Q. What Should I Put in a Roth IRA? Is it Smart to Put Stocks in a Roth and Bonds in a 401K?
There is an immense amount of misunderstanding, even among financial advisers, regarding what to put in a Roth IRA. Asset location is a very important topic that has a real impact on the accumulation of wealth. But it isn't quite as simple as some would have you believe.
Tax-Protected Vs Taxable
For years, those in the know have put tax-inefficient asset classes like bonds and REITs preferentially into tax-protected accounts (Roth IRAs, 401Ks, etc) and tax-efficient asset classes like stocks (especially in total market stock index funds) into taxable accounts if necessary. In our current historically-low interest rate environment, and especially given the spread between tax-free municipal bonds and other bonds, this doesn't seem to make nearly as much difference as it used to, and some have even argued that the situation has reversed.
Roth Vs Tax-Deferred
But that's not the question you're asking. Most investors have both tax-free investing accounts (like Roth IRAs, Roth 401Ks, and perhaps even HSAs and 529s) and tax-deferred investing accounts (like traditional IRAs, 401Ks, and most other types of retirement accounts) and want to know how to allocate their assets between them.
Some well-meaning financial advisers tell them to put the asset classes with the highest expected return into the tax-free accounts. Since you expect this asset to grow faster, then it's easy to see that after years of compounding, you want the bigger account to be the tax-free one. The reasoning goes like this:
Your portfolio is 50% in a Roth IRA and 50% in a traditional IRA (let's say $100K in each). You have one asset class that you expect an 8% return from (let's call this one stocks) and one that you expect a 5% return from (let's call this one bonds). Let's assume you'll pay 20% in taxes on average while withdrawing money from the traditional IRA. Which asset class should you put into which account?
Stocks in Roth, Bonds in Traditional IRA
After 20 years, you have $466K in the Roth and $265K in the traditional IRA. After taxes, there is $212K in the traditional IRA for an after-tax total of $678K.
Bonds in Roth, Stocks in Traditional IRA
After 20 years you have $265K in the Roth and $466 in the traditional IRA. After taxes, there is $373K in the traditional IRA for an after-tax total of $638K.
See! You should put stocks in Roth, says the adviser. This approach, however, is misleading.
It Doesn't Matter If You Adjust for Taxes
The truth is it doesn't matter AS LONG AS you adjust your asset allocation for the effects of taxes. The reason the “Stocks in Roth” approach earned you more money is that you took more risk. You could have ended up in the same place by putting stocks in your traditional IRA and taking on a more aggressive asset allocation.
Since 20% of that traditional IRA actually belongs to the government, the “Stocks in Roth” approach was really an asset allocation of 56/44 and the “Bonds in Roth” approach was really an asset allocation of 44/56. Which one do you expect to have a higher expected return? The one with the more aggressive after-tax asset allocation of course!
After-Tax Asset Allocating
If you really wanted to get your 50/50 asset allocation right on an after-tax basis, then you'd put $90K into stocks and $10K into bonds in your Roth IRA, and then $100K into bonds in your traditional IRA. Or, alternatively, you'd put $90K into bonds and $10K into stocks in your Roth IRA and $100K into stocks in your traditional IRA. It doesn't matter. You'd have the same outcome.
Few people actually do this, of course, since it's a bit of a pain in the butt. The math is a little more complex and introduces an unknown variable — your average tax rate on future IRA withdrawals. But that doesn't mean you can ignore the fact that a “Stocks in Roth” approach is riskier than a “Bonds in Roth” approach.
There's no “free lunch”
I confess I don't try to figure out my asset allocation on an after-tax basis. It gets especially tricky when you have a taxable account, too. Since taxes on withdrawal are now at a different capital gains rate, there is additional tax drag as the investment grows, calculating the effects of tax-loss harvesting is nearly impossible, and your basis is constantly changing.
But I do realize that when I put stocks in Roth preferentially then I'm actually taking on more risk than my Investment Policy Statement prescribes due to my more aggressive after-tax asset allocation.
The Bottom Line
If you put your riskier, higher-expected return, asset classes preferentially into tax-free accounts, you will probably have a bigger nest egg in the future. However, that is because you took on more risk, not because there is some magic free lunch there.
What have you decided to put in your Roth IRA? Why? Comment below!
