Where Do Bonds Belong?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
User avatar
Abciximab
Posts: 76
Joined: Wed Mar 21, 2007 7:53 pm
Location: Phoenix

Where Do Bonds Belong?

Post by Abciximab » Sun Apr 29, 2007 7:40 pm

I know that bonds should generally be held in tax-advantaged accounts, but does it matter which one? I have a Roth IRA and a 401(k) but don’t know where my bonds should go.

In my 401(k) I have access to a bond fund from State Street that has an ER of 0.18%. I can’t find out what the duration of the fund is, but for the last 5 and 10-year period the fund has performed about the same as the VG Intermediate Bond Index.

I’m finalizing my AA and would really appreciate some input before I make my fund changes. Thanks.
An investment in knowledge always pays the best interest - Benjamin Franklin

xenial
Posts: 2564
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial » Sun Apr 29, 2007 7:49 pm

Abciximab,
I'd suggest that bonds in the 401k and stocks in the Roth is preferable to the reverse. The reason is that stocks have a higher expected return than bonds. The Roth is tax free, while the 401k is only tax deferred. So given the choice, it's better to have a big Roth than a big 401k.
Best wishes,
Ken

User avatar
DaveTH
Posts: 2504
Joined: Thu Apr 05, 2007 7:23 pm

Post by DaveTH » Sun Apr 29, 2007 7:58 pm

Generally you should consider putting the highest expected appeciating, tax inefficient funds (REITs, Small-Cap Value) into the Roth IRA. Put bonds in tax-deffered accounts such as a 401K because they will later be taxed as ordinary income. Ideally (although not always practical) you don't want to put stock funds in tax-deferred accounts because you will effectively convert long-term capital gains and dividends into ordinary income that will be taxed at higher rates.

Dave
Last edited by DaveTH on Sun Apr 29, 2007 7:59 pm, edited 1 time in total.

User avatar
mickeyd
Posts: 4453
Joined: Fri Feb 23, 2007 3:19 pm
Location: Deep in the Heart of South Texas

Post by mickeyd » Sun Apr 29, 2007 7:59 pm

I know that bonds should generally be held in tax-advantaged accounts


In the long run, I prefer them in the Roth account since no tax will be paid on the investment. That said, I'm not sure if it makes a whole lot of difference where your bonds reside as long as they are in some kind of tax-advantaged account.

BTW, you sound like an informed investor. If the fund actually has an ER of .18 and is close to the VG I-T bond idx fnd, I'd take it as a part of my 401(k).
Part-Owner of Texas | | “The CMH-the Cost Matters Hypothesis -is all that is needed to explain why indexing must and will work… Yes, it is that simple.” John C. Bogle

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch » Sun Apr 29, 2007 8:06 pm

If you adjust your asset allocation on an after tax basis it basically doesn't matter what you put in which as they are mathematically equivalent. However, if you do your asset allocation on a pre-tax basis (i.e. believe $1000 in a 401k is worth the same as $1000 in a ROTH), then by all means put the higher earning asset in the ROTH as it should result in a higher return because you've taken on more risk.

Regards,
- Al

User avatar
Abciximab
Posts: 76
Joined: Wed Mar 21, 2007 7:53 pm
Location: Phoenix

Post by Abciximab » Sun Apr 29, 2007 11:25 pm

Thank you everyone. I appreciate the logic behind putting bonds in the 401(k) rather than the roth. I really should've though of that, but I guess that's why we're here. Luckily, I do have a low-cost bond fund available in my 401(k). That's what I'll do. Thanks again.
An investment in knowledge always pays the best interest - Benjamin Franklin

User avatar
fundtalker123
Posts: 874
Joined: Tue Feb 27, 2007 4:18 am

Post by fundtalker123 » Mon Apr 30, 2007 12:04 am

I'm turning 25 soon

One possible answer to your question is: Bonds belong in your grandmother's account, not yours. (Disclaimer: answer provided by a person 12 years older than you with 90% in stocks who followed this approach for the last 15 years, including 2000-2002, without flinching)

yobria
Posts: 5978
Joined: Mon Feb 19, 2007 11:58 pm
Location: SF CA USA

Post by yobria » Mon Apr 30, 2007 12:15 am

This has been discussed many times on the other board, you might do a search.

It makes no difference whether you put your bonds in your Roth or 401(k). To compare apples to apples though, you must tax adjust.

Nick

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

Post by LH2004 » Mon Apr 30, 2007 12:57 am

alvinsch wrote:However, if you do your asset allocation on a pre-tax basis (i.e. believe $1000 in a 401k is worth the same as $1000 in a ROTH), then by all means put the higher earning asset in the ROTH as it should result in a higher return because you've taken on more risk.
The latter is correct, but the former doesn't follow from it.

Yes, putting riskier, higher-returning assets in the Roth account has the effect of increasing risk and return. That's not an improvement unless the asset allocation you picked was too conservative.

Suppose you were left in charge of the portfolio of someone who was going on a long vacation, and he told you to invest his money in whatever you thought was best, but to keep the percentage in stocks in the neighborhood of 65%, and always under 75%. Would you conclude that keeping the stock percentage at 74.999% is best? That's the choice with the highest return, but also the highest risk. It's the best you can do if you think that what he really needs is 90% stocks, but that's quite a separate conclusion.

Now, in fact, I think that most portfolios are infected by loss avoidance and end up too conservative with respect to non-diversifiable risk. That means, I think most people would be better off if they could somehow fool themselves into buying more stocks by looking at nominal, unadjusted values. But even people intentionally kidding themselves ought to do it in a principled way.

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch » Mon Apr 30, 2007 9:31 am

LH2004 wrote:
alvinsch wrote:However, if you do your asset allocation on a pre-tax basis (i.e. believe $1000 in a 401k is worth the same as $1000 in a ROTH), then by all means put the higher earning asset in the ROTH as it should result in a higher return because you've taken on more risk.
The latter is correct, but the former doesn't follow from it.

I meant my comments to mean there is nothing wrong with putting the highest earning asset in the ROTH because it should have a higher expected return though it will be because of higher risk. Didn't mean to imply there was any inherent advantage to it but rather on a tax/risk adjusted basis it doesn't matter.

