Should fixed income securities go in your Roth?

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
the11diesel
Posts: 94
Joined: Wed Sep 05, 2007 10:18 pm

Should fixed income securities go in your Roth?

Post by the11diesel » Mon Jul 07, 2008 8:46 pm

All-

I'm trying to get my portfolio situated, and I was wondering if the fixed income portion of my portfolio should go into my Roth. I've heard that you should place the taxable bond portion of your portfolio into tax-deferred accounts, but I wasn't sure if this was meant for Traditional IRA's and 401K's or if it was true for Roth's as well. It just seems kind of counter-intuitive to be placing bonds that (historically) will have a lower return than equities in a Roth, since the reason that you open a Roth is for the tax break of the gains. Thanks.

-Diesel

mhalley
Posts: 6303
Joined: Tue Nov 20, 2007 6:02 am

Post by mhalley » Mon Jul 07, 2008 10:33 pm

The general consensus in previous discussions regarding this has been that it doesn't matter whether you put the fixed portion in the roth or the regular IRA, as long as you don't put it in a taxable account. If you have plenty of room in a 401k for your fixed income, then it might make sense to put stock funds inthe roth and fixed income in the 401k. I think that it MIGHT matter depending on when you plan to draw the money, whether you plan to draw it or make it part of your estate. Currently I am keeping fixed income in my traditional IRA with the thougth of converting it to ROth IRA in 2010, and keeping stock funds in my ROth 401k. I will reexamine this strategy in 2010 after I convert the IRA to see if I still think it makes sense. I just purchased a new book that supposedly addresses some of these issues, Spend 'Til the End: The Revolutionary Guide to Raising Your Living Standard--Today and When You Retire by Scott Burns and Laurenc Kotiloff (anyone else read this yet?) so I will try to look at that later after I am off work and see if it addresses this.
Mike

User avatar
dave.d
Posts: 935
Joined: Mon Mar 19, 2007 10:30 pm
Location: Richmond, VA

Post by dave.d » Mon Jul 07, 2008 10:48 pm

Is there some debate whether there is any advantage, WITHIN tax-protected accounts, to putting bonds in 401k (or traditional IRA) and stocks in a Roth? I recall hearing it argued that a 401k/traditional IRA behaves just like a Roth, except scaled down by whatever % you will pay in taxes when you withdraw. However, I am convinced that it does matter, that you will pay less in taxes if you put the higher returning asset -- OK, what you hope will be the higher returning asset -- in the completely tax-free vehicle. So I think fixed income is better in Roth than in taxable, but better in 401k than either. Stocks would generally be the opposite -- first in taxable until full, then in Roth until the Roth is full, and only then in 401k/Traditional if no other choice.
Value-based allocation: recently 23% stocks @PE10=27 and real bond yields approx. zero

User avatar
CABob
Posts: 4618
Joined: Sun Feb 25, 2007 8:55 pm
Location: Southern California

Post by CABob » Mon Jul 07, 2008 11:23 pm

However, I am convinced that it does matter, that you will pay less in taxes if you put the higher returning asset -- OK, what you hope will be the higher returning asset -- in the completely tax-free vehicle. So I think fixed income is better in Roth than in taxable, but better in 401k than either. Stocks would generally be the opposite -- first in taxable until full, then in Roth until the Roth is full, and only then in 401k/Traditional if no other choice.
I think dave.d has it nailed. If you follow Taylors rules for asset location you fill your tax deferred accounts with the least tax efficient investments then fill the Roth and then put your most tax efficient investments into taxable accounts.
The tax considerations would indicate that you would like to have the highest tax inefficient returning investment in the Roth. The trick is to identify in advance what that will be. It is often suggested that REIT are good to have in a Roth since they typically have high non qualified dividends.
What goes into the Roth may be different depending upon the specific investments and maybe other considerations.

Bob

User avatar
LH2004
Posts: 1741
Joined: Tue Mar 27, 2007 4:59 pm
Location: New York, NY

Post by LH2004 » Mon Jul 07, 2008 11:37 pm

You should always put the lowest-risk assets in your Roth accounts, because losing money in a traditional account doesn't hurt as much (since, at least, you save some taxes); but every penny you lose in a Roth account costs you that full penny, plus all the future pennies it would have earned.

Anybody seeing a problem with this type of reasoning yet? Anybody? Bueller?

baldeagle
Posts: 61
Joined: Sun Mar 04, 2007 6:23 pm
Location: Portland, OR

Post by baldeagle » Tue Jul 08, 2008 12:22 am

LH, interesting idea...