Focusing on tax efficient investments simplifies this question. When investing, focus on no-load index mutual funds. This includes stock index funds, bond index funds, and target date funds that are made up of index funds. You can find a wide assortment of index funds at Vanguard.com. Focus on reducing your costs to the lowest possible denominator (get rid of the middlemen like financial advisors, insurance agents, brokers, etc.) and this will reduce your transaction costs that a regular managed fund would incur. Less trading = fewer realized capital gains = less tax you will pay on those gains. You can learn more on this issue by going to my website: thecrazymaninthepinkwig.com. A place where you can learn without being sold.
Great article, but I have a question. I don’t follow the calculation where it says:
After-Tax Asset Allocating
If you really wanted to get your 50/50 asset allocation right on an after-tax basis, then you’d put $90K into stocks and $10K into bonds in your Roth IRA, and then $100K into bonds in your traditional IRA. Or, alternatively, you’d put $90K into bonds and $10K into stocks in your Roth IRA and $100K into stocks in your traditional IRA. It doesn’t matter. You’d have the same outcome.
Can someone please clarify? Thanks.
It’s all about tax adjusting your asset allocation. It’s a reflection of the fact that you don’t own all of your traditional IRA, the government owns some. If the government owns 20% of your IRA ($20K), then in reality you have $80K in a traditional IRA and $100K in a Roth IRA. Does that help?
Thanks for your comment. Yes, it helps, but I’m not quite getting the arithmetic where it says “If you really wanted to get your 50/50 asset allocation right on an after-tax basis, then you’d put $90K into stocks and $10K into bonds in your Roth IRA, and then $100K into bonds in your traditional IRA. Or, alternatively, you’d put $90K into bonds and $10K into stocks in your Roth IRA and $100K into stocks in your traditional IRA.” I must be missing something. Thanks again.
Let me try again Dean. You have a $100K Roth IRA. You own it all. You have a $100K Traditional IRA. You own 80% of it, the government owns 20% of it. In reality, you have $180K. Now you want a 50/50 allocation. How should you do it? You have two choices. You can either put $90K in stocks in the Roth IRA and $10K in bonds in the Roth IRA plus $80K in bonds in the Traditional IRA or you can put $80K in stocks in the traditional IRA plus $10K in stocks in the Roth IRA and $90K in Bonds in the Traditional IRA. The government’s money will be along for the ride in whatever you select for your traditional IRA, proportionally. But you can ignore it when looking at your after-tax asset allocation.
It doesn’t matter what you put in your Roth AS LONG AS YOU TAX ADJUST YOUR ASSET ALLOCATION. If you do not, then putting stocks in Roth will lead to a higher risk/potentially higher return asset allocation.
Does that help?
Yes, I finally got it. Thanks very much. Dean
Wow, I must have missed this post somehow. Glad you linked to it in your recent one. It makes sense to me now. I’ll probably still try to keep my roth accounts full of stocks, but it’s good to know that there is more risk in that.
This is a helpful article on Traditional IRA /Roth IRA location during the accumulation phase, but I don’t think it adequately addresses the de-accumulation (retirement) phase. During retirement I am not going to withdraw money from each account equally. In fact, I will make the majority of my early withdrawals from my Traditional IRA, and then after those funds are depleted, from my Roth. (Note: I am ignoring money in my taxable account. I am also aware that a combination of withdrawals from both IRA accounts may help with tax planning). Thus it is make investing sense to put higher growth / higher risk / longer term investments like stocks in my Roth account. This also minimizes the sequence of return risks during earlier years (see Kitces and Pfau) by withdrawing funds from more conservative (bond) investments in my Traditional IRA.
Comments?
I disagree. You’re simply taking more risk. Of course you expect higher returns from that. And that’s fine to do, but just realize what you’re doing.
I’m not sure I get what you’re talking about with minimizing sequence of returns risk by withdrawing from bonds. If you do that without rebalancing, your portfolio just gets riskier and riskier, increasing your sequences of returns risk. Was your solution to sequence of returns risk to NOT rebalance? That doesn’t seem like a great idea to me.
I am in the same boat as Ricky. This is a great post that I missed from a few years ago. I think that the concept of after-tax asset allocation is pretty cool. I, like Dean above, had some difficulty understanding the example above, but now it makes great sense (great clarification WCI).
