering the taxation of Social Security benefits. That, in turn, means they should strive to keep their account assets not much higher than $400,000--- and less for younger workers.

The Roth IRA Account. These accounts bypass the question of future tax rates. They allow us to pay taxes today for tax-free accumulations tomorrow. These accounts are an important tool for upper middle-income two-earner households.

How do we structure our "portfolio" of accounts?

Sorry, I have yet to find a researcher who can provide any rules of thumb. But here's a start.

- •  If you are neither rich nor poor, you need to be aware of all four types of accounts. You should have part of your net worth in each type of account.

•  If most of your financial assets are in your 401(k) or 403(b) account, you aren't diversified enough.

•  If you don't take paying off your home mortgage seriously and your home equity isn't growing rapidly, you aren't diversified enough.

•  If you don't have a plan for eliminating all consumer debt, you aren't paying enough attention to your imputed income assets.

Filed Under: Income Investing, Retirement