I think the question of how one should allocate someone else's portfolio given specific stock/bond ratio instructions is an interesting question. If one was asked to keep a 50/50 stock/bond split and had $10k of 401k space and $10k of ROTH space what should one do? Judging by this forum I'd guess that 99% of investors would complain you hadn't followed their instructions if you didn't split them 50/50 on a pretax basis.

Guess I'm just getting worn down by the continued lack of understanding of what is such a simple mathematical relationship. ;)

Regards,
- Al

User avatar
Doc
Posts: 7690
Joined: Sat Feb 24, 2007 1:10 pm
Location: Two left turns from Larry

Post by Doc » Mon Apr 30, 2007 10:44 am

Just to reemphasize the point.

al wrote: … because you've taken on more risk.

yobria wrote: It makes no difference whether you put your bonds in your Roth or 401(k). To compare apples to apples though, you must tax adjust.

LH5004 referring to Al wrote: The latter is correct …

Al wrote:Guess I'm just getting worn down by the continued lack of understanding of what is such a simple mathematical relationship.

The future value of a ROTH and Traditional IRA are the same on an after tax basis if your tax bracket does not change. It makes no difference which asset is put in which account.

Oh dear, I’m beginning to pick up Taylor’s technique. Sorry guys.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

JeanY
Posts: 45
Joined: Thu Apr 26, 2007 11:25 pm
Location: USA

Post by JeanY » Mon Apr 30, 2007 11:01 am

This is a response more about process rather than location of assests.

What does anyone think about converting bonds (or even cash!) first, wait a bit, and then reallocate among ROTH and traditiona?

It is my emotional fears, rather than my brain that's throwing up red flags. If I convert stock funds, pay taxes, and then the market dives (past recharacterization period), I would be regretting the loss of both my stock values and the taxes I paid on the money I no longer have. If I convert bonds, then potential short term losses don't feel so bad if it happens, and a short time later I can switch moneys around within ROTH and traditional.

I actually have more questions about whether or not to convert to ROTH but that's another day.


... jean

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch » Mon Apr 30, 2007 11:08 am

JeanY wrote:This is a response more about process rather than location of assests.

What does anyone think about converting bonds (or even cash!) first, wait a bit, and then reallocate among ROTH and traditiona?

It is my emotional fears, rather than my brain that's throwing up red flags. If I convert stock funds, pay taxes, and then the market dives (past recharacterization period), I would be regretting the loss of both my stock values and the taxes I paid on the money I no longer have. If I convert bonds, then potential short term losses don't feel so bad if it happens, and a short time later I can switch moneys around within ROTH and traditional.

I actually have more questions about whether or not to convert to ROTH but that's another day.


... jean

I have seen it recommended to ROTH convert more than you want from multiple assets at the beginning of the year and then at the end of the year (or before filing taxes), undo all the conversions except for the one(s) with the biggest gain to minimize some of the possibility of having an asset decline greatly after having paid the conversion taxes.

My "pre-tax" two cents.
- Al

JeanY
Posts: 45
Joined: Thu Apr 26, 2007 11:25 pm
Location: USA

Post by JeanY » Mon Apr 30, 2007 11:26 am

Thank you Al, for the interesting suggestion to convert a bunch of IRAs.

Regarding an earlier reply of yours, do you mean to say that given that one is looking at the risk of an entire portfolio as a whole and the after-tax return of a portfolio as a whole, it does NOT matter where bonds are located (ROTH or traditional) since they are the same after-tax assuming constant tax bracket? I think I see the mathematics of that statement, but would you consider taking more ris iwithin ROTH or traditional? I have bought into the idea of taking greater risks in ROTH because of longer time horizon but now I am thinking (fearfully) I would want to protect what I've already paid taxes on (in ROTH) and let Uncle Sam absorb the volatility risk in Traditional -- hence favor bonds in ROTH, stocks in Traditional. Am I missing something?


... jean

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch » Mon Apr 30, 2007 1:15 pm

JeanY wrote:Thank you Al, for the interesting suggestion to convert a bunch of IRAs.

Regarding an earlier reply of yours, do you mean to say that given that one is looking at the risk of an entire portfolio as a whole and the after-tax return of a portfolio as a whole, it does NOT matter where bonds are located (ROTH or traditional) since they are the same after-tax assuming constant tax bracket? I think I see the mathematics of that statement, but would you consider taking more ris iwithin ROTH or traditional? I have bought into the idea of taking greater risks in ROTH because of longer time horizon but now I am thinking (fearfully) I would want to protect what I've already paid taxes on (in ROTH) and let Uncle Sam absorb the volatility risk in Traditional -- hence favor bonds in ROTH, stocks in Traditional. Am I missing something?


... jean

Not sure I totally understand the distinction in your questions but I'll try to beat the subject to death with a few examples.

Regarding risk I was trying to point out that the risk of $1000 in a TIRA is less than the risk of $1000 in a ROTH on an after tax basis. This is because if you were in say the 25% bracket, and the assets in the TIRA drop by 50% your after tax value only drops $375 while the same 50% drop in the ROTH means you've lost $500 after tax. So if you adjust your TIRA/401k to an after tax basis to make it equivalent to a ROTH, then it doesn't matter whether you have bonds in the ROTH and equity in the TIRA or vice versa.

Taking an actual example let's say your entire portfolio consists of $1k in a TIRA and $1k in a ROTH. If you put the $1k of equity in the ROTH and $1k of bonds in the TIRA, then on an after tax basis (assuming 25% tax bracket) you really have a 57.1%/42.9% stock portfolio ($1000/($1000+($1000*.75))). However, if you put the equity in the TIRA then you effectively have only 42.9% in equity. Of course one would expect the portfolio with a higher percentage in equity to outperform the other portfolio because it has higher risk.

Now if one wanted a true 50/50 ratio between them on an after tax basis, then there are two possible ways to allocate them but both give the same after tax end result no matter the return or time frame. Let's assume the same pre-tax $1k in both a ROTH and a TIRA so the total after tax value is $1750.

