Asset Allocations in Roth and Traditional?

[mountainsoft]

For the sake of simplicity, let's say you want a 50% stocks/50% bonds asset allocation, and you have both a traditional IRA and a Roth IRA with equal balances (again, just for simplicity). Is it better to put a 50/50 mix in EACH account, or put all stocks in the Roth and all bonds in the traditional?

Since the typical spending order is Taxable -> Deferred -> Roth, it seems you would want less risk in deferred since you'll spend it sooner, and more risk in the Roth since it has more time to grow.

Is one approach better than the other, or does it even matter?

Also, is there any downside to putting tax exempt bond funds like VWITX or VWLTX in a taxable account? Same reasoning, that's the account we'll spend from first, so it seems like I would want the least risk there?

 

[RunningBum]

I'd want stocks in Roth. More growth over time,and it'd be tax free there. 100 or maybe 90%.

 

[pb4uski]

For the sake of simplicity, let's say you want a 50% stocks/50% bonds asset allocation, and you have both a traditional IRA and a Roth IRA with equal balances (again, just for simplicity). Is it better to put a 50/50 mix in EACH account, or put all stocks in the Roth and all bonds in the traditional?

Since the typical spending order is Taxable -> Deferred -> Roth, it seems you would want less risk in deferred since you'll spend it sooner, and more risk in the Roth since it has more time to grow.

Is one approach better than the other, or does it even matter?

Also, is there any downside to putting tax exempt bond funds like VWITX or VWLTX in a taxable account? Same reasoning, that's the account we'll spend from first, so it seems like I would want the least risk there?

I have all fixed income in IRAs and our Roths are all domestic equities... so in your hypothetical I would put all bonds in tIRA and all stock in the Roth. The reason is tax efficiency since the historically faster growth stocks are tax free and the slower growth fixed income will be subject to ordinary taxes when withdrawn.

While the conventional spending order is taxable>tax-deferred>Roth and we did that for a few years, a couple years ago I decided to leave the taxable be because our domestic equities had appreciated so much that to raise money for spending was causing big capital gains that was using up a lot of headroom that could otherwise be used for Roth conversions. Also, those taxable equities will eventually get a stepped up basis and if so then those gains will never be taxed and I was loathe to pay tax on them when I had other sources that I could tap for spending.

What I do now is leave taxable alone, do Roth conversions to the top of 12% tax bracket which moes the maximum amount possible at a low-tax cost to the Roth and then pull from the Roth for spending.... I think that is the most tax efficient approach for us. Since we are over 59 1/2 we can pull spending money from the Roth without penalty.

If you have taxable accounts, my first preference for those is international equities because you get the foreign tax credit for foreign taxes paid and if you hold international equities in a tIRA or Roth then foreign taxes paid go to waste.... and I hate waste.

 

[Out-to-Lunch]

I would favor placing the equities in the Roth, and the bonds in tIRA, for the reasons pb4uski presents. But, in this scenario, you must accept that this is NOT a 50/50 allocation. You do not own all of your tIRA, you only own a fraction of it. In my case, I expect to pay ~25% of my tax-deferred assets in taxes, so I only really own the remaining 75% of it.

If your tax rate were similar to mine, and you truly wanted a 50/50 split, I believe the correct allocation would be to have your tIRA to be 100% bonds (knowing that you only own 75% of them), and to hold 12.5% of your Roth in bonds.

To make it easy, let's say you have $500k in Roth, and $500k in tIRA. You really own something like $500k Roth + 0.75*$500k tIRA = $875k. For 50/50/ you want to hold $437.5k stock and $437.5k bonds. You can do this by holding 100% bonds in tIRA (which nets you $375k that you actually own), and then holding $62.5k (or 12.5%) bonds in Roth. Your remaining $437.5k in your Roth would be stocks, as desired.

Here is a link that may be helpful: https://www.bogleheads.org/wiki/Tax-adjusted_asset_allocation

 

[pb4uski]

^^^ We've had debates about AA and about deferred taxes, but I've never seen anyone integrate the two like this.... it seems absurd to me. How do you know that Uncle Sam would't prefer that you invest his money in bonds?

You live up to your screen name proposing this.

 

[VanWinkle]

^^^ We've had debates about AA and about deferred taxes, but I've never seen anyone integrate the two like this.... it seems absurd to me. How do you know that Uncle Sam would't prefer that you invest his money in bonds?

You live up to your screen name proposing this.

Seems that he is proposing that the actual amount owned after taxes should be invested to attain the 50/50 AA. This is an unusual way to look at AA, but I would not say it is absurd. I do believe that the funds should be invested at the desired AA until removed from the tax deferred account and taxes become due. But mine is just one view, like yours.