I'm doing some of that but not intentionally for that reason. I am putting a substantial amount of money market in my Roth as I will have spent down the taxable account within the next couple years, and will still need to have an emergency account. So, part of the Roth will hold that.

pastafarian
Posts: 386
Joined: Fri Apr 20, 2007 12:55 am

Post by pastafarian » Tue Jul 08, 2008 1:32 am

mhalley wrote: I just purchased a new book that supposedly addresses some of these issues, Spend 'Til the End: The Revolutionary Guide to Raising Your Living Standard--Today and When You Retire by Scott Burns and Laurenc Kotiloff (anyone else read this yet?)
I recently bought and read Spend 'til The End, actually wished I had read it sitting in Barnes & Noble. I found their previous book, The Coming Generational Storm more interesting. It specifically makes the argument for putting TIPS in your Roth...so I have.

Cheers

the11diesel
Posts: 94
Joined: Wed Sep 05, 2007 10:18 pm

Post by the11diesel » Tue Jul 08, 2008 5:58 am

LH2004 wrote:You should always put the lowest-risk assets in your Roth accounts, because losing money in a traditional account doesn't hurt as much (since, at least, you save some taxes); but every penny you lose in a Roth account costs you that full penny, plus all the future pennies it would have earned.

Anybody seeing a problem with this type of reasoning yet? Anybody? Bueller?
LH, thanks for your comments, but that seems a little like blank economics...voodoo economics :lol:

User avatar
bottlecap
Posts: 5880
Joined: Tue Mar 06, 2007 11:21 pm
Location: Tennessee

Post by bottlecap » Tue Jul 08, 2008 7:26 am

LH2004 wrote:You should always put the lowest-risk assets in your Roth accounts, because losing money in a traditional account doesn't hurt as much (since, at least, you save some taxes); but every penny you lose in a Roth account costs you that full penny, plus all the future pennies it would have earned.

Anybody seeing a problem with this type of reasoning yet? Anybody? Bueller?
I'll bite. I disagree, LH, and fall more into dave.d's camp.

It makes economic sense to place the investment expected to give the greatest return in a Roth. If anything, it makes even more sense from a psychological standpoint: I doubt many people think of losses in Roths as greater than those in Traditional IRA's. As such, an investor can put the higher risk/higher return investment in a Roth without any greater emotional effect as loss in a traditional account.

JT

User avatar
White Coat Investor
Posts: 13588
Joined: Fri Mar 02, 2007 9:11 pm
Location: Greatest Snow On Earth

Post by White Coat Investor » Tue Jul 08, 2008 8:03 am

bottlecap wrote:It makes economic sense to place the investment expected to give the greatest return in a Roth. If anything, it makes even more sense from a psychological standpoint: I doubt many people think of losses in Roths as greater than those in Traditional IRA's. As such, an investor can put the higher risk/higher return investment in a Roth without any greater emotional effect as loss in a traditional account.

JT
I suppose if the investor doesn't realize he's just taking more risk in hopes of a greater return, then I suppose you're right. Most of us here though realize that holding a riskier asset in the Roth is just the equivalent of holding more of the riskier asset in a traditional IRA. Changing your AA to 65/35 instead of 60/40 and not putting it down on paper makes just as much sense (if I don't "know" then it can't hurt me.)
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

larryswedroe
Posts: 15711
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Post by larryswedroe » Tue Jul 08, 2008 8:28 am

First, remember that you own 100% of the Roth account but 1-tax rate on withdrawal of your Traditional IRA. So that really should be taken into account in terms of what you own (Asset allocation)

Second, if you have choice then should put equities in Roth and bonds in Traditional IRA. You want the highest expected return in the Roth and lowest in Traditional. Reason is not what most people think. It has to do with the RMD. You want to minimize the RMD. That allows you to control tax situation better.

User avatar
White Coat Investor
Posts: 13588
Joined: Fri Mar 02, 2007 9:11 pm
Location: Greatest Snow On Earth

Post by White Coat Investor » Tue Jul 08, 2008 8:32 am

dave.d wrote:Is there some debate whether there is any advantage, WITHIN tax-protected accounts, to putting bonds in 401k (or traditional IRA) and stocks in a Roth? I recall hearing it argued that a 401k/traditional IRA behaves just like a Roth, except scaled down by whatever % you will pay in taxes when you withdraw. However, I am convinced that it does matter, that you will pay less in taxes if you put the higher returning asset -- OK, what you hope will be the higher returning asset -- in the completely tax-free vehicle. So I think fixed income is better in Roth than in taxable, but better in 401k than either. Stocks would generally be the opposite -- first in taxable until full, then in Roth until the Roth is full, and only then in 401k/Traditional if no other choice.
Nope. Holding MORE stocks in traditional, rather than holding stocks in the Roth would result in the same outcome as putting stocks in the Roth. If you always adjust your holdings for tax effects (not an easy task if you actually try to do it) it doesn't matter where you hold the riskier/higher returning asset. Think of it this way, if your traditional IRA is taxed at 25% on average, and you have equal amounts of money in a traditional IRA and a Roth IRA, and you want a 50/50 portfolio.

