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Diversifying Investment Accounts

J Terwilliger 2014
James P. Terwilliger, PhD, CFP®
Retired 2/2022, Senior Vice President, Senior Planning Advisor
[email protected]
(585) 419-0670 x50630

The media have done a good job emphasizing the importance of diversification with regard to two factors:

  • Macro allocation – Choosing a ratio of stock to bond investments that’s appropriate for your goals, risk tolerance, and investment time horizon.
  • Asset class allocation – Ensuring that holdings are properly allocated among domestic and foreign stock and bond asset classes.

However, there’s another very important diversification factor that’s often neglected: diversifying across account types (tax-deferred, taxable, and tax-free).

Tax-deferred accounts typically consist of 401(k)/403(b)/457 employer plans and IRAs. Contributions are generally tax-deductible, and earnings and growth are tax-deferred. Income taxes are paid when distributions are made.

Taxable accounts include bank and investment accounts. Income taxes have already been paid on the principal, but are then paid annually on the interest and dividend earnings, and on gains realized from security sales.

Tax-free accounts include the greatest gifts ever given to the American taxpayer by Congress: the Roth IRA and Roth 401(k). None of the generated income or capital gains on securities sales is taxable, as long as some simple timing and age rules are followed.

Each of the three accounts has its advantages and disadvantages—but except in unusual circumstances, I encourage clients to develop a mix of all three. This allows people to maximize financial flexibility during their working and retirement years, while minimizing the impact of the few associated downsides of each account type.

When accumulating assets, I typically suggest the following priority, once an adequate cash emergency fund is in place:

  • First, contribute to a traditional 401(k) up to the company match, if any
  • Next, max out a Roth IRA or contribute to a Roth 401(k), if available
  • Finally, allocate remaining dollars between taxable and tax-deferred accounts

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Please feel free to contact us with any questions you have. James Terwilliger can be reached at (585) 419-0670 ext: 50630 or via email at [email protected].

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