Rationale for placing high expected return funds in Roth rather than tIRA

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
tmcandrews
Posts: 3
Joined: Wed May 09, 2018 12:18 am

Rationale for placing high expected return funds in Roth rather than tIRA

Post by tmcandrews » Wed May 09, 2018 12:37 am

I'm new to the Boglehead forum - thanks for having me. I want to get to the bottom of the rationale for placing your highest expected return funds in your Roth IRA rather than (or with higher priority than) your traditional IRA. This is certainly consensus, but I haven't found a full rationale that I totally understand yet. My best shot at explaining it is that, if you place your highest expected return assets in your Roth, odds are that you'll end up with a greater proportion of your assets in your Roth (i.e., you may not end up with more after-tax assets total at any given point, but a greater proportion of them will be in the Roth). Thus, because Roths don't have RMDs, you'll have more control over your distributions and taxable income after age 70.5.

Can anyone offer a better explanation than that? I have a simple spreadsheet illustrating this point I can share offline if folks are interested.

Thanks!

donheff
Posts: 5
Joined: Thu Jan 25, 2018 1:19 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by donheff » Wed May 09, 2018 6:58 am

I wasn't aware of this as a thing but reflecting on it it seems to me that if you bet right and the funds in your Roth turn out to be the highest gainers, the advantage is more tax free capital gains when you take them out. to the extent you can't put them all in a Roth, you would concentrate the other equities (to the extent possible) in a normal after tax account. The remainder of the equities and all or most bond funds go in the traditional IRA/401K to balance out the AA but will all be taxed at income rates when they come out.

larryswedroe
Posts: 15703
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by larryswedroe » Wed May 09, 2018 9:34 am

Simple explanation is that you OWN 100% of your ROTH and only 1-your tax rate of your traditional IRA or other tax advantaged accounts. And as noted don't have to take withdrawals, allowing tax free growth to continue as long as possible.
Larry

User avatar
House Blend
Posts: 4492
Joined: Fri May 04, 2007 1:02 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by House Blend » Wed May 09, 2018 10:06 am

Welcome to the forum.

The most common explanation you see on this forum is something like "you want high-risk assets in a Roth, because you want more of the growth to be tax free". As explanations go, it's a poor one.

More precisely, it's a gross oversimplification and easily misunderstood as a free lunch, when in fact what it does is hide risk. It works as a "rationale" only if you believe that more risk is better, and you need a strategy that allows you to maintain a higher risk portfolio than you might otherwise be comfortable with.

Better rationales are based on the fact that Roth IRAs do not have RMDs (during your lifetime), but trad IRAs do.

For example, shifting higher growth assets into tax-deferred will tend to produce higher RMDs. This by itself isn't terrible, but it is generally suboptimal if you spend less than your RMDs--in that case, you will be re-investing the excess in taxable, and subjecting the investments to further tax drag.

In other words, among all the portfolios with equivalent risk, you'd rather have one that is expected to produce RMDs that are small enough that you won't need to re-invest in taxable.

A related conundrum for young accumulators attempting to tax-adjust their asset allocation is that your marginal tax rate in retirement could depend in the long run on how you choose to locate assets.

But in a parallel universe with a flat tax of X% on all taxable income (and hence no such conundrums), the only thing that distinguishes your trad IRA from a Roth IRA denominated in a currency that is worth X% less than a dollar is the fact that the account also has RMDs. And so if the future RMDs were a problem, you would simply convert enough trad IRA assets to Roth until the RMDs were small enough not to matter.

In short, the only valid justifications for higher risk assets in a Roth versus tax-deferred has to either be based on the rather un-flat nature of our tax laws, or the issue of RMDs.

tmcandrews
Posts: 3
Joined: Wed May 09, 2018 12:18 am

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by tmcandrews » Wed May 09, 2018 10:12 am

Thanks, both. But @larryswedroe, let's take the simplified example where someone has equal after-tax amounts in a tIRA and a Roth. Assuming a marginal tax rate of 37%, let's say the investor has $1,000 in the Roth and $1,587 in the tIRA [$1,587 = 1,000 / (1 - 37%)]. Let's also make the (overly) simplifying assumption that this investor's marginal tax rate stays the same forever. Finally, let's assume that in one account they have an asset earning 2% and in the other account an asset earning 8%. It doesn't matter which account you put each asset in - your total after-tax value is the same! That is, you can put the 2% e(return) asset in the Roth and the 8% e(return) asset in the tIRA or vice verse - it doesn't matter. The accumulated after-tax value is the same, and differences only come into play if you factor in RMDs/withdrawals.

Doesn't that refute the "owning 100% of your Roth" argument, so that the only rationale for putting the higher e(return) asset in the Roth is you'll have a greater % of your assets in the account you aren't forced to take withdrawals from?