If you put stocks in Roth, your after tax AA is 57/43.
If you put bonds in your Roth, your after tax AA is 43/57.

Of course you'd expect to have a better return over the years if you're taking that much additional risk.

If you track the numbers out to the end (whenever that might be), you'll see it holds true all the way through. As long as you adjust for the tax-adjusted AA, it doesn't matter in which account you hold the riskier asset.

Say you want a 50/50 after tax portfolio. Let's say you have $100K in a Roth and $100K in a traditional IRA and expect a 25% tax rate on the traditional withdrawals. We'll assume you get 8% returns on the stocks and 5% returns on the bonds each year.

First, with stocks preferentially in the Roth:

At the beginning, you'll hold $43,750 of stocks in the Roth and $6,250 of bonds in the Roth. You'll have $50,000 worth of bonds in the IRA.

After one year, it's time to rebalance. You now have $52,500 in the traditional IRA and $6562 in bonds and $47250 in stocks in the Roth. Your after-tax AA is now 51/49 so you rebalance, selling $656.50 of stocks and buying $656.50 of bonds in the Roth. Your total after-tax money is $93,187.

Now, with stocks preferentially in the traditional IRA:

At the beginning, you'll hold $43,750 of bonds in the Roth and $6250 of stocks in the Roth. You'll have $50,000 worth of stocks in the IRA.

After one year, it's time to rebalance. You now have $54,000 in the traditional IRA (stocks). You have $45937 in bonds and $6750 in stocks in the Roth. Your after-tax AA is now 51/49 so you rebalance, selling $656.50 worth of stocks and buying $656.50 worth of bonds in the Roth. Your total after-tax money is $93,187.

You can continue this process ad nauseum, and AS LONG AS YOU ADJUST FOR TAX EFFECTS it doesn't matter where you hold the higher returning asset.

The only way to justify putting a higher returning asset in the Roth is behavioral. If you can fool yourself that way, more power to you.

Edit: Agree with Larry that there can be a benefit in minimizing the RMD as well. Personally, I plan to spend the RMD. I'm not planning on saving forever. RMD doesn't kick in until 70, and even at that age it is only 3.6%. I'll be spending at least 3.6% of what is in my traditional IRA by 70 (remember if you retire at 55 with a 4% SWR you'll be well over 3.6% by age 70.) and saving what's in my Roth. I prefer to preferentially leave taxable assets (step up in basis) and Roth assets (stretch Roth IRA) to my heirs (assuming I leave anything.) Flexibility is nice, but I suspect for most folks the RMD isn't that big a deal. The RMD is usually a pretty safe withdrawal rate. At age 80 it's 5.3% and at age 90 it's 8.8%. Even at that, if you've been preferentially spending your traditional IRA, that 8.8% may be only 2% of your assets. It seems to me you have to be pretty darn wealthy for the RMD to be a really big deal.
Last edited by White Coat Investor on Tue Jul 08, 2008 9:18 am, edited 1 time in total.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

Tramper Al
Posts: 3628
Joined: Thu Oct 18, 2007 11:42 am

Post by Tramper Al » Tue Jul 08, 2008 8:43 am

EmergDoc wrote: The only way to justify putting a higher returning asset in the Roth is behavioral. If you can fool yourself that way, more power to you.
Yeah, there are many people out there who do not recognize the relationship between location and the (after-tax) value of each dollar invested, which I can fully comprehend because I used to be one of them.

I don't particularly understand how someone can come to be convinced that location matters and then choose to ignore it anyway.

The only thing about this that bothers me is when I see these people giving bad advice to others.

User avatar
LH2004
Posts: 1741
Joined: Tue Mar 27, 2007 4:59 pm
Location: New York, NY

Post by LH2004 » Tue Jul 08, 2008 9:45 am

larryswedroe wrote:Second, if you have choice then should put equities in Roth and bonds in Traditional IRA. You want the highest expected return in the Roth and lowest in Traditional. Reason is not what most people think. It has to do with the RMD. You want to minimize the RMD. That allows you to control tax situation better.
Sounds like you're falling into the same logical trap. Putting higher-return, higher-risk assets in lifetime-RMD-free accounts (which, note, is not the same as Roth accounts: it includes deferred annuities but does not include Roth 401(k)'s if, for some reason, you can't or don't want to roll over to a Roth IRA) increases the expected amount of lifetime-RMD-free assets, but at the cost of increasing the risk as to that amount. Putting the safest assets into the no-RMD accounts reduces your risk of having unexpectedly small RMD-protected savings.