Best to you pb,

VW

 

[pb4uski]

I guess if Kitces or Mike Piper or someone with more cred than bogleheads authors a paper on it I might open my mind to the idea.... until then I don't see the point... I manage the portfolio to make withdrawals to pay for spending and taxes.

I read the boglehead article and the reasons as to why seemed weak.

ETA: I see that Mike Piper did write on this and read his article... I still think the rationale is very weak.

If one was to go down this rabbit hole than you would also adjust AA for deferred taxes on significantly appreciated equities in taxable accounts because a portion of those unrealized gains also "belong" to Uncle Sam. Where does it end?

 

[RunningBum]

It ends when you have all deferred taxes covered. I use post-tax tax values for my AA as well. Includes tIRA, unrecognized cap gains,pension, and SS. Not saying anyone else has to follow but it's what I do.

 

[pb4uski]

While obviously people can do anything that they want, I don't see the benefit... it seems like a complicated solution in search of a problem.

What about estate tax? Would you include that as an encumberance on the whole pie? If someone has a mortgage should that be included too since it will eventually be paid from taxable funds?

I'll pass and KISS. My view is that I set my AA to provide reliable income and withdrawals from my portfolio and that is used for spending which includes paying taxes.

 

[Out-to-Lunch]

You live up to your screen name proposing this.

Thanks for the warm welcome to ER!

As Mike Piper concluded (when making identical arguments to the ones I made)

Bottom line: It’s worth taking a few minutes to look at your accounts to consider whether this is something you need to be concerned about.

So, you did, and concluded it was not something that concerns you. Good. I was addressing the OP's query.

So far in my life, I had reached the same conclusion, that it didn't make enough difference to matter much. This is because only about a quarter of my savings are in Roth now. However, I am planning to aggressively Roth-convert before 2025, so I am trying to ascertain if I need to worry about it going forward.

To my mind, the whole point of having a mixed AA is to control the amount of risk I am bearing. If I have a larger fraction of Roth funds, then my risk is different than a naive examination of my AA would indicate. However, I think will agree that even for AA's in the range near 50/50 (the worst case), it does not matter too much. Back-of-envelope calculations suggest it is a ~10% effect even for a large market correction (decrease) or large market growth. (Of course, we routinely see people go to much greater lengths for far less than 10% effects, so YMMV!)

 

[capjak]

For the sake of simplicity, let's say you want a 50% stocks/50% bonds asset allocation, and you have both a traditional IRA and a Roth IRA with equal balances (again, just for simplicity). Is it better to put a 50/50 mix in EACH account, or put all stocks in the Roth and all bonds in the traditional?

Since the typical spending order is Taxable -> Deferred -> Roth, it seems you would want less risk in deferred since you'll spend it sooner, and more risk in the Roth since it has more time to grow.

Is one approach better than the other, or does it even matter?

Also, is there any downside to putting tax exempt bond funds like VWITX or VWLTX in a taxable account? Same reasoning, that's the account we'll spend from first, so it seems like I would want the least risk there?

The preferred recommendation would be Bonds in Tax Deferred, High Growth in Tax Free.

In regards to holding bonds or federal and/or state tax exempt in taxable is ok (depends on tax rates) but not needed in regards to assets allocation. For example, if you have 100% stock in taxable and 100% in Bonds in tax deferred and you want to spend $50,000 in bonds than sale $50,000 stock in taxable and on the same day buy $50,000 stock in your IRA using your bond allocation (you will now have some stock in IRA but some believe this is better than having a tax drag in taxable from having too much bond allocation in taxable).

 

[pb4uski]

Thanks for the warm welcome to ER!

As Mike Piper concluded (when making identical arguments to the ones I made)


So, you did, and concluded it was not something that concerns you. Good. I was addressing the OP's query.

So far in my life, I had reached the same conclusion, that it didn't make enough difference to matter much. This is because only about a quarter of my savings are in Roth now. However, I am planning to aggressively Roth-convert before 2025, so I am trying to ascertain if I need to worry about it going forward.

To my mind, the whole point of having a mixed AA is to control the amount of risk I am bearing. If I have a larger fraction of Roth funds, then my risk is different than a naive examination of my AA would indicate. However, I think will agree that even for AA's in the range near 50/50 (the worst case), it does not matter too much. Back-of-envelope calculations suggest it is a ~10% effect even for a large market correction (decrease) or large market growth. (Of course, we routinely see people go to much greater lengths for far less than 10% effects, so YMMV!)

