allocating bonds across 401k & Roth IRA to max Roth balance

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allocating bonds across 401k & Roth IRA to max Roth balance

Postby 15202guy » Thu Dec 27, 2012 2:52 pm

I am seeking opinions/advice as to whether I would be more likely to maximize the return *in my Roth IRA* if I put my AA-dictated allocation of bonds in both my 401k and my Roth IRA, or if I should put the entire bond position in the 401k. I guess the argument for splitting the position across the two accounts is that the bonds will provide a rebalancing opportunity within the Roth, whereas the argument for concentrating it in the 401k is that the additional stock value in the Roth has a higher expected return than the corresponding value in bonds. To be clear, my goal is to maximize the ending balance of my Roth, since my understanding is that my overall ending balance will be the same no matter which option I choose (if this is incorrect, please correct me).

As a concrete example, say my bond allocation is 20%, my 401k balance is 100K and my Roth balance is 50K. Should I go with:

All bonds in 401k scenario: 70K stock in 401k, 30K bond in 401k, and 50K stock in Roth
Bonds split between Roth and 401k scenario: 80K stock in 401k, 20K bond in 401k, 40K stock in Roth, 10K bond in Roth

I posted in this forum because I believe that this is a general question and that the answer is not specific to my unique financial situation. Thanks in advance for your thoughts!
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby TS1 » Thu Dec 27, 2012 3:04 pm

Historically, in the US, and over time periods of many years, 100% stocks gives a higher return than any mix of stocks and bonds. To the extent that is repeated over your time horizon, your Roth will grow larger if you keep the bonds elsewhere. This is made more likely by the particularly low expected return on bonds currently.

However, on shorter timescales, keeping your Roth all-stock will make it more volatile.

So you should consider both your long-term expectations for stock returns and the length of your investment timeframe. Deviating from a 'mirrored' allocation in both accounts has potential benefits but does add some uncertainty to the eventual relative sizes of the accounts. It is possible to end up worse off.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby Taylor Larimore » Thu Dec 27, 2012 3:23 pm

To be clear, my goal is to maximize the ending balance of my Roth.


If you ignore other considerations (future tax rates, safety, etc.) the answer is easy. Put funds with the higher expected return (stocks) in the Roth.

Best wishes.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby 15202guy » Thu Dec 27, 2012 6:26 pm

Thank you for the replies. Leaving the Roth as all stock is what I expected the answer would be, but I wanted to seek confirmation. Since my time horizon is 20+ years and I am willing to take considerable risk in this portion, I will proceed with that plan for the current time...I will likely gradually add bonds to the account several years in the future.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby Bob's not my name » Thu Dec 27, 2012 9:03 pm

It doesn't make any difference where you hold your bonds. tfb's site appears to be down right now, so here's the article I contributed there. When it's back up, the link is http://thefinancebuff.com/stocks-or-bonds-in-roth.html

A number of spurious arguments are made for holding riskier assets in your Roth IRA as opposed to a Traditional IRA. Let’s examine them. For simplicity, we’ll refer to risky assets as stocks and less risky assets as bonds, but the arguments get more specific than that, arguing for small cap stocks and REITs in Roth, for example.

Myth #1: The Roth is a Magical Tax Kingdom
Some people believe that if you hold stocks in your Roth you’ll pay less in taxes. Their argument goes like this: if I hold a $5,000 Roth (post-tax) IRA and a $5,000 traditional (pre-tax) IRA, and stocks triple in value by my withdrawal date while bonds only double, it will be better to have held the stocks in my Roth because then I have $10,000 taxed at withdrawal (from bonds in Traditional IRA) and $15,000 tax-free (from stocks in Roth).

The fallacy of this argument is that $5,000 of post-tax savings and $5,000 of pre-tax savings are obviously not equivalent, so what you’re really doing when you make your Roth all stocks is taking on a riskier asset allocation. It’s easy to prove this to yourself by considering the outcome if stocks drop by half instead of tripling. Now your stocks-in-Roth plan would leave you with $10,000 taxable and $2,500 tax-free, whereas the stocks-in-Traditional-IRA alternative would leave you with $2,500 taxable and $10,000 tax-free.

If you tax-adjustyourassetallocation the perceived difference is eliminated. Is that necessary? For most people, tax-adjusting your Asset Allocation won’t make a very big difference. It’s just important to recognize that the false advantage of holding stocks in Roth is entirely eliminated if you make a true comparison by tax-adjusting your asset allocation.

Sticking with our simplistic example, a 20% tax rate on withdrawals would make a $5,000 Traditional IRA equivalent to a $4,000 Roth, so a 50/50 stock/bond asset allocation would compromise, e.g., $5,000 of bonds in the Traditional IRA, $4,500 of stocks in the Roth, and $500 of bonds in the Roth.

