In their mutual-fund investing, many people follow two separate paths that never meet.
Some of their fund investments are held in standard taxable accounts, and the rest in tax-favored retirement savings programs such as individual retirement accounts and employer-sponsored 401(k) plans. By one recent Investment Company Institute tally, retirement accounts make up more than one-third of all the money invested in mutual funds.
In any individual investor’s case, each of these two separate elements may be well designed in its own right. But if the left hand (the taxable side) doesn’t know what the right hand (the tax-deferred side) is doing, and vice versa, the whole effort may be flawed.
If you’re like most other fund investors, chances are your taxable fund holdings are organized at least loosely around some strategy designed to meet your personal goals while keeping some limits on risk. Also, you probably have made an effort to build a retirement portfolio that emphasizes long-term growth goals.
But even people who do all that may overlook the need to fit the two pieces together.
“By failing to treat taxable and 401(k) accounts as a complementary combination, you may unintentionally create an investment program that is too risky, too conservative, or poorly positioned to take advantage of the benefits offered by each type of account,” the Vanguard Group says in the current issue of its newsletter.
There are several important differences between the two types of investing. For one thing, taxable accounts usually contain a significant amount of money that has already been taxed by Uncle Sam, while retirement-plan money typically is pretax, since it stays outside the income tax system until it is withdrawn from the account.
Also, the choices in a 401(k) plan are often limited to a selected list of mutual funds, while money in taxable accounts can generally be invested wherever the investor pleases.
“To make the best use of both taxable and tax-deferred accounts,” suggests Vanguard, “consider first selecting investments from those available through your 401(k), and then filling in gaps in your asset allocation by using taxable accounts for investments unavailable through your employer’s plan.”