Investing With Two Portfolios In Mind
When it comes to investing, many people divide their money into two separate investment vehicles—a tax-advantaged retirement account, such as a 401(k) or IRA, where the funds are tied up until you’re 59 ½; and a personal investment account, which can be accessed at any time.
Both accounts are integral to your financial well-being, helping you save for retirement, buy a house, pay for college or simply prepare for a rainy day.
However, in order to achieve their maximum benefits, it’s essential that you manage these accounts properly—and not necessarily in the same way.
Because of the accounts' different characteristics, that means taking on the right amount of risk, choosing the appropriate investments and rebalancing to ensure you are maintaining an optimum asset allocation over time.
"There are certainly two different needs,” says Tom Applegate, a senior product specialist with ING Investment Management.
Risk Comes First
For either account, risk is the primary consideration.
“If you’re saving for a specific need, you look more at risk over a particular time horizon,” says Applegate.
For instance, if you are planning to use the funds in your investment account to purchase a home in the next two years, it’s important to have a conservative allocation that is light on risk to avoid big losses in a particularly bad year.
Meanwhile, he says, with retirement savings you need to focus on a combination of income replacement, risk and longevity.
With retirement accounts, “the idea is to build up a nest egg that will allow you to replace [in retirement] as much of the income you get during your current life."
Karen J. Lee, a certified financial planner with Karen Lee and Associates, says if you have at least ten years until you plan to access your retirement funds, investors should take on more risk by ratcheting up their stock exposure, as there is enough time to recoup any losses.
“Many people think the opposite,” says Lee,
On the flip side, she says, personal investment accounts often serve as an emergency reserve in the event that you have a personal financial crisis, so “from a risk perspective those should be more moderate, with less exposure to stocks.”
Taxes Can Make A Difference
Taxes are another major consideration.
In many commonly used retirement accounts such as 401(k)s and IRA rollovers, the money grows tax free.
"People don’t need to be as concerned with taxation...if someone wants active money management—making more frequent buy and sell decisions—that works best in retirement portfolio because you don’t need to worry about taxation," says Lee.
On the other hand, Lee says you need to be more careful about taxes in personal investment accounts. Not only are investors taxed for capital gains but different types of investments incur different tax rates.
For instance, according to Bonnie Biafore, author of "Personal Investing: The Missing Manual", investments such as bonds, bond funds and REITs work best inside tax advantaged retirement accounts because they incur higher taxes.
“These are not really the right investments to have in a taxable account because the income is taxed at ordinary income tax rates,” she says.
In addition, Biafore added, if you are investing in actively managed stock funds, which have a high level of turnover, or a fund that pays high dividends, those are also better in tax advantage retirement accounts as the tax bite will be greater.
In terms of the best investments for personal investment accounts, experts agree more passive investments, such as index stocks funds, are the way to go.
“Index funds have low turnover, low expense ratios and the taxable gains are taxed at a lower rate,” says Biafore, adding that index funds only change investments if the index changes and they only sell investments in the index if they have to.
In addition, personal investment accounts are also a good place to hold individual stocks, as long as it is for more than 12 months, which allows for the more favorable long-term, capital gains tax rate.
Lee adds that separately managed accounts, or SMAs, are another investment that makes sense in a personal investment account. SMAs are professionally managed portfolios of securities, similar to mutual funds, though investors actually own the underlying holdings and can have some say in customizing the portfolio.
Rebalancing Always Matters
While risk and investment selection are key in managing both retirement and personal investment accounts, another crucial aspect is how you rebalance either accounts in order to maintain the optimum allocations over time.
“Rebalancing is essential in both accounts,” says Lee, who adds "rebalancing trumps taxation.”
Lee says that while many describe theDow Industrials' showing over the past ten years as a lost decade, those who rebalanced at least once a year could have achieved reasonable returns.
When rebalancing, Lee says avoid simply rebalancing each account back to a certain allocation and look at the big picture.
According to Biafore, when you need to reallocate, start with the tax-advantaged account. That way, if your incur a gain with the sale, you wont have to pay taxes.
“If you reallocate in your taxable account you will have to pay taxes on gains and that money is no longer available to you for compounding”.
When it comes to rebalancing, Biafore says, keep things as simple as possible. “In most cases people can reassess their portfolio once a year."
In addition, “As long as you are within 5 percent of your target allocation, let it sit there and don’t worry about it.”
However, she adds that as you start to get closer to retirement—says, starting five years before the fact—be sure you don’t have to sell at a loss to pay for living expenses. it might be worthwhile to reassess your portfolio twice a year to start moving money into safer allocations.
(Editor's Note: This story was originally published in May 2010.)