OPTION A: after tax $875 in both equity and bonds
ROTH
$875 equity
$125 bonds
TIRA
$750 bonds ($1000 pre tax)

OPTION B: after tax $875 in both equity and bonds
ROTH
$875 bonds
$125 equity
TIRA
$750 equity ($1000 pre tax)

Now let's say after 20 years bonds double and equities have quadrupled in value.
OPTION A: net after tax = $3500 equity; $1750 bonds
ROTH
$875*4=$3500 equity
$125*2= $250 bonds
TIRA
$750*2=$1500 bonds ($2000 pre tax)

OPTION B: net after tax = $3500 equity; $1750 bonds
ROTH
$875*2=$1750 bonds
$125*4= $500 equity
TIRA
$750*4=$3000 equity ($4000 pre-tax)

Once one adjusts the allocation on an after tax basis the time frame or return difference just doesn't change the end result that they give the same after tax return. I just can't come up with a reason to prefer the risky, higher earning asset in the ROTH over TIRA but it doesn't hurt either.

Hope that helps but feel free to re-ask your question if I misunderstood.
- Al

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Mon Apr 30, 2007 1:26 pm

I just want to emphasize one point already mentioned, which is that mathematically, if your income tax rate remains the same, then both the traditional and the Roth have the same effect, which is to protect you entirely from taxes on capital gains/investment income. Of course, people often view the income tax on traditional distributions as a tax on gains, but that is actually just the deferred income tax being applied (and again, mathematically it doesn't make a difference when the income tax is applied--pre-gains (Roth) or post-gains (trad.)--if the income tax rate remains constant). But properly speaking, only the non-deductible IRA has the effect of converting the tax on gains/investment income into an income tax.

User avatar
mudfud
Posts: 1202
Joined: Tue Feb 20, 2007 4:34 pm

Post by mudfud » Mon Apr 30, 2007 1:49 pm

Doc wrote:Oh dear, I’m beginning to pick up Taylor’s technique. Sorry guys.


That's funny..I too was thinking of using this technique since this point has been explained so many times by you, LH2004, BrianTH, Al etc. Yet, the misunderstanding persists.

I had hoped that your equation would have helped, but....

Code: Select all

TIRA [or 401(k) etc] = (Pretax$Invested) x (Growth) x (1-TaxThen) 

With a ROTH you pay the taxes first;

ROTH = (Pretax$Invested) x (1-TaxNow) x (Growth)


Nice equation though.

Mud
"Are you sure you have tested an a priori hypothesis?" | | Image

User avatar
paulob
Posts: 1408
Joined: Tue Feb 20, 2007 7:54 am

Post by paulob » Mon Apr 30, 2007 1:55 pm

I would not base my decision on which is the preferred location. Others have chimed to say it doesn't make a difference.

Even if it does, since 401-k plans are typically limited in selection, I would pick the best available option(s) in my 401-k, be it a bond or equity fund.
Paul

JeanY
Posts: 45
Joined: Thu Apr 26, 2007 11:25 pm
Location: USA

Post by JeanY » Mon Apr 30, 2007 1:59 pm

Thank you Al, BrianTh, Mud et. al.

I think I get it -- as long as TaxNow and TaxThen are the same, NO difference in spendable money later whether assets were placed in TIRA or ROTH. But... if tax-later is greater than tax-now, would decision be any different as to where, say bonds, are placed?

.. jean

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Mon Apr 30, 2007 2:24 pm

JeanY wrote:... if tax-later is greater than tax-now, would decision be any different as to where, say bonds, are placed?

.. jean


Well, sort of. I think the main reason people are concerned about bond placement is the effects of the tax drag (a tax being imposed on gains or income you intend to reinvest, which basically results in a tax-related negative compounding effect). Thus, because bonds typically generate a lot of taxable events, stocks tend to be more tax-efficient.

But since with traditional and Roth 401Ks/IRAs, you entirely skip taxes on gains and investment income, you shouldn't have to worry about tax drag. Rather, the comparison of income tax rates will just tell you whether it will be a good idea to prefer investing in a 401K or a Roth. But that reasoning applies equally well to stocks or bonds.

Of course, if tax rates later are going to be higher, and you expect stocks to grow more than bonds, then if you put stocks in the Roth and bonds in your traditional, your ultimate taxed amount will be lower (and vice-versa if tax rates later will be lower). But really, I think this is just a more complicated version of the notion that contributions to a Roth are actually greater on a dollar for dollar basis than contributions to a traditional because you have already paid your income tax on those dollars. Figuring out the dollar for dollar equivalency just becomes a more complex task when you have to factor in a difference in tax rates.

User avatar
Taylor Larimore
Advisory Board
Posts: 26239
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Fund Placement

Post by Taylor Larimore » Mon Apr 30, 2007 3:45 pm

Hi Abciximab:
I know that bonds should generally be held in tax-advantaged accounts, but does it matter which one?


Yes, it makes a difference. You can use this Table prepared jointly by Savant Capital Management and the Zero Alpha Group. The Table shows the best type of fund for your 401k (or Traditional IRA), your Roth IRA, and your taxable account:

401K/TIRA...ROTH...TAXABLE
...Better....... Best.........Bad......Tax Nasty Stocks
...Bad..........Better........Best.....TaxEfficient Stocks
...Best..........Fair..........Bad......Taxable Bonds

http://www.savantcapital.com/zagnews/acl2.pdf

Best wishes.
Taylor

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Mon Apr 30, 2007 4:01 pm

I think that Savant Capital brochure is highly misleading. It claims that traditional IRAs/401Ks apply the income tax rate to gains and dividends, and that Roths avoid all taxes entirely. As we have discussed many times now, that is mathematically incorrect: with no change in income tax rates, the net effect is identical.

xenial
Posts: 2564
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial » Mon Apr 30, 2007 4:09 pm

I agree with Taylor's take on the matter. The tax adjustment approach espoused in this thread, while technically correct, suffers from various problems:
1) I don't think many people really adjust their account balances for future tax consequences. I sure don't.
2) Risk is generally experienced in terms of unadjusted balances. If you log on to vanguard.com, a $1000 loss in your traditional IRA looks the same as a $1000 loss in your Roth IRA.
3) Adjustment is tricky. For a traditional IRA, you need to guess future ordinary income tax rates. For a taxable account, it's an unholy mess.

Best wishes,
Ken

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch » Mon Apr 30, 2007 4:21 pm

JeanY wrote:Thank you Al, BrianTh, Mud et. al.

I think I get it -- as long as TaxNow and TaxThen are the same, NO difference in spendable money later whether assets were placed in TIRA or ROTH. But... if tax-later is greater than tax-now, would decision be any different as to where, say bonds, are placed?

.. jean

Well this may get into a bit of sematics about what you are really asking, but as I understand your question I would say no it makes no difference unless you make a change today based on today's tax rates.

