Two IRA investing questions

[manlymatt83]

I have two questions about IRAs and retirement/investing in general. People always say invest in index funds and forget about it. Don't invest in individual stocks. This leaves me with two questions:

• Do index funds only mean large cap funds? Funds that track an index like S&P? Is it smart to have anything small or mid cap in an IRA? Don't those usually beat the larger caps?
• Let's say hypothetically I wanted to buy and hold an individual stock long term, like Johnson & Johnson. Should I put this in my IRA or is it better to put into a taxable account? If it's in a taxable account, then dividends will only get hit with a long term capital gains tax, right? And if it's in my IRA, even if I reinvest dividends, when I do finally cash out I'll end up paying my normal taxes on all of it.

Any thoughts on these? Thanks!

 

[dullard]

Index funds are a way to significantly reduce risk without affecting your target stock mix (much). For example, if you wanted to invest in computer chips, you could buy Intel or AMD. But which one? Buying just one stock means that you are putting a lot of eggs in one basket. You could go all in on one chip maker and choose the wrong one. You could buy both, but then you are ignoring other chip makers (Samsung, Qualcomm, Micron, TSMC, etc) any of which could have done far better. Why not buy them all?

When it comes to your retirement, which should be of utmost importance to you, you want minimum risk while still maintaining diversity to ensure good growth. Thus, buying just one stock is pretty much the opposite of what you want (individual stocks are high risk). Thus index funds are usually recommended for retirement accounts.

But you aren't limited to any type of index fund in your retirement accounts. Get some large cap, some small cap, some growth funds, some value funds, some US funds, some foreign funds, etc. Then your retirement plans are protected from any one company going bust.

Then if you have additional money, go ahead and get individual stocks.

I highly recommend you read William Bernstein's books. The Four Pillars of Investing is a great quick read. Or at least for a start, go here and look at the Sheltered Sam (where you want stocks sheltered from capital gains taxes, since they are not a concern in an IRA) portfolio: https://www.bogleheads.org/wiki/Talk:Slice_and_dice

 

[manlymatt83]

Index funds are a way to significantly reduce risk without affecting your target stock mix (much). For example, if you wanted to invest in computer chips, you could buy Intel or AMD. But which one? Buying just one stock means that you are putting a lot of eggs in one basket. You could go all in on one chip maker and choose the wrong one. You could buy both, but then you are ignoring other chip makers (Samsung, Qualcomm, Micron, TSMC, etc) any of which could have done far better. Why not buy them all?

When it comes to your retirement, which should be of utmost importance to you, you want minimum risk while still maintaining diversity to ensure good growth. Thus, buying just one stock is pretty much the opposite of what you want (individual stocks are high risk). Thus index funds are usually recommended for retirement accounts.

But you aren't limited to any type of index fund in your retirement accounts. Get some large cap, some small cap, some growth funds, some value funds, some US funds, some foreign funds, etc. Then your retirement plans are protected from any one company going bust.

Then if you have additional money, go ahead and get individual stocks.

I highly recommend you read William Bernstein's books. The Four Pillars of Investing is a great quick read. Or at least for a start, go here and look at the Sheltered Sam (where you want stocks sheltered from capital gains taxes, since they are not a concern in an IRA) portfolio: https://www.bogleheads.org/wiki/Talk:Slice_and_dice

Thanks! I'll read that book, and your answers make sense. I guess my only outstanding question is then ... say I max out my IRA each year. Should I buy JNJ in my IRA, or in a taxable account, if I'm going to own it ANYWAY?

 

[dullard]

Question 2:

For stocks in taxable accounts, then qualified dividends are at the long term capital gains rate. That is, assuming that you have held the stock long enough. Not all dividends are qualified dividends though.

But, you usually don't want dividend paying stocks in taxable accounts. Even if it is a long-term capital gains rate, that is tax money that you have to keep paying year after year even if you never cash in on it (such as if it is reinvested). Plus, if you do reinvest it, then you have to keep track of hundreds of stock purchases for each time it is reinvested which makes doing your taxes a nightmare.

Think of the worst case scenario: you buy a stock for $100/share. Then the next day it pays a $100/share dividend and the shares become worth $0/share (Net effect is theoretically $0, as you had $100/share before and $100/share afterwards). What happens? You pay short-term capital gains on $100/share and leave losing roughly a third of your money. Even though technically, you had $100 in cash both before and after that transaction, but now you owe taxes on that $100.

You are correct that if a dividend paying stock is in a retirement account, then you don't pay any taxes until you cash out your retirement account. Then the tax rate depends on the type of account (Roth IRA = no taxes ever again, regular IRA = pay taxes at your ordinary income tax bracket).

 

[BurnItDwn]

make sure you pay close attention to the maintenance fees. Usually passive index funds are around 1/4 of 1 percentage point. Actively maintained funds can be quite a bit higher.

I like midcaps, but have some in blue chips and some in small caps as well as a token amount in a foreign fund.
I also have approx 10% of my portfolio in Stock shares of the company where I am employed.