Myth #2: Stocks in Roth Protect You from Tax Changes
It is argued that, since a Roth is post-tax, holding stocks in Roth will protect you from changes in the tax code. This is also false.

As illustrated above, to avoid false conclusions about asset placement you have to assume some tax rate on your Traditional IRA withdrawals. You don’t know what it will really be, so you make your best guess. If your tax rate turns out to be higher than your best guess, it will have been better to have had your higher-growth assets (stocks) in Roth. However, if your tax rate turns out to be lower than your best guess, it will have been better to have had your higher-growth assets in your Traditional IRA.

Note that this is all relative to your best guess, not to your current rate, or rates in general. By definition, your best guess is your best guess, which means that there are equal probabilities of it being too high or too low. Therefore, where you place stocks offers no protection from tax changes.

Myth #3: Stocks in Roth Protect You from Social Security Taxation
Social Security taxation is just one of a thousand elements of the tax code. There’s no reason to single it out from all the others.

Sure, many non-retired taxpayers are ignorant of the rule, so their best guess at their future tax rate may be too low. But one can also argue that most taxpayers overestimate their current tax rate, overestimate the rates retirees pay, don’t know that their state exempts a lot of retirement income from taxation, and discount the possibility of being laid off, sick, or disabled in the future, all of which combine to make their best guesses too high.

We come back to the same conclusion: your best guess is your best guess.

Myth #4: Stocks in Roth Reduce Your Required Minimum Distributions (RMDs)
This is the only stocks-in-Roth argument that survives a little scrutiny, but it can’t stand a lot of scrutiny. The argument is that if you hold stocks in Traditional IRA and the stock market does well, you’ll have large RMDs, which is undesirable. However, if you are within a decade of making withdrawals, the risk that stocks will do worse than bonds can’t be ignored, so holding stocks in Roth IRA could backfire on you.

Another way to look at this is to consider what would happen if you held stocks in your Traditional IRA and your seventies (viz., the first decade of RMDs) turned out to be a long bull or bear market. A bull market would trip larger RMDs, but you could afford them. On the other hand, a bear market would reduce your RMDs when you most need to husband your resources and mitigate taxes.
If you are more than a decade from withdrawals, it is an imprudent bet that RMD rules will remain unchanged. I believe the 2009 RMD holiday was a portent – RMD rules are going to change during the first two decades of boomer retirement.

Valid Reasons for Asset Placement
You should really place your assets according to where you can get the best funds at the lowest expense ratios to make up your portfolio. Most 401k’s have at least one low cost stock index fund, but many do not have a low cost bond option. Therefore, a low cost portfolio is often constructed by concentrating stocks in your 401k (meaning a traditional 401k, which is pre-tax like a Traditional IRA) and bonds in your Roth.

Another reason to hold bonds in your Roth IRA is if you are depending on your Roth for an emergency fund. Roth contributions (but not earnings) can be withdrawn at any time for any reason, tax- and penalty-free, so a Roth IRA can be a good back-up emergency fund, especially if you couldn’t otherwise afford to contribute to a Roth. In this case, it’s important not to hold risky assets in your Roth.

If neither of these reasons applies to you, then it doesn’t matter what you hold in Roth vs. Traditional IRA.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby FNK » Thu Dec 27, 2012 9:07 pm

You're looking for http://www.bogleheads.org/wiki/Tax-Adju ... Allocation

My mind was blown a little bit by that concept.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby TS1 » Thu Dec 27, 2012 10:02 pm

It seems to me that even if you tax-adjust your allocation, and even if the adjustment turns out to be perfectly accurate, and even if you rebalance, you will still be better off to have kept the faster growing asset class in the account with the lowest tax rate, because it will have made that account larger relative to the more heavily-taxed one, so you will have more after-tax money.
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IRA calculator

Postby Taylor Larimore » Thu Dec 27, 2012 10:31 pm

Guy:

Morningstar has a free calculator used to determine which type IRA is best for an individual investor. It appears simple to use. Consider your 401k as similar to a Traditional IRA. I would be interested in knowing your result.

http://screen.morningstar.com/IRA/IRACalculator.html

Best wishes.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby grabiner » Thu Dec 27, 2012 11:24 pm

TS1 wrote:It seems to me that even if you tax-adjust your allocation, and even if the adjustment turns out to be perfectly accurate, and even if you rebalance, you will still be better off to have kept the faster growing asset class in the account with the lowest tax rate, because it will have made that account larger relative to the more heavily-taxed one, so you will have more after-tax money.


Tax-adjusting your asset allocation causes this effect to disappear. If you will be in a 25% tax bracket, then $4000 in a traditional IRA is equivalent to $3000 in a Roth IRA. If you invest these amounts in an asset which grows fivefold, you can have $20,000 in a traditional IRA which is $15,000 after tax, or $15,000 in a Roth IRA, which is break-even.

