Some questions on investing in index funds with a Roth IRA

[stilllearning]

Hello from a new member. I like the simplicity and low costs of index funds, and have started one with Vanguard (the 500), contributing to my Roth IRA. If I wanted to add another more aggressive fund (Small-cap or something), would you recommend using the more aggressive fund for the Roth or splitting them?

Also, could I put money from the more aggressive fund into both the Roth IRA and use it in a regular non-Roth? Would I have to create a whole new account for this with the minimum of $3,000? Thanks for the help.

[meaghanchan]

Just so I'm clear: You will have two accounts (the Roth IRA and a taxable account). Right? For the taxable account (the non-Roth), you will have to create a whole new account, and meet the $3000 minimum.

My reccommendation would be to first come up with an allocation that you want for all your money. It might look something like this (very simple example):

40% US large-cap stocks
30% foreign stocks
10% small-cap stocks
10% REIT
10% bonds
____
100%.

Once you come up with that, you have to determine which funds you want to hold in tax-advantaged accounts (the Roth IRA) and which you want to hold outside your Roth, in a taxable account. You should decide not based on return, but on tax efficiency. If your account is getting taxed, I would make sure that it's not getting taxed too much, and different mutual funds have different levels of tax efficiency.

Here's a list of types of assets from least efficient to most efficient:

Hi-Yield Bonds
Taxable Bonds
TIPS
REIT Stocks
Stock trading accounts
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth Stocks
Most stock index funds
Tax-Managed Funds
EE and I-Bonds
Tax-Exempt Bonds

(This is from Taylor Larimore on the Vanguard Diehards message board)

As you can see, your S&P 500 fund is much more efficient than a small-cap fund would be. Therefore, if you wanted to hold both, you would hold the small-cap fund in your Roth IRA and the S&P 500 fund in your taxable account. Also, consider Vanguard's Total Stock Market Index instead of the S&P 500 fund. It behaves nearly the same, but holds the entire market, not just the S&P 500, and thus is even more tax efficient.

One last thing- Unless there's a specific reason for you to do otherwise, I would make sure you're maxing the Roth before starting investing outside of it.

Hope this is helpful.

[disneysteve]

Welcome to the boards!

meaghanchan has given you a great run down of tax efficiency. I agree completely. I just wanted to add that whether you invest in the small cap fund in your Roth or in a separate non-retirement account, either way you will need to meet the $3,000 minimum, so that really isn't a deciding factor.

By their nature, index funds are more tax efficient than actively managed funds regardless of what asset class they hold. The turnover rate is much lower for an index fund.

I think the last statement above is important. Why would you be considering investing outside of your Roth? If this is retirement money, keep it in the Roth unless you've got more than $4,000/year available to invest. If it isn't retirement money, that's a different story.

[stilllearning]

Yes, you are right, a Roth and a taxable. So, I guess I would need to create a new account even if the accounts use the same index fund.

Wow, so even if one fund has had higher yields, you would not put it in the Roth if it is tax-efficient, saving the Roth for things like bonds.

I am not considering investing outside the Roth. I am thinking about adding another fund in addition to the maxed out Roth (both for retirement).

These have been useful replies, thanks for the help and the welcome.

[jIM_Ohio]

A Wilshire 4500 fund should be tax efficient, would compliment S&P 500 fund well, and is a popular index for small/mid caps.

[meaghanchan]

Yes, you are right, a Roth and a taxable. So, I guess I would need to create a new account even if the accounts use the same index fund.

Yes, exactly.

Wow, so even if one fund has had higher yields, you would not put it in the Roth if it is tax-efficient, saving the Roth for things like bonds.

Actually, this is subject to a lot of debate. Whether you come out ahead putting bonds in your Roth or your bonds in a taxable account depends on current and future tax laws, which are of course unknowable. If you have a tax-deferred account, such as a 401(k), 403(b), or traditional IRA available to you, that's where I'd put bonds, and put in the Roth things that both have high expected returns and are tax-inefficient (REIT, small-cap stocks, emerging markets, for example).

But if you don't have a tax-deferred account, I would go for a total stock market index in your taxable account (VTSMX is good) and then do bonds and whatever other tax-inefficient asset classes you want to invest in in your Roth.

If you want a better answer, try Guide to the Vanguard Diehards Forums. There are some very smart people there who could probably help you run the numbers on your particular situation, given the investing vehicles available to you and your current tax bracket.

[jIM_Ohio]

Yes, exactly.



Actually, this is subject to a lot of debate. Whether you come out ahead putting bonds in your Roth or your bonds in a taxable account depends on current and future tax laws, which are of course unknowable. If you have a tax-deferred account, such as a 401(k), 403(b), or traditional IRA available to you, that's where I'd put bonds, and put in the Roth things that both have high expected returns and are tax-inefficient (REIT, small-cap stocks, emerging markets, for example).

But if you don't have a tax-deferred account, I would go for a total stock market index in your taxable account (VTSMX is good) and then do bonds and whatever other tax-inefficient asset classes you want to invest in in your Roth.

If you want a better answer, try Guide to the Vanguard Diehards Forums. There are some very smart people there who could probably help you run the numbers on your particular situation, given the investing vehicles available to you and your current tax bracket.

In general, defer paying taxes on something as long as possible. If you die without paying the tax, you came out ahead, LOL. There are exceptions, but if given the choice to pay some tax now, or defer it to later, defer.

If you KNOW, with certainty, defering will cost you more money, then pay it now.

