Retirement investments typically are held in three types of accounts: taxable, tax-deferred and tax-exempt.

Taxable accounts are subject to current taxation. Contributions to the account are made with after-tax assets. Dividends, interest and capital gains are taxed as they are received. In a taxable account, the investor can choose to defer sales and resulting gains, but does not have this control over dividends and interest.

Tax-deferred accounts offer shelter from tax until the money is withdrawn or distributed. The Thrift Savings Plan, traditional IRAs, 401(k)s and deferred annuity accounts are examples of tax-deferred accounts. Contributions to tax-deferred accounts may be made with after- or before-tax money. The distributions from these accounts, to the extent that they exceed after-tax contributions, are reported as ordinary income for tax purposes in the year in which they are received.

A tax-exempt account allows the contribution of after-tax dollars, and its distributions are free from income tax. Roth IRAs are tax-exempt accounts.

For most federal employees and retirees, the alternatives boil down to TSP, 401(k)s, Roth and traditional IRAs and taxable investment accounts. But, once you’ve decided on which accounts to hold, how do you decide which securities to hold in which accounts?

One option is to allocate your assets identically in each account. The advantage is that it is relatively easy to calculate how much of each security to own in each account. Unfortunately, this method can also be inefficient and costly. If you have five investment accounts, you’ll own five lots of each security in your portfolio. If you need to increase your exposure to large-cap value stocks, for example, you’ll have to make five separate purchases – possibly paying five separate commissions – to make the adjustment. Minimizing the number of accounts you use and strategically distributing your holdings among these accounts will help you produce better after-tax results.

To take advantage of the TSP’s low cost, diversification and ease of management, I generally encourage my clients to move as much of their portfolios as possible and practical into their TSP accounts and leave it there as long as possible.

Beyond that, keep these basic rules in mind when deciding what to put where:

  • Use your TSP account for any bond or stable value allocation. As long as withdrawal restrictions don’t cause a problem, you can’t beat the G Fund for expected return on a zero-volatility investment.
  • Keep your highest-growth assets in taxable accounts. You won’t owe tax on the growth until you sell the security and realize the gain.
  • If you have a Roth IRA that will be left to your heirs, use it for high-growth investments. If you plan to use the money for retirement income, however, putting bond, stable value and dividend-paying assets inside will shelter you from future taxation.

Pay attention to your upcoming withdrawal needs. The primary objective should be to make sure you have access to the cash you’ll need.

Once in retirement and taking withdrawals, I generally recommend that you spend from your taxable accounts first, then Roth accounts and then tax-deferred accounts. This will help to take the most advantage from the benefits of tax deferral and tax avoidance available from the tax-advantaged accounts.

Written by Mike Miles
For the Federal Times
Publication February 11, 2008