I'm glad that you accepted the snide remark in the spirit that it was intended (to gently tug on your chain)

Yeah, if people want to do it then fine for them but I don't see the practice becoming mainstream in financial planning anytime soon.... it just seems to add a lot of complexity for negligible benefit.

 

[MichaelB]

I'm glad that you accepted the snide remark in the spirit that it was intended (to gently tug on your chain)

I think your definition of gentle may differ from the status quo ... more of an outlier.

 

[pb4uski]

Perhaps. Gently yank seemed to be a conflict of words.

 

[RunningBum]

It all starts with the fact that money in a Roth is worth more than money in a tIRA. This is the issue being addressed. If you don't see it,you aren't trying. It may not matter enough to some. I'm already calculating my post-tax values so it's just a matter of using those numbers or the pre-tax ones. Very simple for me. If i wasn't already doing it this i probably wouldn't just for this.

Estate tax? I don't expect to owe one. Even if i did my AA is for me,not my heirs.

No mortgage for me so i haven't thought about that, but i doubt it. I don't include my house in my AA calcs so i don't think mortgages belong either.

 

[pb4uski]

So.... if OP ends up with $500k of stocks in his Roth and $500k of bonds in his tIRA and his marginal tax rate is 20%, then what is his AA?

 

[Out-to-Lunch]

So.... if OP ends up with $500k of stocks in his Roth and $500k of bonds in his tIRA and his marginal tax rate is 20%, then what is his AA?

Assuming you are asking a simple, sincere, mathematical question, and not a rhetorical one, it would be 56/44. (This further assumes that the monies are removed from the tIRA over time at the marginal rate of 20% that you posited.) He effectively (i.e., post tax) has a pot of $900k (0.8*500 + 500), and 55.5% of that is in the Roth, and 44.4% of that is in the tIRA (with $100k going to Uncle Sam).

By the way, his spendable pot of money responds to market changes in just the way that a 56/44 pot that is held all post-tax would.

 

[RunningBum]

900K total after taxes.
500/900 stocks : 400/900 bonds
55.6:44.4

Assume that marginal rate is when they expect to take it out, not necessarily now. And it includes state taxes.

 

[pb4uski]

So let's say that instead he has $250 stocks and $250 bonds in the tIRA and $250 stocks and $250 bonds in the tIRA the Roth. Then what is his AA?

Or $500 stocks in tIRA and $500 bonds in Roth. Then what is his AA?

 

[Out-to-Lunch]

So let's say that instead he has $250 stocks and $250 bonds in the tIRA and $250 stocks and $250 bonds in the tIRA the Roth. Then what is his AA?

50/50. But surely a person with your skilz knows that?

He has ($250+$250)*0.8=$400 spendable dollars in tIRA, and ($250+$250)*1=$500 in Roth for a posttax total of $900, and his effective stock percentage is (0.8*$250+$250)/$900 = 50%.

And, by the way, his spendable pot of money responds to market changes in just the way that a 50/50 pot that is held all post-tax (or all tIRA or all Roth) would.

 

[Out-to-Lunch]

Looks like you added a question after I posted.

Or $500 stocks in tIRA and $500 bonds in Roth. Then what is his AA?

In this case, his effective AA would be 44/56. He has a spendable 0.8*$500 in tIRA, and another $500 in Roth, for a spendable total of $900. Of this, ~44% [which is 0.8*$500/(0.8*500+500)] is in stocks, and the spendable remainder is in bonds.

And, by the way, his spendable pot of money responds to market changes in just the way that a 44/56 pot that is held all post-tax (or all in Roth or all in tIRA) would.

 

[pb4uski]

So while in all cases he has $1,000 in total investments and $500 of stocks and $500 of bonds, depending on the placement of his stocks and bonds his AA can range from 45/55 to 55/45 based on a calculation that integrates deferred taxes with AA.

• $500 stocks in Roth and $500 bonds in tIRA = AA of 55/45
• $500 bonds in Roth and $500 stocks in tIRA = AA of 45/55
• $250 stocks and $250 bonds in Roth and $250 stocks and $250 bonds in tIRA = AA of 50/50

Can we agree that in all 3 cases his overall investment risk is no different since he has $500 of stocks and $500 of bonds?

 

[RunningBum]

I don't agree with that.

 

[pb4uski]

I'm speechless.

 

[RunningBum]

Your turn to do the math.

Take 3 scenarios, a bull market,average market,and a downturn. Over a few years,the stock market
1) doubles
2) goes up 20%
3) loses 10%

The bonds return 4% in all cases.

At the end of this period you withdraw from each IRA and pay the taxes.

What is the return on each of your 3 cases for each of the above scenarios?