## Placement of stock/bonds - tax-deferred vs. tax-free

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Topic Author
Sportswhiz00
Posts: 162
Joined: Mon Aug 18, 2014 8:04 pm

### Placement of stock/bonds - tax-deferred vs. tax-free

I've read the numerous threads about whether, for any given asset allocation, potentially higher-earning assets such as stocks should be placed in Roth accounts vs. tax-deferred accounts and I think understand the various considerations (for example, RMDs and Social Security). For purposes of this post, I have a simple math question and would like to ignore all of the ancillary considerations and focus solely on tax rates. Let's say I have \$5,000 in an TIRA and \$5,000 in a Roth IRA and my desired asset allocation is 50/50. Let's also say that I know that, for purposes of the hypothetical, I'm willing to bet that stocks earn more than bonds, and that for this example bonds will return 20% in the aggregate and stocks will return 100% in the aggregate. Here are three hypothetical allocations and results:

Allocation A - 100/0 stocks/bonds in Roth, o/100 in TIRA
Ending balances: \$10,000 in Roth and \$6,000 in TIRA

Allocation B - 50/50 in Roth, 50/50 in TIRA
Ending balances: \$8,000 in Roth and \$8,000 in TIRA

Allocation C - 0/100 in Roth, 100/0 in TIRA
Ending balances: \$6,000 in Roth and \$10,000 in TIRA

Allocation A results in the greatest after-tax benefit. So, why would NOT make sense to put the potentially highest-earning assets in the Roth during the accumulation phase, if I'm willing to bet that stocks earn more than bonds during the relevant period? If one potential response to this question is that the 50/50 asset allocation reflects the fact that I'm not sure whether bonds or stocks will earn more, isn't the counter-argument that the 50/50 asset allocation in actuality reflects risk tolerance, rather than the optimal portfolio for maximizing returns? That is, I'm willing to bet that stocks return more than bonds during the period for purposes of asset allocation BETWEEN accounts (i.e., for tax purposes), even if I'm not willing to make that bet for the asset allocation for my entire portfolio (i.e., for economic/behavioral purposes). Also, I know that there are tax-adjusted allocation principles, but I think they can be ignored for purposes of simplifying the narrow question that I'm posing.

Thoughts would be appreciated. Tyia.

Userdc
Posts: 270
Joined: Tue Jun 21, 2011 9:30 am

### Re: Placement of stock/bonds - tax-deferred vs. tax-free

I would recommend using a tax-adjusted asset allocation.

So if you expect your tax rate in retirement to be 20% (to make the math easy), you effectively own 80% of that account and the government owns 20%.

Using those values, your actual asset allocations are:

A: 55/45
B: 50/50
C: 45/55

So A does the best because you actually have more stock exposure than the other two.

Topic Author
Sportswhiz00
Posts: 162
Joined: Mon Aug 18, 2014 8:04 pm

### Re: Placement of stock/bonds - tax-deferred vs. tax-free

Userdc wrote:I would recommend using a tax-adjusted asset allocation.
Userdc - thanks for the response. Even with the tax-adjusted allocation in that hypothetical, I'm going to end up with less of an after-tax benefit if stocks outperform bonds than if I had put 100% stocks in the Roth. So if I'm willing to bet that, for purposes of allocation between accounts (i.e., tax purposes), stocks outperform bonds, why would I put any bonds in the TIRA?

randomguy
Posts: 8536
Joined: Wed Sep 17, 2014 9:00 am

### Re: Placement of stock/bonds - tax-deferred vs. tax-free

Sportswhiz00 wrote:I've read the numerous threads about whether, for any given asset allocation, potentially higher-earning assets such as stocks should be placed in Roth accounts vs. tax-deferred accounts and I think understand the various considerations (for example, RMDs and Social Security). For purposes of this post, I have a simple math question and would like to ignore all of the ancillary considerations and focus solely on tax rates. Let's say I have \$5,000 in an TIRA and \$5,000 in a Roth IRA and my desired asset allocation is 50/50. Let's also say that I know that, for purposes of the hypothetical, I'm willing to bet that stocks earn more than bonds, and that for this example bonds will return 20% in the aggregate and stocks will return 100% in the aggregate. Here are three hypothetical allocations and results:

Allocation A - 100/0 stocks/bonds in Roth, o/100 in TIRA
Ending balances: \$10,000 in Roth and \$6,000 in TIRA

Allocation B - 50/50 in Roth, 50/50 in TIRA
Ending balances: \$8,000 in Roth and \$8,000 in TIRA

Allocation C - 0/100 in Roth, 100/0 in TIRA
Ending balances: \$6,000 in Roth and \$10,000 in TIRA

Allocation A results in the greatest after-tax benefit. So, why would NOT make sense to put the potentially highest-earning assets in the Roth during the accumulation phase, if I'm willing to bet that stocks earn more than bonds during the relevant period? If one potential response to this question is that the 50/50 asset allocation reflects the fact that I'm not sure whether bonds or stocks will earn more, isn't the counter-argument that the 50/50 asset allocation in actuality reflects risk tolerance, rather than the optimal portfolio for maximizing returns? That is, I'm willing to bet that stocks return more than bonds during the period for purposes of asset allocation BETWEEN accounts (i.e., for tax purposes), even if I'm not willing to make that bet for the asset allocation for my entire portfolio (i.e., for economic/behavioral purposes). Also, I know that there are tax-adjusted allocation principles, but I think they can be ignored for purposes of simplifying the narrow question that I'm posing.

Thoughts would be appreciated. Tyia.
Imagine stocks grow 0%, bonds grow 10% and 50/50 does 5%? Would you be happy with the large TIRA and small ROTH or would you be happier with both funds being the same size? Going 50/50 is basically a hedge.

Personally I am 100% stocks in the ROTH (and I shoved the funds expect to have higher returns) because I am willing to bet that over the next 40 years (I am most likely spending down taxable and a TIRA before touching the ROTH) the odds of stocks underperforming bonds by a significant amount is very very low.

Userdc
Posts: 270
Joined: Tue Jun 21, 2011 9:30 am

### Re: Placement of stock/bonds - tax-deferred vs. tax-free

Sportswhiz00 wrote:
Userdc wrote:I would recommend using a tax-adjusted asset allocation.
Userdc - thanks for the response. Even with the tax-adjusted allocation in that hypothetical, I'm going to end up with less of an after-tax benefit if stocks outperform bonds than if I had put 100% stocks in the Roth. So if I'm willing to bet that, for purposes of allocation between accounts (i.e., tax purposes), stocks outperform bonds, why would I put any bonds in the TIRA?

If you use a tax-adjusted allocation, it doesn't matter what you put where.

Run these three scenarios assuming a 20% tax rate. All have a 50/50 tax-adjusted allocation and all have equivalent after-tax outcome:

A: 10/90 in Roth, 100/0 in Trad
B: 50/50 in Roth, 50/50 in Trad
C: 90/10 in Roth, 0/100 in Trad