User avatar
bottlecap
Posts: 5880
Joined: Tue Mar 06, 2007 11:21 pm
Location: Tennessee

Post by bottlecap » Tue Jul 08, 2008 9:51 am

EmergDoc wrote:I suppose if the investor doesn't realize he's just taking more risk in hopes of a greater return, then I suppose you're right. Most of us here though realize that holding a riskier asset in the Roth is just the equivalent of holding more of the riskier asset in a traditional IRA. Changing your AA to 65/35 instead of 60/40 and not putting it down on paper makes just as much sense (if I don't "know" then it can't hurt me.)
I see what you're saying, although I suspect for most people - including me - the Roth portion of their asset allocation is quite limited in relation to everything else. With the advent of the Roth 401k this may change in the future and have a greater impact. I can only hope my Roth savings begins to catch up with everything else.

From a psychological standpoint, LH referred to losses in a traditional IRA "not hurting as much," and I don't think most people feel that way, rightly or wrongly. I also don't think its the same as changing your AA "on paper." Most people likely to react drastically to market downturns are looking at their account balance (or entire investment worth), not their AA - they are not thinking "Egads, my asset mix changed by 10%, I better move everything into money market funds!"

I hadn't thought of it from Larry's perspective, which probably makes the most sense. Edit (and second edit due to misread): LH, couldn't an investor simply adjust the allocation in RMD accounts to mitigate the risk in the overall AA?

JT

larryswedroe
Posts: 15711
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Post by larryswedroe » Tue Jul 08, 2008 10:31 am

If you have the choice to take assets from the Roth or the Traditional you want to take the withdrawal from the Roth typically (unless you expect your tax rate to rise later) because you get the deferral as long as possible. And you save on the current tax bill and might keep you in lower bracket

User avatar
LH2004
Posts: 1741
Joined: Tue Mar 27, 2007 4:59 pm
Location: New York, NY

Post by LH2004 » Tue Jul 08, 2008 11:22 am

bottlecap wrote:From a psychological standpoint, LH referred to losses in a traditional IRA "not hurting as much," and I don't think most people feel that way, rightly or wrongly.
Well, it's certainly wrongly, if you're right, which you may well be. But, then, they also certainly don't feel richer when their Roth accounts do better. I mean, there is a very serious problem with any kind of reasoning that results in (1) extra joy, if gains come in a Roth account and (2) NO extra unhappiness, if losses happen there. But everyone who is pushing the highest-return-in-Roth approach seems to think that they do.
I hadn't thought of it from Larry's perspective, which probably makes the most sense. Edit (and second edit due to misread): LH, couldn't an investor simply adjust the allocation in RMD accounts to mitigate the risk in the overall AA?
Yes, of course. I'm sorry if I have been obscure; that is my real point here: shifting asset location between Roth and traditional accounts is just monkeying with your asset allocation; you are free to do it to increase return, but realize that you're increasing risk by doing so, precisely as if you had shifted your asset allocation; the case for doing the opposite shift, to reduce risk, is precisely equally compelling, so you might as well completely ignore this issue.

User avatar
mudfud
Posts: 1218
Joined: Tue Feb 20, 2007 4:34 pm

Post by mudfud » Tue Jul 08, 2008 11:33 am

LH2004 wrote:You should always put the lowest-risk assets in your Roth accounts, because losing money in a traditional account doesn't hurt as much (since, at least, you save some taxes); but every penny you lose in a Roth account costs you that full penny, plus all the future pennies it would have earned.
Brilliant.
"Are you sure you have tested an a priori hypothesis?" | | Image

User avatar
mudfud
Posts: 1218
Joined: Tue Feb 20, 2007 4:34 pm

Post by mudfud » Tue Jul 08, 2008 11:42 am

larryswedroe wrote:Reason is not what most people think. It has to do with the RMD. You want to minimize the RMD. That allows you to control tax situation better.
This point was made by David Grabiner earlier:
http://www.bogleheads.org/forum/viewtop ... 8432#78432
"Are you sure you have tested an a priori hypothesis?" | | Image

User avatar
White Coat Investor
Posts: 13588
Joined: Fri Mar 02, 2007 9:11 pm
Location: Greatest Snow On Earth

