The House with Two Front Doors

By Andy Ives, CFP®, AIF®
IRA Analyst
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A little house on Easy Street has one front door. It is a traditional IRA. There is a sign above the lone entry point the reads, “To All Those That Enter, Thy Earnings Will be Taxable.” It does not matter if the money that enters through the front door is a contribution or rollover or transfer. Most of the arriving dollars, and all of the earnings on those dollars, will be taxable when they leave. (Some money that passes through the front door of the traditional IRA house will receive a special wristband the reads “BASIS” and it will not be taxable upon departure. However, those “Basis” visitors will still enter through the single door beneath the “Earnings Will be Taxable” sign.)

Every traditional IRA home can be decorated differently. This particular traditional IRA house has an ETF sofa, an individual stock leather chair, and a couple of mutual fund recliners. The traditional IRA across the street might have four ETF sofas, or the living room may well be adorned with a dozen mutual fund folding chairs. Another traditional IRA house might have a single stock futon in the middle of the room and no other furniture to speak of. It is up to the account owner to decorate their traditional IRA home with whatever investment furniture they choose – within reason.

Down Easy Street is another house, also with a single front door. This house looks similar to the others, but upon closer inspection, the sign above the door is slightly different. It reads, “To All Those That Enter, Thy Earnings Will be Tax-Free.” This must be the Roth IRA house. Any assets entering through this single front door, whether they be contributions, rollovers, transfers or conversions, will be after-tax dollars and the earnings will be tax-free (assuming all conditions are met). There is no other way to enter the structure.

Peeking through the Roth front door, the furniture is just as random as in the traditional IRA houses. Roth IRA account owners, like traditional IRA owners, can furnish their homes with nearly any investment they like. However, it is recommended that all Roth and traditional IRA account owners consult with an interior decorator, i.e. a financial advisor. A good advisor will know which quality investment fabrics and furniture styles pair best with paint and flooring.

Progressing down Easy Street, a larger building looms through the trees. Rounding a corner, it is apparent that this home has two separate and distinct front doors, but it is not a duplex. There is one owner/resident. The name on the mailbox explains the house with two front doors. It reads, “401(k) Account w/Roth Component.” This makes sense. The signs over the two front doors are exactly the same as the signs over the traditional and Roth IRA doors. One reads, “Taxable,” the other, “Tax-Free.” Two doors, but funds enter a single structure.

Upon inspection inside, the “401(k) Account w/Roth Component” house has a more limited selection of furniture than the IRA houses. Typically, there are no extravagant sculptures or wild investment paintings in a 401(k) house. The 401(k) homeowner can only choose investment furniture from an approved list of sturdy, heavily scrutinized items. While taxable and tax-free dollars can sit on the same approved mutual fund couch within the 401(k) home, it must be an approved couch, and the taxable and tax-free dollars must enter and leave through their own doors.

Not all 401(k) houses have two doors. Some only provide access through a door with an “earnings will be taxable” sign overhead. These 401(k) buildings can be remodeled to add a “tax-free Roth” door, but it is not required. Building codes dictate you cannot construct a 401(k) house with only a “tax-free Roth” door. There must be a “taxable” entry point.

Regardless of the retirement home where your assets reside, be sure to keep it clean and orderly. Mow the lawn and tend to necessary repairs. Have your investment furniture reviewed at least annually by a competent and trusted advisor, and hopefully your house on Easy Street will soon be filled to the ceiling!