The advantage of having higher-return assets in the Roth is secondary; if the traditional IRA is very large, you may have to take required minimum distributions which are more than you need (and you probably won't want to use them to convert the traditional IRA to a Roth, as that will push you into a higher bracket), while if the Roth is very large, you can leave the extra money there until you need it later or die and leave it to your heirs.

The OP has a 401(k), not a traditional IRA, so his main issue may be the options in the 401(k); if the bond funds are better than the stock funds, then he should have bonds in the 401(k).
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby FinancialDave » Thu Dec 27, 2012 11:51 pm

15202guy wrote:Thank you for the replies. Leaving the Roth as all stock is what I expected the answer would be, but I wanted to seek confirmation. Since my time horizon is 20+ years and I am willing to take considerable risk in this portion, I will proceed with that plan for the current time...I will likely gradually add bonds to the account several years in the future.


There is obviously no way to predict the future, but I think you have chosen the correct option, especially with bonds possibly losing money, or staying flat, in the future.

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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby FNK » Fri Dec 28, 2012 12:13 am

TS1 wrote:It seems to me that even if you tax-adjust your allocation, and even if the adjustment turns out to be perfectly accurate, and even if you rebalance, you will still be better off to have kept the faster growing asset class in the account with the lowest tax rate, because it will have made that account larger relative to the more heavily-taxed one, so you will have more after-tax money.

Nope. That's the mind-blowing thing.

Tax adjustment forces you to think of all assets as after-tax. Keeping the slower-growing asset class in Trad will force you to keep more of the slower-growing asset class, exactly canceling the advantage you're talking about.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby TS1 » Fri Dec 28, 2012 2:06 am

Grabiner and FNK,

My apologies - My earlier post was me expressing a conclusion that I remembered having reached in the past but I did not correctly remember the line of reasoning which led me to the conclusion. I agree that if one assumes a certain multiplicative tax adjustment factor, then the effect I described is canceled out, as you said.

But determining the adjustment factor can be uncertain and/or complex, and I question whether it is necessarily a simple multiplier in the first place. Tax rates can change through the withdrawal phase depending on how various accounts are withdrawn (e.g., live off taxable while making low-bracket Roth conversions), and due to the progressiveness of the tax code they can also be affected by the absolute size of the accounts (e.g., SS taxation, or just moving up a bracket).

It appears to me that placing funds asymmetrically to minimize expense ratios and maximize tax efficiency (in aspects other than what I am describing) can come with reduced certainty of what one's 'real' after-tax allocation is.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby 15202guy » Fri Dec 28, 2012 3:05 pm

Thanks for all of the additional discussion.

As noted in my OP, I know that the ending balance will be the same no matter how I divide the assets, but I am still trying to maximize the Roth balance because of the RMD issue (which, as noted, could change). The discussion did force me to consider tax adjustment of AA more than I ever had previously, and that was a good exercise for me.

Many of the traditional factors, specifically availability of "good" funds in the different accounts, don't apply in my case because I have the exact same set of funds available in both accounts since they are both held at Fidelity...so the issue is truly one of optimizing the Roth balance based on asset class placement. (ok, this isn't 100% true since I have a small amount in a 401k from a former employer that provides a superset of the standard Fidelity options, and I am already using that account for Signal/Institutional shares of a few Vanguard funds)

Taylor, I looked at the calculator you linked me to, and it confirms that for any scenario I can reasonably see myself in, the Roth is the preferred choice, although in some scenarios a traditional deductible IRA would be close behind. With that said, I am not sure how it applies to my original question regarding asset placement...the calculator operates in an "either/or" mode to help you choose between various options, but I've already committed to both options. I also wish I understood all of its assumptions...I think it is somehow factoring in an investment of the money you save on taxes in the deductible scenario, but I am not sure exactly how.
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Re: allocating bonds across 401k & Roth IRA to max Roth bala

Postby FNK » Fri Dec 28, 2012 3:24 pm

TS1: agreed on all counts.

You can guesstimate the tax adjustment based on your plan, and it will be one of the many things that are uncertain about investing. My spreadsheet has a 20% adjustment based on my primary plan to retire a bit early and drive most of the 401(k) through the 15% federal/5% state bracket before collecting SS. (I'm ignoring lower brackets as allowance for higher rates and taxable income.)

The important feature of tax-adjusting is that it allows you to optimize the less prominent aspects of asset location, such as fund selection, RMDs and so on.
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Morningstar IRA tool

Postby Taylor Larimore » Fri Dec 28, 2012 3:31 pm

Guy:

Thank you for coming back with your findings after using the Morningstar tool.

Happy Holidays!
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