 

[manlymatt83]

Got it. So investing 90% of my IRA in index funds and keeping a few individual stocks at around 10% total value (like JNJ) isn't the worst thing in the world. And if I'm going to hold JNJ long-term (20-30 years), better in an IRA than in a taxable?

 

[dullard]

Thanks! I'll read that book, and your answers make sense. I guess my only outstanding question is then ... say I max out my IRA each year. Should I buy JNJ in my IRA, or in a taxable account, if I'm going to own it ANYWAY?

Assuming that you buy and HOLD, then the taxable account is okay for it. You'll take the dividend tax hit each year. But if you trade it frequently, you'll pay a lot of capital gains taxes on the transactions and you should be aware of what you are doing.

 

[dullard]

Got it. So investing 90% of my IRA in index funds and keeping a few individual stocks at around 10% total value (like JNJ) isn't the worst thing in the world. And if I'm going to hold JNJ long-term (20-30 years), better in an IRA than in a taxable?

I'd think about it just a bit differently. Get as much into your tax deferred plans as possible (401k, IRA, etc). So, if you don't have much money, put it all into the retirement accounts, even individual stocks.

If there is money left over (you maxed out your retirement accounts), then use taxable accounts. If you have to choose what to put in the tax deferred accounts and what to put in the taxable accounts, then put things that will be taxed a lot into the retirement accounts (volatile stocks, actively managed funds where the broker buys and sells frequently, etc) and things that will be taxed as little as possible in the taxable accounts (such as an individual stock that you buy and hold).

 

[manlymatt83]

I already max out my IRA each year -- but that's only like a $5500 limit. Are there other tax free accounts I could have? I'm self employed.

 

[dullard]

I already max out my IRA each year -- but that's only like a $5500 limit. Are there other tax free accounts I could have? I'm self employed.

Rather than reinvent the wheel, here is one link:
https://www.irs.gov/retirement-plans/retirement-plans-for-self-employed-people

The SEP plan lets you invest far more (up to $55000/year) than us employed people can ever imagine to invest in a retirement account (up to $18000/year in a 401k). I've never had one, so I cannot speak about it.

Not listed on that page, is a health savings account (HSA). It is by far the best way to avoid taxes. The only catch is that you need a high deductible health insurance plan.

 

[Cozarkian]

Index funds usually have the word index in the title. The manager purchases a variety of stocks designed to mimic the market for whatever index is being tracked. They are passively managed to keep expenses low. The low expense ratio is the real identifier and the reason many people recommend them

Conversely, you can find actively managed funds, which have higher expenses because the managers are attempting to beat the market, requiring them to make trades more frequently and spend more time on market research.

Many people recommend index funds because they have lower costs, are less risky, and less time consuming. The theory is over the long run, the market will match or beat all of the mutual fund managers, so you might as well incur less fees. However, other people believe that with adequate research you can find actively managed funds that are worth the higher expenses because they have smart people making smart decisions for higher rewards. If you do that, though, you need to spend more time monitoring them to make sure they don't change personnel or stated goals in a way that will reduce gains.

In sum, index funds require less time and have lower risk than active funds but have lower ceilings for possible gain because the goal is to match the market, not beat it.

 

[brianmanahan]

IRA income limits are pretty restricting if you're single, they start to phase out at ~60$k for traditional IRA and ~120$k for roth IRA

 

[s0me0nesmind1]

IRA income limits are pretty restricting if you're single, they start to phase out at ~60$k for traditional IRA and ~120$k for roth IRA

But of course there is backdoor ROTH.

By the way, I always find this incredibly odd..... Do they just expect everyone to be employed with an employer that provides 401ks as a replacement?

 

[brianmanahan]

But of course there is backdoor ROTH.

yeah i really need to do this, wouldn't have to worry about limits and phaseout anymore. but i'd need to get rid of my traditional IRA first. rolling it into my 401k is probably the easiest thing to do, but i wouldn't be able to do small cap value tilting anymore since my 401k doesn't offer that.

 

[manlymatt83]

Speaking of not re-inventing the wheel... mostly on topic so I'll simply reply here. If I want an aggressive strategy in my IRA, is it better to follow something like Capital One's portfolio builder:

https://ibb.co/dx6Lmb

... or follow creative strategies, like this one:

https://seekingalpha.com/article/41...s-market-37-percent-weathers-downturns-better

For the former... I already checked on feex.com and there are no lower fee alternatives. But the second strategy is simpler, and has better historical returns. And yes, I understand how risky SSO would be with the leverage, but just trying to get some outside perspective.

 

[Exterous]

I vote for the first option but maybe with a few tweaks. Your international holdings in that portfolio tend to be on the lower side of the recommendation range. The typical range is 25-40% (although outliers exist outside those bands). I'm not familiar with schwab offerings but there are Vanguard and Fidelity funds that cover all ex-us stocks in a single fund. This makes rebalancing easier unless you are going for a market tilt for. Some reason. I think the small cap + mid cap is a little high so if you do add more international I'd take it from there.

If this is your overall portfolio mix (ie no bonds or treasuries) then be prepared to weather a drastic drop and stay your course through it. Many people thought they could but 2009 shows us a lot will panic and withdraw money at the bottom making things so much worse for them than if they had given up some gains to add in bonds