If you base your allocation on your expected tax rate when you take the money out then today's tax rate has no effect whatsoever. If this years tax rate is 25% and next years is 90% and then it went back to 25%, but you took no money out of your TIRA, how does that affect the tax you pay when you do take the money out?

The place where today's rate matters is in regard to making decisions now. So it makes a big difference if you are thinking about doing a ROTH conversion now or otherwise take money out because you are in a lower tax bracket now. But if you are not going to take any money out of the TIRA now how can it possibly effect it?

I was disappointed to see the article Taylor linked to uses the same bizarre logic that while they say $1 in ROTH is worth more than a 401k they then assume they have the same value by not tax adjusting. No wonder people are confused.

On the other hand I don't disagree with putting the higher expected return asset in a ROTH versus taxable, assuming similar tax efficiency, because the math is different in that case.

BTW: Just to be clear, converting a 401k/TIRA to a ROTH is equivalent in the same tax bracket if you assume one used part of the TIRA to pay the taxes. The reason the ROTH is considered superior to the TIRA in the same tax bracket is because if you pay the conversion taxes from your taxable you've essentially increased the size of your tax free by shrinking your taxable (i.e. you've increase the size of your $750 ($1000 pre-tax), TIRA by turning it into a $1000 ROTH).

- Al

JeanY
Posts: 45
Joined: Thu Apr 26, 2007 11:25 pm
Location: USA

Post by JeanY » Mon Apr 30, 2007 4:51 pm

Ugh.... I'm new to this stuff and my head is spinning. I read the article Taylor posted and Ken Schwarz's agreement with the slant that contrasts with that of alvinsch and BrianTH and others. I have to say from my naive point of view that the latter group makes a more compelling argument to compare after tax with after tax. In allocation decisions one would apply one's current tax rate but that does not seem so onerous to me if for planning purposes just use the most recent year's tax return rate. After all, whenever TIRA funds are withdrawn, the investor has to say goodbye to the taxable amount so it's not "real" money.

to alvinsch -- FYI you have also responded to my posting of "Help on TIRA to Roth Conversions" -- thanks. I think I am confounding the factors to consider whether or not to make a ROTH conversion with where to locate assets. Sorry... I should stick to one thread at a time.


... jean

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

Post by LH2004 » Mon Apr 30, 2007 4:52 pm

Pardon me for rearranging your points:
Ken Schwartz wrote:I agree with Taylor's take on the matter. The tax adjustment approach espoused in this thread, while technically correct, suffers from various problems:
1) I don't think many people really adjust their account balances for future tax consequences. I sure don't.
...
3) Adjustment is tricky. For a traditional IRA, you need to guess future ordinary income tax rates. For a taxable account, it's an unholy mess.
Whether or not you actually adjust for taxes is COMPLETELY BESIDE THE POINT. The point is that you should know that if you did there would be no reason to preferentially allocate some assets in one type of account (as between the Roth and traditional accounts).

It's perfectly acceptable to use all kinds of horribly rough approximations in your planning. Most of my personal allocation decisions tend to be quite back-of-the-envelope in the exact details. It's even OK to ignore taxes completely, especially if you expect to be paying a reasonably low rate like 15%.

What's not OK is to let your shortcuts bias your thinking WHEN YOU SEE THE BIAS THEY INTRODUCE.

I'm sorry, but Taylor's approach is just completely indefensible. It's not even simpler than just ignoring the issue or trying to make your traditional and Roth allocations similar.
2) Risk is generally experienced in terms of unadjusted balances. If you log on to vanguard.com, a $1000 loss in your traditional IRA looks the same as a $1000 loss in your Roth IRA.
That's a fine argument for ignoring the issue. If you think that way -- which, of course, you should try to avoid doing -- then you get the same $1000 increase when stocks do well whether it's traditional or Roth.

It's the same basic mental error: if you treat the Roth as magnifying your gains, then you've got to treat it as magnifying your losses. If you heard that an unscrupulous advisor stole $10,000 from one of your accounts, would you rather have it be your Roth IRA or traditional IRA? If you don't care, then ignore the issue and don't bother trying to put "high return" assets in the Roth. If you do care, then the need to avoid risk in the Roth IRA is going to push you toward keeping low-risk assets there with exactly the same strength as your desire to put high-return ones there. If you know of an asset with lower risk and higher return, then own just that asset in all of your accounts and stop messing around with the rest.

User avatar
mudfud
Posts: 1202
Joined: Tue Feb 20, 2007 4:34 pm

Post by mudfud » Mon Apr 30, 2007 5:18 pm

JeanY wrote:Ugh.... I'm new to this stuff and my head is spinning. I read the article Taylor posted and Ken Schwarz's agreement with the slant that contrasts with that of alvinsch and BrianTH and others. I have to say from my naive point of view that the latter group makes a more compelling argument to compare after tax with after tax. In allocation decisions one would apply one's current tax rate but that does not seem so onerous to me if for planning purposes just use the most recent year's tax return rate. After all, whenever TIRA funds are withdrawn, the investor has to say goodbye to the taxable amount so it's not "real" money.


Another way to look at this is to make an apples-to-apples comparison based on the amount of money invested.

If you are in the 33% tax bracket, a $4000 Roth "costs" you about $6000 in pre-tax money. Therefore you've actually invested around 50% more in your Roth than your Traditional.

So keep in mind that you have invested 50% more than you think (if you assume equivalence) in whatever asset you invested in the Roth. At retirement the difference would be more or less than 50% depending on how your taxes change. Unfortunately the Savant pdf ignores these concepts.

Best,

Mud
"Are you sure you have tested an a priori hypothesis?" | | Image

xenial
Posts: 2564
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial » Mon Apr 30, 2007 5:23 pm

Hi LH2004,

Here's what I wrote in my initial reply to the original poster:

I'd suggest that bonds in the 401k and stocks in the Roth is preferable to the reverse. The reason is that stocks have a higher expected return than bonds. The Roth is tax free, while the 401k is only tax deferred. So given the choice, it's better to have a big Roth than a big 401k.

