Greetings and a Roth vs. Trad. IRA investing question

[fickle]

Greetings from a newbie here!

I have read a few books on personal finance over the years, and I always check them for an answer to this question, but I don't see it broached.

More than half of my retirement fund is in Roths, 457b, a tax-sheltered retirement plan (with a defined component too), and a bit in a 403b (I've worked a lot of places!).

How should investing be done differently in a Roth vs. an account I will be paying taxes on as I withdraw?

My thinking, possibly very wrong, is that I should have the bond portion of my portfolio in my tax-delayed accounts, because all money will be taxed as income (not capital gains), and leave the Roths with much more aggressive stocks I might get some significant capital gains out of. (Additionally, I hope to have some Roth left over to leave to my heirs, so I see them as my longest term investments.)

I'm a bit perplexed that no writer has mentioned it!
Any thoughts appreciated.

[MakeAStash]

Yes, that's the reverse of the better way. Since CGs are usually taxed less than interest, most people put more of the interest-earning portion of their asset allocation in a Roth. Even so, I do not keep 100% of my bonds in Roth, but I do keep more there than in non-retirement accounts.

[fickle]

Yes, that's the reverse of the better way. Since CGs are usually taxed less than interest, most people put more of the interest-earning portion of their asset allocation in a Roth. Even so, I do not keep 100% of my bonds in Roth, but I do keep more there than in non-retirement accounts.

Okay, I'm confused. I'm saying I have NO bonds in Roth, hoping to harvest some dramatic CG some time in the next 20-30 years (since I won't be paying tax on the CG from the Roth), but to keep my bonds in my pre-tax retirement funds, as the dividend income would be taxed as income not CG AND every penny that comes out will be taxed as income. My bonds-for-stability portion, which historically has less earning than equities, will not have grown as much, and I'll owe less tax than if I'd made some money on the stocks, but have to pay income tax rate on them (coming out of a pre-tax contribution fund.)


Sorry. I've literally never discussed investments with another soul, so I am a bit stiff and slow with the lingo.

[Petunia 100]

Fickle, are you familiar with The Bogleheads Forum? This is one of the topics discussed on occasion. Some do place their riskiest assets in their Roths, in order to (hopefully) maximize the largest tax-free gain possible.

Personally, I think it depends on how you intend to use your Roth.

[fickle]

Fickle, are you familiar with The Bogleheads Forum? This is one of the topics discussed on occasion. Some do place their riskiest assets in their Roths, in order to (hopefully) maximize the largest tax-free gain possible.

Personally, I think it depends on how you intend to use your Roth.

No I'm not, but I will be soon.

I hope to hold my Roth until needed for a difficult time in old age (nursing home need) or to pass it on to my heirs. I mean 30 years literally. However, I'm not fixed in stone, and could move the allocations in the Roth to something more stable if I sensed storms, personal and global, a-coming.

I just found it odd it was not explicitly discussed, even in a Swedroe book where he delineates best to worst things to put in a tax sheltered account. I felt as if he talked about EVerything but this.

[MakeAStash]

Fickle - I used to think like you too, but then read up on it. At the heart of the matter is no one can reliably predict specifically which stocks will have the largest CGs during the next few decades. Think about it: if we could do that, we'd all pile into those same stocks.

Given that unpredictability, and given that most people have an overall asset allocation mix of stocks and bonds, the most tax-advantaged method is to keep more/most of your bonds in the Roth and more/most of your stocks in other accounts. One short book that illustrates this matter succinctly is "Can I Retire?" by Mike Piper.

[Petunia 100]

No I'm not, but I will be soon.

I hope to hold my Roth until needed for a difficult time in old age (nursing home need) or to pass it on to my heirs. I mean 30 years literally. However, I'm not fixed in stone, and could move the allocations in the Roth to something more stable if I sensed storms, personal and global, a-coming.

I just found it odd it was not explicitly discussed, even in a Swedroe book where he delineates best to worst things to put in a tax sheltered account. I felt as if he talked about EVerything but this.