I think a true after-tax asset allocation would be most important to consider for people with larger Roth accounts. It would also be more complex to calculate for investors with Roth, 401k, and taxable accounts in their portfolio. The main problem I see with using an after-tax asset allocation is that your taxes on withdrawal can be only estimated. Using some of the methods described by WCI in other posts, for the average physician or professional, taxes could be very low in the withdrawal phase if a combination of 1. “filling up the low brackets” 2. Social Security 3. using some long term capital gains to supplement income or 4. Roth withdrawals (I know many would want to use as a “stretch” Roth IRA, so it might be used last). To keep the conversation going: wouldn’t a low tax bracket in the withdrawal phase (very possible for many docs) limit the effect of an after tax asset allocation?
You’re right, the lower your retirement tax bracket, the less any of this matters. Truthfully, I mostly ignore it. I just think it’s important that people realize that the strategy of putting your riskiest assets in Roth does increase your expected return, but only because it increases the risk of the portfolio.
Took a couple of reads but makes sense to me now. Good concept to be aware of even though I, like you, will likely continue to set and enact my asset allocation on a pre tax basis. My Roth currently is 90/10 stock bond. Currently, I’m fine with more risk as I’m young and don’t plan to need the money for at least 20 years.
The Prudent Plastic Surgeon
This is a bit outside the scope of the article, but: what about withdrawals in retirement? Meaning: if the conventional wisdom is to withdraw first from taxable, then tax deferred, then tax-free (Roth), and there’s a huge dip in the market, should i be revisiting the withdrawal order? Should i be planning to re-allocate what i’ve invested in those accounts, if i’m 3 or 5 years from retirement?
Thanks for any advice, or pointing me in the right direction…
I’m not sure that’s the conventional wisdom. If I were asked for a rule of thumb for retirement withdrawals, it would be:
# 1 All taxable income including distributions from the taxable account, Social Security, Pensions, real estate rents, interest on bank accounts, and RMDs.
# 2 High basis taxable assets
# 3 Low basis taxable assets (maybe, if you’re going to die soon this may not be a good move.)
# 4 A mix of tax-deferred and tax-free accounts in an effort to manage your tax rate. i.e. tax-deferred to the top of a bracket and tax-free after that. Again, this could vary depending on who you plan to leave money to upon death. For example, if you plan to leave to charity, then spend tax-free and leave tax-deferred to charity. If you plan to leave to your kids, then spend tax-deferred and leave tax free to the kids (assuming they’ll also be in a high tax bracket).
All that said, if there is a “huge dip” you could make an argument to just spend from your bonds, wherever they might be. You could also make an argument to spend from tax-deferred and taxable because the tax hit would be lower than it used to be. But there is no reason to reallocate. You can rebalance at any point you need to. If you withdraw from stocks in tax-deferred, you can exchange from bonds to stocks in tax-free and it’s all the same.
That conventional wisdom can go out the door under many different circumstances based on someone’s individual circumstances, income from other sources when pulling out money, what kind of account(s) they want to leave their heirs, etc. Yes, the general rule of thumb is to keep low turnover stock index funds in the taxable account (earning long term capital gains), bonds in the qualified account and your higher risk stocks that are not tax efficient (Small-Cap Value and Real Estate for example) in your Roth, but that can cause a problem if you are ready to withdraw and stocks are tanking at the moment, forcing you to pull from the qualified account and pay taxes, which may or may not be a bad thing since hopefully you are in a lower marginal federal and/or state tax bracket.
Here is an easy way to play it safe in case that scenario plays out. Put some high quality bonds like the Short-Term Bond Index Fund or the Total Bond Market Index Fund at Vanguard in your Roth IRA just in case you need to pull from bonds and you don’t want to add to your tax bill. This is especially relevant in the first half year of retirement when you may still be paying taxes on your earned income from your job. Also, you want to consider your fixed income at the time and whether pulling from the portfolio will even be necessary. Learn more on these issues by reading What Color is the Sky and Graduation! They will set you down the path toward that place called Financial Freedom!!!!!!
You don’t need to do that. You can simply pull stocks from the Roth and swap bonds for stocks somewhere else.
For someone who is first deciding how much to contribute to their Roth vs Traditional IRA: How do you factor in the taxes lost up front when contributing to the Roth IRA? Does that impact allocation, and are there any strategies?
The best way to think about it is to realize a tax-deferred account consists of a tax-free account and an account that you are investing on the government’s behalf. Once you look at it from that point of view, everything else falls into place. i.e. The upfront taxes on the Roth IRA don’t matter.
