Bonds in Roth

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the_wiki
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Bonds in Roth

Post by the_wiki »

The common wisdom I hear often on this forum is to not use bonds in Roth. The logic is that you want the higher growth to be protected from taxes. However, if we knew for certain that stocks will have higher growth, why would we ever invest in bonds at all? This seems like an argument for 0% Bonds in every account.

Obviously we do not know that stocks will always outperform and wouldn't we want to protect from volatility in our Roth as well as we would a 401k?
sycamore
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Re: Bonds in Roth

Post by sycamore »

the_wiki wrote: Mon Nov 21, 2022 5:16 pm The common wisdom I hear often on this forum is to not use bonds in Roth. The logic is that you want the higher growth to be protected from taxes. However, if we knew for certain that stocks will have higher growth, why would we ever invest in bonds at all? This seems like an argument for 0% Bonds in every account.
That is a common suggestion but that's not quite the logic as I understand it. The logic is to put higher expected growth assets in Roth. I don't think people are assuming that stocks will certainly do better. It's more that if the expected growth happens, it's better to have withdrawals of growth taxed at 0% rather than income tax rates (as with a Trad IRA).
the_wiki wrote: Mon Nov 21, 2022 5:16 pm Obviously we do not know that stocks will always outperform and wouldn't we want to protect from volatility in our Roth as well as we would a 401k?
Some people think of their portfolio as a whole, and measure volatility at the portfolio level.
Other people end up focusing on each of their accounts.
And of course still other people look at the individual holdings within an account.

This is one of those things where an investor needs to know him/herself, and if volatility of a holding or an account is proving to be a problem, best to structure one's holdings and/or accounts such that they keep the investor out of trouble.

Of course if a person gets stuck thinking about accounts and individual holdings, what does that say for the person's portfolio Asset Allocation?
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Artsdoctor
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Re: Bonds in Roth

Post by Artsdoctor »

The reason why some people prefer to load their Roths with equities is because equites should outperform bonds in the very long run and many believe they will tap their Roths last. However, there are plenty of people in various stages of their investment lives which would have a more balanced approach to investing within a Roth. If someone is in their 20s or 30s and won't need to tap their Roth, there's certainly nothing wrong with having a 100% equity allocation in a Roth. Approaching retirement, some people may want to have a choice of how to extract money from their investments: taxable, tax-deferred, HSA, Roth, etc., and would want a variety of investments in each. So no, I don't believe you can say that bonds never belong in a Roth--it just depends on what your goals are and where you are in your investment life.
Exchme
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Re: Bonds in Roth

Post by Exchme »

I used to think this was magic, but read here that it was just equivalent to holding a higher stock allocation. I then tested in Pralana Gold through a couple of historical bull markets and historical bear markets and at least for my situation, that seems to be true. In spite of all the oddities of the tax code, IRMAA, capital gains, SS taxes, etc., there existed an equivalent, higher stock allocation that behaved very close to the same in both up and down markets as just holding the same percentages everywhere.

Your pre-tax accounts can be thought of as partly owned by you and partly by the government. If you stick bonds in there, the government is stuck with owning bonds, while you own stocks. You then get more upside potential and more downside risk, just the same as holding more stocks! The exact equivalent allocation will depend on the relative size of your tax deferred to other accounts and your tax bracket. For our case, our 80/20 allocation that puts bonds preferentially in tax deferred was extremely close to 83.5%/16.5% holding the same allocations everywhere.

[Edit: Therefore holding bonds in Roth is the opposite, lowering your effective overall allocation, since you would have more stocks held in your tax deferred accounts.]
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grabiner
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Re: Bonds in Roth

Post by grabiner »

If you know the tax rate on traditional withdrawals, and adjust allocations to keep risk constant, then there is no advantage to stocks in traditional or Roth. If you will withdraw in a 22% tax bracket, then $10,000 in a traditional account and $7800 in a Roth account will have the same after-tax value if invested the same way, so it doesn't matter which one is in stock and which is in bonds. Having an equal dollar amount in stock in a Roth rather than a traditional account increases expected returns and risk, but you can do that just as well with stock in the traditional account by holding more stock.