I can send over a simple spreadsheet if the math I'm trying to explain above is unclear.

Thanks again!

tmcandrews
Posts: 3
Joined: Wed May 09, 2018 12:18 am

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by tmcandrews » Wed May 09, 2018 10:15 am

@House Blend - this makes sense to me. Thank you.

asif408
Posts: 1443
Joined: Sun Mar 02, 2014 8:34 am
Location: Florida

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by asif408 » Wed May 09, 2018 10:29 am

tmcandrews wrote:
Wed May 09, 2018 10:12 am
Thanks, both. But @larryswedroe, let's take the simplified example where someone has equal after-tax amounts in a tIRA and a Roth. Assuming a marginal tax rate of 37%, let's say the investor has $1,000 in the Roth and $1,587 in the tIRA [$1,587 = 1,000 / (1 - 37%)]. Let's also make the (overly) simplifying assumption that this investor's marginal tax rate stays the same forever. Finally, let's assume that in one account they have an asset earning 2% and in the other account an asset earning 8%. It doesn't matter which account you put each asset in - your total after-tax value is the same! That is, you can put the 2% e(return) asset in the Roth and the 8% e(return) asset in the tIRA or vice verse - it doesn't matter. The accumulated after-tax value is the same, and differences only come into play if you factor in RMDs/withdrawals.
The assumption in bold is a big one. With the Roth, at least you know what you owe in taxes because you have already paid it. There is greater uncertainly with the tIRA because, as history has shown, tax rates change pretty regularly, so you may be better or worse off, but in all likelihood if you have a 20+ year horizon your marginal tax rate will probably be different, for better or worse. In fact, if memory serves me correctly, the tax rates in the US have historically changed every 5-10 years on average.

GAAP
Posts: 585
Joined: Fri Apr 08, 2016 12:41 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by GAAP » Wed May 09, 2018 11:23 am

Plans to do Roth conversions would also be a reason. Keeping the lower expected return in the TIRA hopefully reduces the total taxes paid during the conversions.

Minimizing local/state estate taxes would be another potential reason -- likely combined with Roth conversions. Keeping the higher growth asset in the Roth increases the net benefit to the heirs after estate taxes. Keeping the higher growth asset in the TIRA effectively forces the estate to pay estate taxes on monies that will ultimately go to the IRS.

ThrustVectoring
Posts: 496
Joined: Wed Jul 12, 2017 2:51 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by ThrustVectoring » Wed May 09, 2018 11:40 am

Putting different funds in Roth vs Taxable or Traditional based on expected returns bothers me. Like, a lot. If you expect something to have a lower return, why are you buying it at all? IMHO you should put your higher expected return funds in both Roth and tIRA, and drop the lower expected return funds.

Yeah, I know protection against volatility is a thing for bonds, but you are probably not retiring soon enough for that to matter at all. Over 20+ years, buying bonds today isn't the best way to protect against the risk of bear markets. It's getting enough participation in bull markets that a drawdown still leaves you at a better place.

FoolMeOnce
Posts: 282
Joined: Mon Apr 24, 2017 11:16 am

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by FoolMeOnce » Wed May 09, 2018 11:54 am

tmcandrews wrote:
Wed May 09, 2018 10:12 am
Thanks, both. But @larryswedroe, let's take the simplified example where someone has equal after-tax amounts in a tIRA and a Roth. Assuming a marginal tax rate of 37%, let's say the investor has $1,000 in the Roth and $1,587 in the tIRA [$1,587 = 1,000 / (1 - 37%)]. Let's also make the (overly) simplifying assumption that this investor's marginal tax rate stays the same forever. Finally, let's assume that in one account they have an asset earning 2% and in the other account an asset earning 8%. It doesn't matter which account you put each asset in - your total after-tax value is the same! That is, you can put the 2% e(return) asset in the Roth and the 8% e(return) asset in the tIRA or vice verse - it doesn't matter. The accumulated after-tax value is the same, and differences only come into play if you factor in RMDs/withdrawals.

Doesn't that refute the "owning 100% of your Roth" argument, so that the only rationale for putting the higher e(return) asset in the Roth is you'll have a greater % of your assets in the account you aren't forced to take withdrawals from?

I can send over a simple spreadsheet if the math I'm trying to explain above is unclear.

Thanks again!
The point of putting the 8% return in the Roth is that you would not have the same in after-tax amounts in the two accounts.