For most high income professionals, there is no option to make a tax-deferred IRA contribution, so it’s Roth (usually Backdoor Roth) IRA or nothing. If you’re talking about 401(k)s, this article should help:
https://www.whitecoatinvestor.com/should-you-make-roth-or-traditional-401k-contributions/
This is also a nuanced issue. Here are my guidelines for those living in Iowa who pay state income tax as it relates to a 401(k), 403(b), TSP, 457 at work and a Traditional or Roth IRA outside of work. If an individual/couple make under $60,000/$120,000 go with the Roth at work and Roth outside of work. If you make over those amounts, go with the Traditional at work and probably the Roth outside of work (there are income thresholds that stop you from contributing to a Traditional IRA starting at $104,000 for a couple and $196,000 for a Roth in 2020. In most cases, the Traditional IRA should be avoided when it comes to contributions. Use it for transferring old retirement accounts only.
Contribute to the Roth IRA as long as you can stay under that income threshold (contributing to a traditional retirement plan at work will bring the income down). If you are over that threshold, consider a backdoor Roth IRA, but first get all of your Traditional IRA money in a Traditional retirement plan at work with good investments if possible to avoid a tax nightmare later down the road. These recommendations apply to the current marginal rates that keeps your federal marginal bracket at 12% for the income under those thresholds and 22% for those over (which is why you are trying to get the tax benefit now).
In the simplest terms, get the 22% discount when it applies, but pay the 12%. It is more likely that will work out in your favor when you retire and your marginal bracket is lower (hopefully, but not a guarantee). One more point, these numbers apply to a state that taxes income. If you live in one of the 9 that do not, you might consider raising the income thresholds to $70,000 and $140,000.
If you’re making $60K/$120K and don’t expect a rapid increase in income any time soon you might be reading the wrong blog. 🙂 That said, the advice is probably pretty good, at least as good as other rules of thumb.
WCI,
This is quite an old post but since it landed in my inbox today, I will send you a link to one I did on the exact same subject in 2016:
https://seekingalpha.com/article/3979557-myths-concerning-roths-iras-and-rmds
I took a somewhat easier path (at least I think) by comparing equal pre-tax earnings rather than equal dollar amounts which are unequal earnings.
When you compare equal earnings it is easy to see that it doesn’t matter whether your 2% assets are in the Roth and your 8% assets are in the IRA or vice versa, as long as the tax rates are the same. Of course, if you are the purist then you may want to adjust the asset allocation on an after-tax basis in both accounts.
We republish “classic” posts every Tuesday. I agree the purest thing to do is to look at asset allocation on an after-tax basis. Few do that and I don’t blame those who don’t since I don’t do it either.
Michael Kitces writes about Tax Diversification in Retirement very clearly and with graphs using all three buckets-taxable, tax deferred, and tax free
Michael Kitces writes about Tax Diversification in Retirement very clearly and with graphs using all three buckets-taxable, tax deferred, and tax free
Common Sense dictates all equity in Roths as for most its the last bucket to touch and a nice inheritance
Personally building mine up with conversions as A fla resident with a low effective tax rate 16-18% on 300k income
Using a 500k Roth as long term care insurance if need be
I’m too lazy to tax-adjust my allocation. But, I buy VTSAX in my Roth and buy bonds and international funds in my 401(k) because the employer institutional shares of those funds are cheaper than what I can buy in my personal Roth.
Ok… tangential comment here. I had that EXACT Marvel superheroes lunch pail when I was a kid!
I remember just staring at all the different heroes while eating lunch at school and talking to other kids, of course: )
I always thought the panel that had the hulk transforming from Bruce Banner to Hulk was the most intriguing for some reason.
Little did I know at the time that Marvel would eventually become a Disney juggernaut. Should’ve bought Disney stock at that time with my milk money.
Ok, back to Roth IRAs, tax brackets, and asset allocation.
I have a different take on Roth asset allocation, and I hope you can let me know if I’m missing something. I plan on an annual percentage of portfolio withdrawal of 4% from a Traditional IRA with a 75/25 asset allocation. For simplicity, assume a 10% tax rate. For every $90 net income, I am selling $75 from stocks. For the Roth, I will reduce to a 3.6% withdrawal rate, because no taxes are due. If I have an 83/17 asset allocation in Roth, for every $90 of net income, I’m again selling $75 from stocks. It seems like these should be considered equivalent asset allocations.
No. The asset allocations are different. You simply don’t own all of the traditional IRA account. You only own 90% of it.