The advantage of stock in the Roth is that you may not know the tax rate on traditional withdrawals, and the volatility works against you. If you put stock in the traditional account, you are more likely to pay 24% tax on some of the withdrawals, since the stock market grows faster. But if the stock market crashes, you might drop to the 12% bracket. So the IRS might take 24% of some of your gains, and will give back only 12% of some of your losses. This asymmetry makes stocks better in the Roth if all else is equal. (If all else is not equal, such as a 401(k) with better stock than bond options, that is more important.)

One other advantage of stocks in a Roth is that a booming stock market may force you to take traditional IRA RMDs which are more than you want to spend, turning tax-deferred dollars into taxable dollars prematurely.
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Re: Bonds in Roth

Post by longinvest »

the_wiki wrote: Mon Nov 21, 2022 5:16 pm The common wisdom I hear often on this forum is to not use bonds in Roth. The logic is that you want the higher growth to be protected from taxes. However, if we knew for certain that stocks will have higher growth, why would we ever invest in bonds at all? This seems like an argument for 0% Bonds in every account.

Obviously we do not know that stocks will always outperform and wouldn't we want to protect from volatility in our Roth as well as we would a 401k?
The_wiki, here's a link to a comparison between 3 investors. Investor A prioritizes the placement of stocks into the Roth IRA first. Investor B prioritizes the placement of stocks into the traditional IRA first. Investor C maintains an identical allocation in all accounts.

Here are some of the highlights of the comparison:
longinvest wrote: Sat Jan 29, 2022 9:05 pm [...]
It's best focus on the big numbers that matter, like total net income available to spend after taxes, instead of focusing on ratios between small numbers with little impact on the retiree's wellness, like ratios of between tax amounts.
[...]
It's a mistake to only consider good scenarios and ignore risk, when evaluating the after-tax impact of asset location strategies. A complex strategy delivering better outcomes when things go well and worse outcomes when they don't, when compared to a simpler strategy, unnecessarily complicates the life of its investor. A slightly-higher stock allocation with the simpler strategy is likely to deliver similar outcomes.
[...]
An identical asset allocation in all portfolio accounts (a mirrored asset allocation) doesn't affect the effective riskiness of the portfolio, even after taxes. In contrast, so called "tax-efficient" asset location strategies often promise better "expected" outcomes without disclosing that they do so by increasing the effective after-tax risk of the portfolio. In other words, a mirrored asset allocation is not only good enough, it also delivers more consistent outcomes.
In a follow-up post I checked that, effectively, a slightly-different stock allocation with a mirrored asset allocation delivers similar outcomes to a "tax-efficient" asset location.

Here's an actionable conclusion. If an investor wishes to get, for example, 60/40 stocks/bonds outcomes before and after tax, the investor can simply mirror this allocation in every account (Roth, traditional, taxable). This will reliably work regardless of future asset returns, future tax laws, future investor circumstances, and many other unknown-in-advance future things.
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Re: Bonds in Roth

Post by Beensabu »

I have bonds in my Roth. But that's because it's my emergency fund. Also, I probably won't pay much (if anything) in the way of taxes anyway in retirement (if I make it there), so it doesn't matter. But that's me.
the_wiki wrote: Mon Nov 21, 2022 5:16 pm The logic is that you want the higher growth to be protected from taxes.
It's allowing the assets with higher potential returns to grow tax-free and be withdrawn tax-free after 59 1/2 years of age as long as the account is at least 5 years old (and contributions can be withdrawn tax-free anytime). Why not? Sounds good if you have to pay taxes in retirement, especially if you're probably going to be in a high tax bracket.
the_wiki wrote: Mon Nov 21, 2022 5:16 pm wouldn't we want to protect from volatility in our Roth as well as we would a 401k?
Look at your portfolio as a whole, not by account.

People with real emergency funds, and large checking accounts, and actual taxable accounts put stocks (and usually the kinds of stocks that create otherwise undesirable taxable events) in their Roth. Because they're probably going to have to pay taxes in retirement. That's why they capped contributions at a particular income level. That's why people found a backdoor (still open for now). People like leaving their Roths to heirs too - how nice is that gift?