User avatar
FiveK
Posts: 5565
Joined: Sun Mar 16, 2014 2:43 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by FiveK » Wed May 09, 2018 12:06 pm

tmcandrews wrote:
Wed May 09, 2018 10:12 am
...let's take the simplified example where someone has equal after-tax amounts in a tIRA and a Roth.
...let's assume that in one account they have an asset earning 2% and in the other account an asset earning 8%.
That's the commutative property of multiplication, with "Original_amount/2" placed in both the traditional and Roth accounts, so "It doesn't matter which account you put each asset in - your total after-tax value is the same!" is correct.
Doesn't that refute the "owning 100% of your Roth" argument, so that the only rationale for putting the higher e(return) asset in the Roth is you'll have a greater % of your assets in the account you aren't forced to take withdrawals from?

I can send over a simple spreadsheet if the math I'm trying to explain above is unclear.
For completeness, one should also consider the math behind Maxing out your retirement accounts. If your spreadsheet is already warmed up, how do things look when a taxable "side account" must be used?

User avatar
FiveK
Posts: 5565
Joined: Sun Mar 16, 2014 2:43 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by FiveK » Wed May 09, 2018 12:16 pm

FoolMeOnce wrote:
Wed May 09, 2018 11:54 am
The point of putting the 8% return in the Roth is that you would not have the same in after-tax amounts in the two accounts.
Are you sure about that? ;)

bradpevans
Posts: 328
Joined: Sun Apr 08, 2018 1:09 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by bradpevans » Wed May 09, 2018 12:25 pm

ThrustVectoring wrote:
Wed May 09, 2018 11:40 am
Putting different funds in Roth vs Taxable or Traditional based on expected returns bothers me. Like, a lot. If you expect something to have a lower return, why are you buying it at all? IMHO you should put your higher expected return funds in both Roth and tIRA, and drop the lower expected return funds.

Yeah, I know protection against volatility is a thing for bonds, but you are probably not retiring soon enough for that to matter at all. Over 20+ years, buying bonds today isn't the best way to protect against the risk of bear markets. It's getting enough participation in bull markets that a drawdown still leaves you at a better place.
^^^ this. The math is the same independent of the return. With tax-deferred, you "save now" vs Roth. With Roth, you "save later" compared to tax-deferred. Since "later" typically means the numbers are bigger, this may skew the perception.

tax rate in / tax rate will determine if you made the right choice, not performance.
tax rate in is pretty easy to know (unless you have highly variable income)
(future) tax rate out is much harder to know, and depends on lots of *other* things beside Roth vs tax-deferred,
such as SS, filing status, pension, etc.

User avatar
Epsilon Delta
Posts: 7430
Joined: Thu Apr 28, 2011 7:00 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by Epsilon Delta » Wed May 09, 2018 1:09 pm

House Blend wrote:
Wed May 09, 2018 10:06 am
In short, the only valid justifications for higher risk assets in a Roth versus tax-deferred has to either be based on the rather un-flat nature of our tax laws, or the issue of RMDs.
I agree with this and would put it this way:

We have a largely progressive income tax structure. The higher your assets and income the greater the advantage of having money in a Roth. Putting the higher variance (and expected return) assets in the Roth means that the higher your income the more that will be in the Roth and the more advantage you get from it.

This is not the same as taking more risk. If your risky assets all go to zero you will be in a low tax bracket so it doesn't matter much if the remainder is in a Roth or tIRA.

FoolMeOnce
Posts: 282
Joined: Mon Apr 24, 2017 11:16 am

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by FoolMeOnce » Wed May 09, 2018 1:27 pm

FiveK wrote:
Wed May 09, 2018 12:16 pm
FoolMeOnce wrote:
Wed May 09, 2018 11:54 am
The point of putting the 8% return in the Roth is that you would not have the same in after-tax amounts in the two accounts.
Are you sure about that? ;)
After doing some math, no!

One consideration aside from RMDs is that this only holds if other income sources push you into the equivalent marginal tax rate before accounting for withdrawals. That is, in the example, the entirety of your future withdrawal is at the 37% marginal rate rather than filling up some of the lower brackets first. (And same can be said for current tax payments on Roth money, though the small annual limit makes it less likely and less impactful to straddle brackets).

If you are able to max your accounts regardless of whether you are paying taxes up front, then the location of higher performance matters, right? Or am I still missing something?

MathWizard
Posts: 2997
Joined: Tue Jul 26, 2011 1:35 pm

Re: Rationale for placing high expected return funds in Roth rather than tIRA

Post by MathWizard » Wed May 09, 2018 9:55 pm

My rationale:
Roth is tax free on withdrawals.
If you win big, Roth will not push you into a higher bracket.
If you win , but less big, in a tIRA rather than ROTH, your RMDs are bigger, eventually pushing you into a higher bracket, especially when only one spouse is left, and so is filing single.

Bigger tIRA may mean a higher % of SS benefits are taxed.

If the risk a s volatility risk, which I'd the primary risk of diversified equities, and assuming you pull less from the ROTH early on, it has a longer time in market, and hence less downside risk (IMHO).

Post Reply