Saturday, June 02, 2007

Taxable vs. Roth investment

As I gradually get back on my financial feet after all those lean years between 2000 and 2006 and my bankruptcy in 2005, suddenly I have more investment issues than income issues. One investment issue that pops up is the question of how to decide whether each incremental dollar of savings should be invested in a taxable account versus contributed to a non-taxable Roth retirement account where it will never be taxed. The real tradeoff is the flexibility of having immediate access to the money in my taxable account, including interest and dividends that it kicks off, balanced by the fact that 15 or 20 years down the load I will be paying taxes on the investment income and capital gains taxes on the investment gains versus absolutely zero taxes on either the normal distributions of the Roth account or the investment returns that continue to accumulate in the Roth account. Superficially, investing in the Roth account seems the better way to go, but giving up flexibility is always a difficult step to take, especially given how strong the lingering, painful memories of my "recent" financial difficulties continue to be.

Currently, I have no plans to buy a house or a car or start a business and I don't have family expenses, so my needs for cash are rather minimal and don't look likely to change that much over the next few years. Still, "you never know."

The simple solution is to do both. Split each dollar, putting half in a taxable investment account and half in a Roth account.

There are strict limits on how much you can contribute to a Roth account each year, but I'm not even close to hitting them, especially considering that since I am over 50 years old I get to make significant additional "catch up" contributions. Also, I am well below the maximum annual contribution for my company Roth 401K plan, so I could easily bump that up as well.

I do have a fully-funded rainy day contingency fund for unexpected expenses, but that wouldn't be appropriate for something like buying a house or starting a business, so I do feel the need to establish at least a minimum level of taxable investments that are earmarked as "flexible use." At the present, I don't have a clue as to what size such a "fund" should be. That would argue for the 50/50 split until maybe a couple of years from now when I finally get a handle on how much of my investments I keep outside of my Roth accounts.

A minor issue for the investment money I earmark for Roth accounts is whether there is any difference whether I contribute it to one of my Roth IRA accounts or to my company Roth 401K account. I suspect that it simply doesn't matter. The company Roth 401K account has the advantage that regular payroll contributions are easy to set up, but my Roth IRA accounts have more investment options available to them.

Currently, I am accumulating a modest amount of investment capital in a taxable account every month, so it is appropriate that I come to a tentative decision relatively soon. On the other hand, I have only a very, very modest amount of taxable capital at this stage, so I might simply opt to accumulate taxable investment capital at least another year or two before boosting my Roth savings rate. My strawman proposal might be that you should have a minimum of readily accessible taxable capital of 10% of your gross annual income. I am well below that now, and even that is more of a bare minimum.

More thinking on this a required, but I think it is clear that there is no benefit to accumulating such a large amount of taxable investment capital that 20 years from now I would have to give 20% to 30% of the resulting investment income to the government when it all could be tax-free in a Roth account. For a modest amount of capital the tax amount would be bearable, but for any significant amount of capital the amount of taxes would be downright depressing.

-- Jack Krupansky


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