If you have read Swedroe, then you are going to like it fine at TBH. They discuss him too, and he is well thought of there. Other authors are also discussed. Several of them post on occasion.

Bogleheads • Index page

[fickle]

Given that unpredictability, and given that most people have an overall asset allocation mix of stocks and bonds, the most tax-advantaged method is to keep more/most of your bonds in the Roth and more/most of your stocks in other accounts. One short book that illustrates this matter succinctly is "Can I Retire?" by Mike Piper.

Hmm, my reply got lost.

I understand unpredictability, but I'm trying to understand how having dividends, something that would be taxed as income in an account where everything coming out of it is taxed as income is less tax-advantaged than having CG, which could be taxed at a lower rate if not coming out of a pre-tax funded account, in that "everything is taxed as income" account.

I see it as: 1) Roth (I had no choice but to do Roth, as my income was too high for a traditional)-- everything that comes out is untaxed. Now, while nothing is a shoe in and there is unpredictability, we do indeed invest with some logic. Historically, bond return in the long run is not as good as equity return. If you have time on your side, you get a better return on stocks. If no one believes this, why don't we all just invest in TIPS and call it a day? So, with a long time horizon and a "cushion" fund I'm not counting on that will be untaxed on withdrawal, why not take more risk in the hope of getting more benefit?

2) Tax deferred (457b, 403b, etc) ALL coming out will be taxed as income. If I follow the governing mantra of age-X= % bonds for maximum stability and profit for my timeline, I want bonds somewhere. Why not in an account where everything coming out of it, principal and dividends, will be taxed at income rates. Why would I want to pay income tax rates on my bonds AND my CG from stocks by having bonds "elsewhere" and stocks in my tax-deferred accounts.

I'm sorry, I'm not understanding you. That's why I'm here. I've never discussed it with anyone and I wanted to know if I'm wandering around in the dark. I don't know what I don't know.

[MakeAStash]

Your income is too high for a traditional IRA but not too high for a Roth? It's typically the reverse, so I'll assume that's what you meant.

The asset classes taxed highest (REITs, TIPs and fixed income bonds) should be held mostly in the most tax-advantaged accounts, that's Roth. A traditional IRA or 401k are also suitable. The asset classes taxed lowest, growth (Capital Gain) stocks, should be held mostly in the least tax-advantaged accounts, that's a non-retirement investment account. Dividend stocks fall in between the two, and tax laws on dividends are changing, so that means some guesswork.

[fickle]

Your income is too high for a traditional IRA but not too high for a Roth? It's typically the reverse, so I'll assume that's what you meant.

The asset classes taxed highest (REITs, TIPs and fixed income bonds) should be held mostly in the most tax-advantaged accounts, that's Roth. A traditional IRA or 401k are also suitable. The asset classes taxed lowest, growth (Capital Gain) stocks, should be held mostly in the least tax-advantaged accounts, that's a non-retirement investment account. Dividend stocks fall in between the two, and tax laws on dividends are changing, so that means some guesswork.

I cannot get a tax break from a Traditional IRA due to income, so I choose to do a yearly Roth. I'm in that frame where I can't deduct for a traditional, but still can take a full Roth for me and spouse.

I have a LOT more money in 457b, 403b etc, so I have both the Roth (already taxed) and the tax-deferred accounts. I have almost all my bonds in by 457b (I have a few munis in a taxable account, for when I have something to invest and have completely run out of tax-advantaged places for the year). So, I don't need to use my Roths for my bonds. I did put my 10% REIT in the Roth because there was no REIT available in the 457b plan.

Once I've tucked my REITs, TIPs, and nominal bonds in for the night, what else should I put in my Roth? The large-cap growth types, the small-cap value stock, or something wooly like emerging markets? And why?