I'm somewhat embarrassed to admit that the thought of tax adjustment hadn't occurred to me when I wrote this. However, I believe it's correct within the context of my "ignorance is bliss" approach to taxes. Let's say I want an unadjusted 50/50 equity/bond split. I've got $10K of room in a Roth and $10K of room in a TIRA. I'll rebalance once per year to 50/50. Should I preferentially fill the Roth with stocks or bonds? I claim the answer is stocks (assuming they have the higher expected return). The decision will not affect my total unadjusted portfolio value, but it will maximize the expected value of the Roth. Since the Roth is tax free, this is a desirable result. Of course, I've fooled myself a bit: my effective equity allocation is more than 50%.

Best wishes,
Ken

JeanY
Posts: 45
Joined: Thu Apr 26, 2007 11:25 pm
Location: USA

Post by JeanY » Mon Apr 30, 2007 5:23 pm

This from LH2004 finally finally articulates what has been bothering me about the risky vs conservative assets in ROTH vs TIRA

It's the same basic mental error: if you treat the Roth as magnifying your gains, then you've got to treat it as magnifying your losses. If you heard that an unscrupulous advisor stole $10,000 from one of your accounts, would you rather have it be your Roth IRA or traditional IRA? If you don't care, then ignore the issue and don't bother trying to put "high return" assets in the Roth. If you do care, then the need to avoid risk in the Roth IRA is going to push you toward keeping low-risk assets there with exactly the same strength as your desire to put high-return ones there.


From a personal psychological point of view, ROTH money is already fully paid for but TIRA is part Uncle Sam's money so I have more to lose in ROTH -- looks like fear trumps higher return potenial for me. Thanks LH2004.


... jean

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Mon Apr 30, 2007 5:30 pm

Ken Schwartz wrote: The decision will not affect my total unadjusted portfolio value, but it will maximize the expected value of the Roth. Since the Roth is tax free, this is a desirable result. Of course, I've fooled myself a bit: my effective equity allocation is more than 50%.

Best wishes,
Ken


I think the conceptual problem many of us are pointing out is that the Roth is NOT tax free--but you have already paid the taxes. These are, however, the exact same taxes you will someday pay on the TIRA--income taxes.

I honestly wouldn't really care--I think the allocation issue is not really important given how little people usually end up being able to put in Roths anyway--if it wasn't for the implication that Roths somehow get more favorable gains/investment-income tax treatment than TIRAs. That is just wrong, and that strikes me as an important mistake. Indeed, I see people here all the time discounting the important of TIRAs and 401Ks since they "only" provide "tax deferral", when in fact they actually provide complete protection from gains and investment income taxes.

In short, I think this is a dangerous mistake not because it confuses the Roth versus TIRA tradeoff (although it does confuse that issue), but rather because it confuses the TIRA versus taxable issue.

xenial
Posts: 2564
Joined: Tue Feb 27, 2007 1:36 am
Location: USA

Post by xenial » Mon Apr 30, 2007 5:39 pm

Hi Brian,

The Roth really is tax free for the purpose of my example. My assumption was $10K of room in a Roth and $10K of room in a TIRA. I don't see why the fact that I had to earn $15K of salary initially to fund that Roth is relevant.

Best wishes,
Ken

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch » Mon Apr 30, 2007 9:02 pm

I'm back but don't really have much of anything to add except to thank those who chimed in with better explanations than mine. If you've gone through the math and believe that you are arguing that 1+1=2 but others seem to disagree that 1+1=2, it's hard to come up with alternative explanations except 1+1=2.

Just seems odd to me that we spend so much time talking about the importance of tax efficiency and that what matters is what we keep not what we earn pre-tax but then we ignore all that when it specifically comes to comparing TIRA/401k's to Roths and that only pre-tax matters and one can ignore all tax implications.

I do agree the difference between having say 6% of REITs in a ROTH versus it only being 4.5% in a TIRA isn't the type of error that is going to ruin someones retirement but as Brian has pointed out, I do think it is important when making decisions regarding TIRA versus ROTHs. If pre-tax was all that matter then one would never invest in a ROTH over a TIRA and there would be no need for Roth conversions.

Just my "pre-tax" two cents. ;)
- Al

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Tue May 01, 2007 6:42 am

Ken Schwartz wrote: I don't see why the fact that I had to earn $15K of salary initially to fund that Roth is relevant.


I am basically making two points.

The first is a direct answer to your question. In Scenario A you make $15K, pay $5K in taxes, and put $10K into a Roth. In Scenario B you make $15K, put $10K into a TIRA, and do not yet pay taxes on that $10K. You then have $5K left. You'll have to pay taxes, but then you will still have $3333 left (at the tax rate we are assuming). So what happened to that $3333? By hypothesis you do not need it for consumption, so it is available to invest. Accordingly, you need to account for it when comparing Scenario B to Scenario A.

Don't get me wrong, though: likely you will eventually do better with Scenario A. But that is not for any reason we have discussed yet. The actual reason is that both the TIRA and Roth allow you to entirely skip capital gains and investment income taxes. So, in Scenario A the full $15K has received this protection. In Scenario B, only $10K has received this protection, and the other $5K has not (any gains or investment income you make on the $3333 will be subject to more taxes). But that is the real fundamental difference between Scenario A and Scenario B: not different tax treatment for the funds IN the accounts, but different tax treatment for the funds you had to leave OUT of the account in Scenario B.

Which leads me to my second point. I think it is absolutely crucial to understand that TIRAs and Roths share this attribute in common (completely protecting the funds in the account from capital gains and investment income taxes). And as I see it, the problem with people claiming that the Roth is "tax free" in comparison to the TIRA is that it suggests that somehow the Roth provides this protection, whereas the TIRA does not. That is wrong, and I believe it is wrong in a potentially very serious way.

User avatar
Doc
Posts: 7690
Joined: Sat Feb 24, 2007 1:10 pm
Location: Two left turns from Larry

Post by Doc » Tue May 01, 2007 9:58 am

BrianTH wrote:
Which leads me to my second point. I think it is absolutely crucial to understand that TIRAs and Roths share this attribute in common (completely protecting the funds in the account from capital gains and investment income taxes).


I've never thought of this concept in this way. It may be helpful to some people if you could illustrate the concept with some equations or examples so we get a better grasp of what you mean.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Tue May 01, 2007 10:45 am

Doc wrote:I've never thought of this concept in this way. It may be helpful to some people if you could illustrate the concept with some equations or examples so we get a better grasp of what you mean.