Sometimes, you just have to look at "the rules" and figure out who they're for. And then you determine whether that is your situation. And if yours is different, you pinpoint how. Then you figure out how "the rules" might be different for you and your situation, and you follow those ones instead.
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longinvest
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Re: Bonds in Roth

Post by longinvest »

the_wiki wrote: Mon Nov 21, 2022 5:16 pm ...?
The_wiki, you didn't provide feedback, so I'll ask. Did the analysis I linked to fully answer your question? If it didn't, what was missing? If it did, what did you learn from the analysis?
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Re: Bonds in Roth

Post by Kevin M »

the_wiki wrote: Mon Nov 21, 2022 5:16 pm The common wisdom I hear often on this forum is to not use bonds in Roth. The logic is that you want the higher growth to be protected from taxes. However, if we knew for certain that stocks will have higher growth, why would we ever invest in bonds at all? This seems like an argument for 0% Bonds in every account.

Obviously we do not know that stocks will always outperform and wouldn't we want to protect from volatility in our Roth as well as we would a 401k?
I've made the exact same argument!

The other thing, that's been mentioned in a couple of replies, is that if you adjust for risk, there is little to no difference between holding riskier assets in Roth or tIRA. There are scenarios where the Roth does slightly better, but it's not enough to worry about. It's clear that the vast majority of people who promote preferring higher-risk, higher-expected-return assets in Roth either don't understand this or don't believe it.

I hold mostly fixed income in my Roth IRAs, but I market time the buying and selling of VTI as it moves up or down in 5% increments. I've done several round trips with this so far, but am still holding the lots I purchased at -5%, -10%, and -15%, or something like that.

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the_wiki
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Re: Bonds in Roth

Post by the_wiki »

longinvest wrote: Tue Nov 22, 2022 4:33 pm
the_wiki wrote: Mon Nov 21, 2022 5:16 pm ...?
The_wiki, you didn't provide feedback, so I'll ask. Did the analysis I linked to fully answer your question? If it didn't, what was missing? If it did, what did you learn from the analysis?
I did read it and I appreciate the calculations shows. It seems like in the long run, the results are not that different and it's as probably as much luck as strategy.


I do also appreciate the comment about how many people hold Roth for longer due to RMD for 401k. So perhaps the longer time horizon in Roth can warrant a riskier AA.
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grabiner
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Re: Bonds in Roth

Post by grabiner »

longinvest wrote: Mon Nov 21, 2022 11:27 pm In a follow-up post I checked that, effectively, a slightly-different stock allocation with a mirrored asset allocation delivers similar outcomes to a "tax-efficient" asset location.
This is correct for traditional versus Roth, but not necessarily correct for taxable versus tax-advantaged. In particular, an investor in the 12% tax bracket has a near-zero tax cost for stocks in a taxable account, with no tax on qualified dividends, nor on long-term gains if the stocks are sold. Conversely, an investor in a very high tax bracket in CA or NY, who pays a high tax even on qualified dividends, may be better off holding all their bonds in CA or NY munis in a taxable account.
Here's an actionable conclusion. If an investor wishes to get, for example, 60/40 stocks/bonds outcomes before and after tax, the investor can simply mirror this allocation in every account (Roth, traditional, taxable). This will reliably work regardless of future asset returns, future tax laws, future investor circumstances, and many other unknown-in-advance future things.
Even if this is close to correct for your own tax situation, there are still adjustments needed; mirroring the asset classes does not mean mirroring the funds. Investors who hold an actively-managed stock fund in a 401(k) should hold an index in a taxable account. Investors in high tax brackets should hold munis in a taxable account. Investors in moderate tax brackets in high-tax states should hold Treasuries or in-state munis in a taxable account.
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Re: Bonds in Roth

Post by longinvest »

grabiner wrote: Tue Nov 22, 2022 10:54 pm
longinvest wrote: Mon Nov 21, 2022 11:27 pm In a follow-up post I checked that, effectively, a slightly-different stock allocation with a mirrored asset allocation delivers similar outcomes to a "tax-efficient" asset location.
This is correct for traditional versus Roth, but not necessarily correct for taxable versus tax-advantaged. In particular, an investor in the 12% tax bracket has a near-zero tax cost for stocks in a taxable account, with no tax on qualified dividends, nor on long-term gains if the stocks are sold. Conversely, an investor in a very high tax bracket in CA or NY, who pays a high tax even on qualified dividends, may be better off holding all their bonds in CA or NY munis in a taxable account.
Here's an actionable conclusion. If an investor wishes to get, for example, 60/40 stocks/bonds outcomes before and after tax, the investor can simply mirror this allocation in every account (Roth, traditional, taxable). This will reliably work regardless of future asset returns, future tax laws, future investor circumstances, and many other unknown-in-advance future things.
Even if this is close to correct for your own tax situation, there are still adjustments needed; mirroring the asset classes does not mean mirroring the funds. Investors who hold an actively-managed stock fund in a 401(k) should hold an index in a taxable account. Investors in high tax brackets should hold munis in a taxable account. Investors in moderate tax brackets in high-tax states should hold Treasuries or in-state munis in a taxable account.
Grabiner, we don't know how the taxation of stocks and bonds will change in the future. We don't know if an investor won't move from a state to another in the far future. We don't know how the tax bracket of the investor will change in the future. We don't know if the (after-tax) returns of munis will be relatively similar or different from the (after-tax) returns of Treasuries in the future. There's a lot we don't know about the future that could affect after-tax outcomes.