[smk]

this is a fairly complex question, so it is no wonder you are confused. i have an analysis i use to make this determination on a case by case basis. generally, while the taxation of bonds is at a higher rate, if stocks provide higher total returns over long periods, the nominal increase in taxable income can generate taxes that substantially outweigh the taxes of the bonds (at the higher tax rates). to answer your questions, i need to ask you a few. first, do you expect your tax rate to go up or down at the point of withdrawal? a drop in tax rates is the primary advantage of trad vs roth ira. second, do you expect stocks to have higher returns than bonds and by how much? last question is what rate would you expect to harvest capital gains for stocks held outside of any taxable account? then i will try to highlight the principles at work regarding your question. left too open ended this can get very complex.

[fickle]

this is a fairly complex question, so it is no wonder you are confused. i have an analysis i use to make this determination on a case by case basis. generally, while the taxation of bonds is at a higher rate, if stocks provide higher total returns over long periods, the nominal increase in taxable income can generate taxes that substantially outweigh the taxes of the bonds (at the higher tax rates). to answer your questions, i need to ask you a few. first, do you expect your tax rate to go up or down at the point of withdrawal? a drop in tax rates is the primary advantage of trad vs roth ira. second, do you expect stocks to have higher returns than bonds and by how much? last question is what rate would you expect to harvest capital gains for stocks held outside of any taxable account? then i will try to highlight the principles at work regarding your question. left too open ended this can get very complex.

Thank you for your reply.

My tax rate will go down, given today's rates. I don't assume tax rates will stay the same, but mine will probably go down. But I was stuck with Roths. My 457b, however, has much more in it than the Roths. In my first years of retirement, I hope to have 15% income tax range (todays rates) and therefore a very low capital gain rate.

I cannot "know" how much more the stock will provide in profit than the bonds, but historically it seems higher. I really can't say. With so many unknowns I think it statistically likely the stocks will have more gain than bonds, but my concrete mind won't give me "what I think".

[bjl584]

Greetings from a newbie here!

I have read a few books on personal finance over the years, and I always check them for an answer to this question, but I don't see it broached.

More than half of my retirement fund is in Roths, 457b, a tax-sheltered retirement plan (with a defined component too), and a bit in a 403b (I've worked a lot of places!).

How should investing be done differently in a Roth vs. an account I will be paying taxes on as I withdraw?

My thinking, possibly very wrong, is that I should have the bond portion of my portfolio in my tax-delayed accounts, because all money will be taxed as income (not capital gains), and leave the Roths with much more aggressive stocks I might get some significant capital gains out of. (Additionally, I hope to have some Roth left over to leave to my heirs, so I see them as my longest term investments.)

I'm a bit perplexed that no writer has mentioned it!
Any thoughts appreciated.

Without getting too complicated a Roth IRA is a good place to keep dividend yielding stocks and funds. You can take the distributions completely tax free when you retire.

[smk]

okay, i'll give you the amount of money you will have after investing $1 in stocks or bonds after 40 years. i assumed stock returns are 5% and bonds are 4%, your current tax rate is 25% and will fall to 15% in retirement. in all cases i assumed your dividend and capital gains tax rates are 15% and you don't liquidate any of your capital gains in stocks until the end (this does not have a major effect evan assuming 100% liquidation currently):
bonds stocks
tax 3.26 5.94
trad 5.03 7.47
roth 4.80 7.04


if you want to know how to assume you will regularly sell stocks in a taxable account, i can show you that. now if you increase the additional returns stocks get over bonds or increase the returns of both equally, it will amplify the $ benefit of the traditional ira to some degree. however, increasing bond returns may cause you to prefer a roth for bonds at some point. next step is you need to figure out what your actual choices are (all iinvestments in ira & whether to place stocks vs bonds in roth; have investments outside iras and can put all stocks or all bonds in them, etc.) and select the best ones. the point is that with the formulas you can look at many scenarios and figure out what you want to do. i give the formulas below with an explanation. if you need more help let me know...