Sure. I've actually posted these equations before both here and at the old forum, and many other people have as well, but it is always worth reviewing. Where $X is pre-tax dollars, I1 is the income tax rate at the time of contribution, I2 is the income tax rate at the time of distribution, G is the capital gains and investment income return rate, and C is the applicable tax rate for gains and investment income (simplified for the sake of discussion to a single rate applied once at distribution), for the total return at distribution we get:

Roth:

$X(1-I1)(1+G)

TIRA:

$X(1+G)(1-I2)

Taxable:

$X(1-I1)(1+G(1-C))

One point that we have made using these equations is that if I1=I2, then the Roth and TIRA equations are mathematically identical.

But a second important point is that both the Roth and the TIRA equations do not have this (1-C) factor being applied to G. In other words, C is zero for the Roth or TIRA, or in still other words, Roth and TIRA funds get to entirely skip any tax on capital gains or investment income (but the TIRA, unlike the Roth, also converts I1 to I2).

In fact, in my view this is the chief benefit of either scheme relative to taxable investments, and it is a benefit they share in common, as these equations show. Among other things, this motivates me to call these accounts "tax-protected", because they both provide complete protection from an entire category of taxes.

And my point above was that to the extent people call the Roth "tax free" and the TIRA "tax-deferred", they are obscuring the fact that both of these schemes are actually free from the same taxes (taxes on gains and investment income), and not free from the same tax (income tax), with the difference being when you have to pay the income tax.

People also sometimes claim that the TIRA converts the capital gains and investment income taxes into an ordinary income tax. Again, as the equations above show, that is incorrect once you understand what is really going on. But that claim IS true of a non-deductible IRA, and so it may be worth putting that equation on the table:

Non-Deductible IRA:

$X(1-I1)(1+G(1-I2))

Thus, it is true that non-deductible IRAs convert C to I2, or in other words they convert the tax that would have been determined by the capital gains and investment income rates into an ordinary income tax (although with a deferral effect, which in some circumstances could make the conversion worthwhile). But that is NOT true of the TIRA, which again basically turns C to zero.

And as I suggested, I think this is important and arises in many contexts. For example, I sometimes see people asking if they really should make non-matched contributions to their 401Ks, given their poor investment choices and the fact that a 401K "only defers taxes" (or other words to that effect). And at some point it is true that the choices could be so bad that it makes sense to prefer taxable investments, but the barrier is higher than some people seem to think, particularly when you factor in the possibility of an IRA rollover down the road.

And the reason the barrier is so high is largely this tax-protection effect: it is very difficult for a taxable investment to make up for the fact that any gains or investment income it produces will be taxed, whereas the 401K/IRA gains and investment income will not be. So, this is one example of why I think it is important to keep in mind the fundamental benefit of both Roths and 401Ks (protection from capital gains and investment income taxes).

User avatar
Doc
Posts: 7690
Joined: Sat Feb 24, 2007 1:10 pm
Location: Two left turns from Larry

Post by Doc » Tue May 01, 2007 11:01 am

Brian,

I think this is a very good presentation of the various factors involved in the TIRA/ROTH/Taxable decision process. The equations involve simple algebra and can be understood without the need for any future value calculations which may be difficult for those investors with a limited math background.

I would strongly suggest that everyone take the time to fully understand the equations so that they can better understand their own situation.

Thanks for taking the time to repeat your presentation here.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

User avatar
Taylor Larimore
Advisory Board
Posts: 26239
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Traditional IRA or Roth IRA?

Post by Taylor Larimore » Tue May 01, 2007 11:12 am

Hi Bogleheads:
I am not a mathematician like many on this forum. I wouldn't trust my own mathematics, anyway. It is too easy to overlook necessary inputs in complex analysis.

One of the best Traditional/Roth IRA calculators is offered by reputable Commerce Clearing House. Here is a link:

http://www.finance.cch.com/sohoApplets/RothvsRegular.asp

In ALL the comparisons I have made, Traditional and Roth IRAs are not equal. Higher returning assets are nearly always better in the Roth IRA assuming tax rates remain the same.

Best wishes.
Taylor

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Re: Traditional IRA or Roth IRA?

Post by BrianTH » Tue May 01, 2007 11:33 am

Taylor Larimore wrote:In ALL the comparisons I have made, Traditional and Roth IRAs are not equal. Higher returning assets are nearly always better in the Roth IRA assuming tax rates remain the same.


I don't want to beat a dead horse, but are you making sure to keep the pretax amount contributed the same? If not, you are coming out ahead in the Roth simply because you have de facto contributed more.

But I want to emphasize that a higher de facto contribution limit is a real advantage to the Roth. Indeed, as I noted before, either scheme has the net effect of letting you skip taxes on gains and investment income. So, the more gains and investment income you expect per dollar invested, the greater the advantage of making the contribution to an account with this feature. Therefore, in a sense it is true you get more benefit when you contribute higher gaining assets to the Roth rather than the TIRA, but again that is because of the de facto higher contribution limit on the Roth.

B185CS
Posts: 98
Joined: Thu Apr 26, 2007 11:24 am
Location: California

Post by B185CS » Tue May 01, 2007 11:55 am

BrianTH wrote:Roth:

$X(1-I1)(1+G)

TIRA:

$X(1+G)(1-I2)

Taxable:

$X(1-I1)(1+G(1-C))

Non-Deductible IRA:

$X(1-I1)(1+G(1-I2))

Would a 401k account use the same calculation as a TIRA?

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Tue May 01, 2007 11:57 am

B185CS wrote:Would a 401k account use the same calculation as a TIRA?


Yes, sorry, it would.

[Edit: as noted by another poster below, a Roth 401K would actually use the Roth formula]

Keep in mind, by the way, that these are all simplified for the purpose of underscoring the key elements of the tax schemes in question.
Last edited by BrianTH on Tue May 01, 2007 12:13 pm, edited 1 time in total.

ruud
Posts: 134
Joined: Sat Mar 03, 2007 1:28 pm
Location: san francisco bay area

Post by ruud » Tue May 01, 2007 12:09 pm

B185CS wrote:Would a 401k account use the same calculation as a TIRA?

A "traditional" 401k, yes.
A Roth 401k would use the same formula as for the Roth IRA.

- Ruud

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Re: Traditional IRA or Roth IRA?

Post by alvinsch » Tue May 01, 2007 12:15 pm

BrianTH wrote:
Taylor Larimore wrote:In ALL the comparisons I have made, Traditional and Roth IRAs are not equal. Higher returning assets are nearly always better in the Roth IRA assuming tax rates remain the same.