A mirrored asset allocation is generally more resilient to an unknown long-term future than prioritizing the placement of specific assets into specific accounts. Some assets, like I-bonds, can't be held in all accounts, and practicality could play against complete replication in all accounts due to the number and size of replicated holdings. A mirrored asset allocation is simplest to implement when using a single all-in-one fund or ETF.
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skierincolorado
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Re: Bonds in Roth

Post by skierincolorado »

sycamore wrote: Mon Nov 21, 2022 5:38 pm
the_wiki wrote: Mon Nov 21, 2022 5:16 pm The common wisdom I hear often on this forum is to not use bonds in Roth. The logic is that you want the higher growth to be protected from taxes. However, if we knew for certain that stocks will have higher growth, why would we ever invest in bonds at all? This seems like an argument for 0% Bonds in every account.
That is a common suggestion but that's not quite the logic as I understand it. The logic is to put higher expected growth assets in Roth. I don't think people are assuming that stocks will certainly do better. It's more that if the expected growth happens, it's better to have withdrawals of growth taxed at 0% rather than income tax rates (as with a Trad IRA).
the_wiki wrote: Mon Nov 21, 2022 5:16 pm Obviously we do not know that stocks will always outperform and wouldn't we want to protect from volatility in our Roth as well as we would a 401k?
Some people think of their portfolio as a whole, and measure volatility at the portfolio level.
Other people end up focusing on each of their accounts.
And of course still other people look at the individual holdings within an account.

This is one of those things where an investor needs to know him/herself, and if volatility of a holding or an account is proving to be a problem, best to structure one's holdings and/or accounts such that they keep the investor out of trouble.

Of course if a person gets stuck thinking about accounts and individual holdings, what does that say for the person's portfolio Asset Allocation?
But expected returns don't always happen, which is why we invest in bonds in the first place. If expected returns were always realized we would always invest in equities because they have higher expected returns.

So what happens if expected returns aren't realized and bonds actually outperform equities on our investment horizon? By holding bonds in the traditional account, the higher growth of the bonds will face income tax rates. We have now made a bad situation even worse by taxing our modest bond gains while our smaller equity gains ( or possibly even losses) are wasted in a totally tax free account.

An example:

If we put 200k bond in trad and 200k equity in Roth, we expect that in 20 years we would have 300k in trad and 600k in Roth, for 800k total - making for a comfortable retirement.

However what if expected returns fail and equities do horribly and have 0% return? Now we have 300k bonds in trad and 200k equities in Roth. After a 25% tax on trad, our after tax value is 425k. A very bad retirement.

If instead we had done the bonds in Roth and equities in trad, well now after 20 years we would have 300k in Roth and 200k in trad. After tax we would have 450k. Still a bad retirement but 25k better.

This is a 25k improvement by holding bonds in Roth.

It's true that most of the time equities will do better and we would owe less tax if they were held in Roth. But in the worst case nightmare scenarios - the scenarios that cause us to hold bonds in the first place - we will wish that our bonds were in Roth and equities were in trad.

For this reason it is clear that bonds should be held more in Roth than in traditional. Doing so will make our mean and best case outcomes worse. But it will make our worst case outcomes better. I'd suggest hedging ones bets and holding bonds in both, with some preference for holding the bonds in Roth.

If our investment horizon is so long that we think equities are essentially guaranteed to outperform, we shouldn't hold bonds at all.
skierincolorado
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Re: Bonds in Roth

Post by skierincolorado »

Ah I see Longinvest already made the same argument.
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