most of the formulas are simple (i will explain):

bonds
tax (1+(F$8*(1-$F$6)))^$E9
trd (((1+F$8)^$E9)*(1-$F$6)+('Taxable B'!$F$6*((1+(F$8*(1-$F$6))))^$E9))
roth (((1+F$8)^$E9))
stocks
tax (1+$I$6*(1-$H$6)+(F$8-$I$6))^$E9-((1+(F$8-$I$6))^$E9-1)*$G$6
trd (((1+F$8)^$E9)*(1-$F$6)+('Taxable S'!$F$6*'Taxable S'!F9))/'Taxable S'!F9
roth ((1+F$8)^$E9)

these are excel formula's so the $ just holds the cell number constant.

for bonds f8 is the return (3%), f6 is the ord inc tax rate (25%), e is the period (40 years). so the formula is the 1+ the after tax return raised to the power of the number of years held.

the trad ira is simple 1+ the pretax return raised to 40 years and then taxed at withdrawal tax rate of 15% (these are in different worksheets so the tax rates used can be different.) then you add the tax savings when you first fund the ira and returns on it from bonds in a taxable account (you can change it to invest in something else if you wish)

the iras for stocks are exactly the same as bonds.

the formula for stocks in a taxable account is a little tricky. you will raise the after tax returns to the 40 years again. but you have to break up the components. first you take the dividend after tax ($I$6*(1-$H$6)); then you add the capital gains (F$8-$I$6) - (I6 is the dividend rate and F8 is the dividend rate + capital gains rate). then you have to subtract the taxes on the capital gains -((1+(F$8-$I$6))^$E9-1)*$G$6 where g6 is the cg tax rate.

formulas from Financial Analysts Journal
Volume 62 • Number 4
©2006, CFA Institute
PERSPECTIVES
After-Tax Asset Allocation
William Reichenstein, CFA

[fickle]

okay, i'll give you the amount of money you will have after investing $1 in stocks or bonds after 40 years. i assumed stock returns are 5% and bonds are 4%, your current tax rate is 25% and will fall to 15% in retirement. in all cases i assumed your dividend and capital gains tax rates are 15% and you don't liquidate any of your capital gains in stocks until the end (this does not have a major effect evan assuming 100% liquidation currently):
bonds stocks
tax 3.26 5.94
trad 5.03 7.47
roth 4.80 7.04


if you want to know how to assume you will regularly sell stocks in a taxable account, i can show you that. now if you increase the additional returns stocks get over bonds or increase the returns of both equally, it will amplify the $ benefit of the traditional ira to some degree. however, increasing bond returns may cause you to prefer a roth for bonds at some point. next step is you need to figure out what your actual choices are (all iinvestments in ira & whether to place stocks vs bonds in roth; have investments outside iras and can put all stocks or all bonds in them, etc.) and select the best ones. the point is that with the formulas you can look at many scenarios and figure out what you want to do. i give the formulas below with an explanation. if you need more help let me know...

most of the formulas are simple (i will explain):

bonds
tax (1+(F$8*(1-$F$6)))^$E9
trd (((1+F$8)^$E9)*(1-$F$6)+('Taxable B'!$F$6*((1+(F$8*(1-$F$6))))^$E9))
roth (((1+F$8)^$E9))
stocks
tax (1+$I$6*(1-$H$6)+(F$8-$I$6))^$E9-((1+(F$8-$I$6))^$E9-1)*$G$6
trd (((1+F$8)^$E9)*(1-$F$6)+('Taxable S'!$F$6*'Taxable S'!F9))/'Taxable S'!F9
roth ((1+F$8)^$E9)

Thank-you. I'm looking forward to the weekend to chew this over.

A quick glance at what your calculations were seems to argue for Roth for bonds now when stocks are the majority of my allocations, and later, when I'm older, the reverse. But that is at first glance. I'm not intuitively mathematical, but I can reason it out with a little time and a quiet house. I'll come back and ask if I find something I can't manage.