I don't want to beat a dead horse, but are you making sure to keep the pretax amount contributed the same? If not, you are coming out ahead in the Roth simply because you have de facto contributed more.

But I want to emphasize that a higher de facto contribution limit is a real advantage to the Roth. Indeed, as I noted before, either scheme has the net effect of letting you skip taxes on gains and investment income. So, the more gains and investment income you expect per dollar invested, the greater the advantage of making the contribution to an account with this feature. Therefore, in a sense it is true you get more benefit when you contribute higher gaining assets to the Roth rather than the TIRA, but again that is because of the de facto higher contribution limit on the Roth.

Using the simpliest case the calculator gives strange results so it's impossible to know what "unique" assumptions they have made. If you invest $3000 in a ROTH at 5% they correctly calculate it is worth $3150 at the end of the year. However, if you invest $3000 in a TIRA in the 25% tax bracket for both contribution and withdrawal they claim it is only worth $3141 at the end of the year, which makes no sense ($3147 if using 15% bracket and $3132 if using 35% bracket for both).

I suppose it's possible they are assuming that one withholds the correct amount of taxes if they do a ROTH but aren't smart enough to do it if they own a TIRA and are therefore assuming that one doesn't get the saved taxes back on the TIRA until they file a year later? That would be a bizarre and unfair assumption. Maybe the calculator says it best:
We can not and do not guarantee their applicability or accuracy in regards to your individual circumstances.


- Al

User avatar
Taylor Larimore
Advisory Board
Posts: 26239
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Method of calculation

Post by Taylor Larimore » Tue May 01, 2007 12:15 pm

Hi Brian:
You ask:
"Are you making sure to keep the pretax amount contributed the same?"

I believe the Calculater includes this factor in their analysis. It is the last item of their explanation of how the calculations are made:

IRA total after taxes
For the Roth IRA, this is the total value of the account. For the Traditional IRA, this is the sum of two parts: 1) The value of the account after you pay income taxes on all earnings and tax-deductible contributions and 2) what you would have earned if you had invested (in an ordinary taxable account) any income tax savings.


Notice that the calculater places the taxes saved in the TIRA contribution into a taxable account (which is logical). This, is one reason the end result of a TIRA and Roth are not always identical.

Another reason is that, although the tax-saving of a deductible TIRA and the tax-saving of a Roth withdrawal are offsetting when returns are the same, the tax saving is different if returns are different. This is because the IRA with the largest ending value will enjoy the biggest tax-saving at withdrawal--and only a Roth IRA gets this.

Best wishes.
Taylor

B185CS
Posts: 98
Joined: Thu Apr 26, 2007 11:24 am
Location: California

Post by B185CS » Tue May 01, 2007 12:22 pm

BrianTH wrote:
B185CS wrote:Would a 401k account use the same calculation as a TIRA?


Yes, sorry, it would. Keep in mind, by the way, that these are all simplified for the purpose of underscoring the key elements of the tax schemes in question.

That's okay, I was just asking for the sake of completeness. I don't really have any idea what's going on here. Or rather, I have just enough of an idea to become both curious and confused. So I'm going to ask some stupid questions. :)

I think I understand the common error that many people, including myself, make when comparing a Roth to a TIRA. Typically, one thinks of contributing the "concept" of $4000 (for example) to either. However, with the Roth that conceptual $4000 was originally $5333.33 (if you're in the 25% bracket like me), and with the TIRA that conceptual $4000 is actually just $4000. I hope I'm just repeating what's already been said, but in a dumbed down fashion.

So, question number one. I've been trained to think that a Roth is the best, no ifs ands or buts. Assuming my tax rate at retirement is lower than it is now, is that true?

Question number two. Again, assuming a lower tax rate during retirement, is there or is there not a simple way to decide what kind of assets to put where? This is basically going back to the original "Where do bonds go" question. I have eleventyteen frickin' different tax-sheltered/deferred/protected accounts between my wife and myself (one each Rollover, Roth, Traditional, Nondeductible, 401k, and one SEP-IRA just for good measure). I fear my upcoming AA project. Even if I can come up with a good allocation, spreading it out over all those accounts is going to be a nightmare. :) It would be great if there were some rules to follow. I've read The Four Pillars of Investing, but Bernstein just uses two categories of accounts in his examples: taxable and non-taxable. Maybe that's a clue that it doesn't matter regardless of starting and ending tax rates?

Thanks!

User avatar
alvinsch
Posts: 1599
Joined: Mon Feb 19, 2007 10:16 pm
Location: Northwest

Post by alvinsch » Tue May 01, 2007 12:28 pm

I found where they explain the calculation and Brian is correct they aren't putting the same after tax value in each. In essence they compare putting $3000 in a ROTH with putting $3000 in a TIRA and the $750 tax savings in taxable.

So a ROTH after one year equals: $3000*1.05=$3150

But a TIRA equals: ($3000*1.05)*.75)=$2362.5
plus taxable: ($3000*.25)*(1+(05*.75)) = $778.12

For a total after tax value of $3141.

So yes the reason the ROTH looks better is because one is putting more after tax dollars in it versus the TIRA. Same reason a ROTH conversion makes sense in the same tax brackets because you are essentially sheltering more after tax money in the ROTH if you pay the conversion tax with taxable money.

- Al

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Re: Method of calculation

Post by BrianTH » Tue May 01, 2007 12:39 pm

Taylor Larimore wrote:Notice that the calculater places the taxes saved in the TIRA contribution into a taxable account (which is logical). This, is one reason the end result of a TIRA and Roth are not always identical.


Absolutely, but this is the contribution limit issue we have discussed: the difference in end result between the Roth and the TIRA arises because with the Roth's higher de facto contribution limit, you can protect more funds from certain taxes, and with the TIRA's lower de facto contribution limit, you are forced to expose the funds that you couldn't put into the TIRA but could have put into a Roth to those taxes (hence this little side taxable account the calculator comes up with). So, you are seeing the benefits of protecting more funds from certain taxes thanks to the higher de facto contribution limits on the Roth.

Another reason is that, although the tax-saving of a deductible TIRA and the tax-saving of a Roth withdrawal are offsetting when returns are the same, the tax saving is different if returns are different. This is because the IRA with the largest ending value will enjoy the biggest tax-saving at withdrawal--and only a Roth IRA gets this.