[disneysteve]

Interesting article in Kiplinger's this month about how to draw down your accounts in retirement. It says that what makes sense during your saving years can be exactly opposite what makes sense once you've retired. When you sell shares in taxable accounts, you pay capital gains tax on the profits at a max rate of 15%. When you withdraw from a tax-deferred account, you pay income tax on the entire amount at a max rate of 38%.

So in retirement, it can make more sense to hold your growth investments in your taxable accounts and your CDs and bonds in your tax-free accounts.

Kind of a tangent to the current conversation but an interesting side note.

[jIM_Ohio]

Interesting article in Kiplinger's this month about how to draw down your accounts in retirement. It says that what makes sense during your saving years can be exactly opposite what makes sense once you've retired. When you sell shares in taxable accounts, you pay capital gains tax on the profits at a max rate of 15%. When you withdraw from a tax-deferred account, you pay income tax on the entire amount at a max rate of 38%.

So in retirement, it can make more sense to hold your growth investments in your taxable accounts and your CDs and bonds in your tax-free accounts.

Kind of a tangent to the current conversation but an interesting side note.

I have also read some financial pieces (misc.invest.financial-planning) where people are in 10% tax bracket from 401k's because the income from capital gains does not increase marginal tax rates.

I think if a person is in 25% tax bracket while working, the likelihood of being in 35% federal bracket during retirement is minimal. There is no 38% tax bracket according to my sources (see below)

If a person is in 33/35% brackets while working, the "reverse advice" is probably quite accurate. Meaning keep money outside tax shelters and use the lower capital gains tax rates to push overall tax rate lower.


Reference Room
Married Filing Jointly
Qualifying Widow(er)

Taxable income is over But not over The tax is Plus Of the amount over

• $0 15,650 $0.00 10% $0

• 15,650 63,700 1,565.00 15% 15,650

• 63,700 128,500 8,772.50 25% 63,700

• 128,500 195,850 24,972.50 28% 128,500

• 195,850 349,700 43,830.50 33% 195,850

• 349,700 + 94,601.00 35% 349,700

[disneysteve]

There is no 38% tax bracket according to my sources (see below)

33/35% brackets

You're correct. My mistake. There is no 38% bracket. 35% is tops right now.

[kv968]

Interesting article in Kiplinger's this month about how to draw down your accounts in retirement. It says that what makes sense during your saving years can be exactly opposite what makes sense once you've retired. When you sell shares in taxable accounts, you pay capital gains tax on the profits at a max rate of 15%. When you withdraw from a tax-deferred account, you pay income tax on the entire amount at a max rate of 38%.

So in retirement, it can make more sense to hold your growth investments in your taxable accounts and your CDs and bonds in your tax-free accounts.

Kind of a tangent to the current conversation but an interesting side note.

A couple of things to keep in mind with the 15% max tax rate on capital gains:

1) You have to hold the fund or stock for a year to qualify for that rate. Anything cashed in before then is taxed at your regular rate.

2) And more importantly, that 15% tax rate on capital gains is due to expire in 2010. And with the Democrats seemingly taking control, they don't like that "tax break for the wealthy" and may do away with it.

Just something to keep an eye on.

[disneysteve]

A couple of things to keep in mind with the 15% max tax rate on capital gains:

1) You have to hold the fund or stock for a year to qualify for that rate. Anything cashed in before then is taxed at your regular rate.

2) And more importantly, that 15% tax rate on capital gains is due to expire in 2010. And with the Democrats seemingly taking control, they don't like that "tax break for the wealthy" and may do away with it.

Just something to keep an eye on.

Both true. Also, we are enjoying historically low income tax rates. Those are likely to rise in the future as well. This has little to do with what party is in power IMO. It is simple arithmetic and economics. Taxes are going to need to be increased in the future to continue meeting financial obligations.

[kv968]

Both true. Also, we are enjoying historically low income tax rates. Those are likely to rise in the future as well. This has little to do with what party is in power IMO. It is simple arithmetic and economics. Taxes are going to need to be increased in the future to continue meeting financial obligations.

Although I'm not in favor with any particular political party Republican or Democrat, I do think who's in power does play a part in it. I know it's simple arithmetic and economics but that doesn't always play true in politics. More along the lines of you scratch my back and I'll scratch yours

And that's not to say that either party won't take away that tax advantage. It's just that it's coming due in 2010 and all I'm saying is keep an eye on it.

[jIM_Ohio]

A couple of things to keep in mind with the 15% max tax rate on capital gains:

1) You have to hold the fund or stock for a year to qualify for that rate. Anything cashed in before then is taxed at your regular rate.

2) And more importantly, that 15% tax rate on capital gains is due to expire in 2010. And with the Democrats seemingly taking control, they don't like that "tax break for the wealthy" and may do away with it.

Just something to keep an eye on.

If this is the logic, I just read an article this morning where people making 50k-100k are saving more (as a percentage of income) than people making 200-250k. It's not just you: rich don't save either - MarketWatch

So the way to tax the rich is thru payroll, IMO.

Let me also state for the record that I am against any taxes for anything... I already pay quite a bit and do not mind paying my share, but I do not want my tax rate increased for any reason and will vote against anyone which says they will increase taxes, has increased taxes in the past, or believes they are entitled to the money I earn and/or save.

[disneysteve]

I am against any taxes for anything.

Just curious. How do you think government should be funded if not by taxes?

Are there any developed countries that do not have some tax system to fund government services?