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Savvy ways to build a retirement investment plan

There seems to be some debate about whether it's best to hold stocks and other equities inside a qualified retirement plan or outside the plan. For most people, building an equity portfolio outside the restrictions of a retirement plan makes sense.

Consider the person I was advising this week: John recently sold a piece of property and had $150,000 in cash to invest. As often happens, his question to me was where he should be investing these dollars at this point in time. Rather than just putting together a portfolio for that cash, I began to dig a little deeper.

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In addition to the new cash to invest, John also had a 401(k) plan through his work in which he had a balance of about $300,000. Given that he planned to work another 15 years, the vast majority of funds in his 401(k) plan were invested in stock mutual funds.

Therefore, rather than simply advising him on the dollars that were outside his retirement account, we began a discussion about his overall asset allocation and what he was comfortable with, given the current level of the stock market.

John felt he would be fine with an equity exposure of about 70 percent, with the remaining 30 percent invested in fixed income, along with a smattering of real estate and other alternative investments.

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In scenarios such as this, the easiest thing to do is to simply build a portfolio that precisely matches that allocation and then invest all of the new cash accordingly. This is, in fact, what most people settle for. Yet the problem with this approach is that it ignores the tax benefits and tax detriments of retirement plans.

Assets that are held primarily for capital appreciation, such as many stocks and stock funds, can actually benefit from being owned outside of a retirement account.

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Why is that, you are most likely asking.

Because of the favorable tax treatment that is given to capital gains. Capital gains tax rates are lower than ordinary income, with the current maximum federal capital gains rate at 20 percent versus ordinary income rates topping out at 39.6 percent.

In addition to the favorable tax rates, assets held outside of retirement plans are not subject to the required minimum distributions that occur with individual retirement accounts and 401(k) plans when participants reach 70½ years of age.

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Furthermore, capital gains are typically forgiven upon death with a "stepped-up" cost basis, which is also not the case with retirement plans.

Think about this: If you obtain shares of your employer's stock, wouldn't you rather own those shares outside of your employer's retirement plan? Why would you want to be subjected to the restrictions of your 401(k) and have ordinary income tax rates imposed upon a withdrawal that was derived from proceeds of a capital gain?

Many investors don't have much money outside of their employer's retirement plan, so they don't have the option of holding stock funds independently. But for those who do, it's imperative that they evaluate what they own through the company's plan versus what they own on the outside.

Here's what I recommended for John: With a total portfolio of $450,000, we determined that he should allocate $315,000 in equities if he was shooting for a 70 percent allocation toward stocks.

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I advised him to invest the entire $150,000 of new cash in stock index funds. Then, with his 401(k) of $300,000, we could make up the rest of his stock allocation with index and actively managed funds and place the remaining amount in fixed income and real estate funds.

The beauty of this strategy is that the ongoing rebalances, fund replacements, changes in allocations, etc., can all occur inside his 401(k) without any tax consequences.

"Take a look at viewing all of your assets as one portfolio, then ask yourself which assets should be held in your retirement account and which ones should not."

He'll owe a little bit in taxes from dividends that are paid from the fund held outside his 401(k), but not nearly as much as he would had he built a separate portfolio of equities and fixed income.

I know many 401(k) plans have limited investment options, but almost half of all employer's plans now offer a Self-Directed Brokerage Account as part of the 401(k).

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This option enables a person to opt out of his or her employer's limited investment menu to use a brokerage window that can provide for countless investment options.

The next time you are considering making an investment change, take a look at viewing all of your assets as one portfolio, then ask yourself which assets should be held in your retirement account and which ones should not.

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