Post by White Coat Investor » Tue Jul 08, 2008 12:02 pm

larryswedroe wrote:If you have the choice to take assets from the Roth or the Traditional you want to take the withdrawal from the Roth typically (unless you expect your tax rate to rise later) because you get the deferral as long as possible. And you save on the current tax bill and might keep you in lower bracket
Now I've always thought it smarter to draw from the traditional IRA preferentially to a Roth. I'll buy that it might lower your current taxes (at the risk of raising them later as RMDs get bigger due to you not making withdrawals earlier,) but I don't buy this "get the deferral as long as possible" argument. If you withdraw preferentially from a Roth you're also losing the deferral (AKA tax-free growth) The Roth isn't taxed as it grows and neither is a traditional IRA. Losing tax-free growth seems at least as bad as losing tax-deferred growth.

It seems to me that withdrawing preferentially from a Roth is a good way to set yourself up for getting stuck converting some of your tax-protected (traditional IRA) assets into taxable assets. i.e. if your RMDs exceed your living expenses because you weren't using the traditional IRA assets for the first few years of retirement.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

User avatar
White Coat Investor
Posts: 13588
Joined: Fri Mar 02, 2007 9:11 pm
Location: Greatest Snow On Earth

Post by White Coat Investor » Tue Jul 08, 2008 12:21 pm

mudfud wrote:
larryswedroe wrote:Reason is not what most people think. It has to do with the RMD. You want to minimize the RMD. That allows you to control tax situation better.
This point was made by David Grabiner earlier:
http://www.bogleheads.org/forum/viewtop ... 8432#78432
He makes two other important points which sways me a little more toward his and Larry's argument:
4. If all else is equal, put funds with higher expected returns in tax-free (Roth) accounts in preference to tax-deferred (401(k), 403(b), traditional IRA) accounts.

The reason for my wording of Rule #4 is that there are minor advantages to the Roth, even adjusting for after-tax value. You have better protection against the risk that tax rates will change. The RMD rules are more flexible for Roth IRA's. And the Roth IRA will lower your nominal income in retirement, which may reduce the amount of your Social Security benefits that are taxed.
Additional insurance against rising tax rates seem prudent in the current environment. The reduction in taxation of SS is also a nice bonus.

My problem is that my Roths are my ONLY IRAs, so I have to use them to round out my 401K. This includes assets such as TIPS and REITs which aren't necessarily my highest returning. But it does help me justify my plan to stuff my TSP with tax-exempt money (basically non-deductible contributions) in order to convert it all to a Roth upon leaving the military in 2010.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

User avatar
Justin618
Posts: 204
Joined: Fri Mar 02, 2007 10:37 am
Location: accumulation phase

Post by Justin618 » Tue Jul 08, 2008 12:29 pm

"Investing is simple, but not easy" - Buffett.

User avatar
Justin618
Posts: 204
Joined: Fri Mar 02, 2007 10:37 am
Location: accumulation phase

Post by Justin618 » Tue Jul 08, 2008 3:24 pm

You should sell $100 of fixed income assets and buy $100 of stocks. Assuming your expectations are met, that will increase the total value of your portfolio.
If that's what your AA calls for - go ahead :D

If you expect bonds to return more than stocks for the next 20 years, then load up your tax-fee accounts with bonds and your tax-deferred accounts with stocks SO LONG AS you meet your AA.

I do agree with your earlier statement-
Putting the safest assets into the no-RMD accounts reduces your risk of having unexpectedly small RMD-protected savings.
Justin
"Investing is simple, but not easy" - Buffett.

User avatar
dave.d
Posts: 935
Joined: Mon Mar 19, 2007 10:30 pm
Location: Richmond, VA

Post by dave.d » Tue Jul 08, 2008 7:32 pm

EmergDoc wrote:AS LONG AS YOU ADJUST FOR TAX EFFECTS it doesn't matter where you hold the higher returning asset.
EmergDoc, thanks for the good illustration. This was the argument I dimly recalled but never quite "got" before, or at least hadn't retained.
larryswedroe wrote:if you have choice then should put equities in Roth and bonds in Traditional IRA. You want the highest expected return in the Roth and lowest in Traditional. Reason is not what most people think. It has to do with the RMD. You want to minimize the RMD. That allows you to control tax situation better.
grabiner wrote:the Roth IRA will lower your nominal income in retirement, which may reduce the amount of your Social Security benefits that are taxed.
But the plot thickens! My conclusion was right, just for different reasons I didn't even think about. Larry's reason won't matter for people who would withdraw their RMD anyway... but hey, you never know, you might have a windfall of new assets in taxable between now and then.
Value-based allocation: recently 23% stocks @PE10=27 and real bond yields approx. zero

Post Reply