I think here is where the equations really help. If you look at the equations, it makes no difference what G (the return rate) ends up being as long as $X is the same. Mathematically, that is because it doesn't matter whether you apply the income tax factor (1-I) before or after the gains factor (1+G): it has the exact same effect on $X, just in a different order.

When you compare it to the taxable equation, however, it becomes apparent that the real tax savings come from the fact that there is no additional reduction of G by the (1-C) factor, meaning there is no additional tax on gains or investment income which would further reduce your after-tax return. But again, this is true of both the Roth and the TIRA.

And I really think this is an absolutely crucial point to understand, even if it requires a little math to see it clearly. And it means that once you have accounted for the higher de facto contribution limit on the Roth, there is no additional advantage to putting higher gain assets in a Roth versus a TIRA.
Last edited by BrianTH on Tue May 01, 2007 1:14 pm, edited 1 time in total.

BrianTH
Posts: 1340
Joined: Tue Feb 20, 2007 6:10 pm

Post by BrianTH » Tue May 01, 2007 12:54 pm

B185CS wrote:So, question number one. I've been trained to think that a Roth is the best, no ifs ands or buts. Assuming my tax rate at retirement is lower than it is now, is that true?


If your tax rate is lower at retirement, then the TIRA may be better on a pre-tax dollar for dollar basis, since it will apply the lower income tax rate to those dollars.

But here is where it gets complicated: if you then account for the higher de facto contribution limit on the Roth, you have to account for the fact that using the Roth saves you capital gains and investment income tax on these additional funds. You then have to weigh the advantages of entirely avoiding those taxes on these additional funds against the advantages of paying lower income taxes on the funds in the TIRA. And there is no hard mathematical rule for making that comparison: it depends entirely on the assumptions you make when it comes to the factors above (what I called I1, I2, G, and C), plus the contribution limits. I wish I could give you a simpler answer, but that is the bottomline.

Question number two. Again, assuming a lower tax rate during retirement, is there or is there not a simple way to decide what kind of assets to put where? This is basically going back to the original "Where do bonds go" question. I have eleventyteen frickin' different tax-sheltered/deferred/protected accounts between my wife and myself (one each Rollover, Roth, Traditional, Nondeductible, 401k, and one SEP-IRA just for good measure). I fear my upcoming AA project. Even if I can come up with a good allocation, spreading it out over all those accounts is going to be a nightmare. :) It would be great if there were some rules to follow. I've read The Four Pillars of Investing, but Bernstein just uses two categories of accounts in his examples: taxable and non-taxable. Maybe that's a clue that it doesn't matter regardless of starting and ending tax rates?


Here are some possible rules of thumb:

(1) It doesn't matter enough to worry about, so treat all tax-protected accounts as identical (but NOT nondeductible IRAs, for the reasons I gave above).

The rule's virtues: really simple. Vices: not entirely accurate, and so your AA may end up off target by some amount.

(2) Normalize the allocation amounts based on an assumption about the applicable income tax rate at withdrawal. So, for example, if you assume an applicable income tax rate of 0.25, multiply anything in a TIRA or T401K by 0.75 when comparing with Roth amounts.

Virtues: more accurate. Vices: more complex, and requires some assumptions about the future which may not be accurate.

(3) Put higher expected return assets in Roths.

Virtues: expected to increase returns. Vices: It is only expected to increase returns because your AA is not what you think it is.

I think Rules #1 and #2 both work. As we have been discussing, I think there is no real basis for Rule #3.

ruud
Posts: 134
Joined: Sat Mar 03, 2007 1:28 pm
Location: san francisco bay area

Re: Method of calculation

Post by ruud » Tue May 01, 2007 1:01 pm

Taylor Larimore wrote:Another reason is that, although the tax-saving of a deductible TIRA and the tax-saving of a Roth withdrawal are offsetting when returns are the same, the tax saving is different if returns are different. This is because the IRA with the largest ending value will enjoy the biggest tax-saving at withdrawal--and only a Roth IRA gets this.

As the equations show, that's simply not true.

Here's an example.

Let's assume a constant tax rate of 25%
Let's also assume bonds will double over the length of the investment, and stocks will quadruple.

In both scenarios we'll invest $1333.33 in a TIRA and $1000 in a Roth. After-tax, these amounts are the same (if withdrawn immediately (assuming no penalties), you'd end up with $1000 each).

Scenario 1:

$1333.33 in TIRA in bonds.
$1000 in Roth in stocks.

At withdrawal, the TIRA has grown to (2x1333.33=) $2666.66 and the Roth has grown to (4x1000) $4000.
Paying taxes on the TIRA withdrawal leaves us with (0.75x2666.66=) $2000.

Total amount after taxes: (4000+2000=) $6000.

Scenario 2:

$1333.33 in TIRA in stocks.
$1000 in Roth in bonds.

At withdrawal, the TIRA has grown to (4x1333.33=) $5333.32 and the Roth has grown to (2x1000=) $2000.
Paying taxes on the TIRA withdrawal leaves us with (0.75x5333.32=) $4000.

Total amount after taxes: (4000+2000=) $6000.

So it does not matter which account has the highest yielding asset, as long as you properly account for the taxes upon withdrawal.

(edit) So yes, you do save more in taxes IN ABSOLUTE DOLLARS when placing the highest yielding asset in the Roth, but in after-tax returns it does not matter.

User avatar
Taylor Larimore
Advisory Board
Posts: 26239
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

I think we agree

Post by Taylor Larimore » Tue May 01, 2007 1:45 pm

Hi Ruud:
This is because the IRA with the largest ending value will enjoy the biggest tax-saving at withdrawal--and only a Roth IRA gets this.


So yes, you do save more in taxes IN ABSOLUTE DOLLARS when placing the highest yielding asset in the Roth


I think we are saying the same thing.

Best wishes.
Taylor

ruud
Posts: 134
Joined: Sat Mar 03, 2007 1:28 pm
Location: san francisco bay area

Re: I think we agree

Post by ruud » Tue May 01, 2007 2:01 pm

Taylor Larimore wrote:I think we are saying the same thing.


Assuming a constant tax rate of 25%, why does it matter if you make $6000 as a result of paying $1000 in taxes on a $7000 investment or $2000 in taxes on a $8000 investment?

Post Reply