When it comes to asset location (i.e. where should you place you various investments), the question is usually about whether certain investments belong in taxable or tax-protected accounts. By making smart decisions, you can reduce your tax drag and improve optimization of your overall portfolio which helps you keep more of your returns. That’s one of the reasons why it pays to spend time making sure your accounts are as optimized as possible. The general rule is that you want your least tax efficient investments in tax-deferred or tax-free accounts, while you can place your most tax efficient investments anywhere.
But sometimes the question is whether you should care about putting certain investments in tax-deferred or tax-free accounts. The answer isn’t quite as intuitive.
Tax-deferred accounts are the ones where you’ll eventually pay ordinary income taxes (i.e. Traditional IRA, 401(k), etc.). Tax-protected accounts are the ones where you paid income taxes originally so you won’t have to pay them in the future (i.e. Roth IRA, Roth 401(k), etc.).
Quite often someone will say something like this:
So is that right? Should you put the asset class with the highest expected return in your Roth IRA? I will argue that the answer is no.
But first, let’s explain why the statement seems intuitively correct. Let’s say you have two $1,000 investments. Fund A is stocks and has an expected return of 100% over an arbitrary time period. Fund B is bonds and has an expected return of 50% over the same arbitrary time period. At the end of the time period, Fund A is worth $2,000 and Fund B is worth $1,500. It stands to reason that you’d prefer for Fund A to be in your Roth account, since you’ll capture all of the gains.
Following that logic, one would assume that the riskiest asset classes with the highest expected return belongs in our Roth account and that asset classes with a lower expected return belong in Traditional accounts.
Not so fast.
The reason for the higher return is not because of the placement of the asset in the Roth account. The reason for the higher return is that those higher returns came at the cost of higher risk.
An example will make this clear.
Let’s go back to the previous hypothetical, which I’ll lay out again but let’s also layer on a few assumptions:
- You have $2,000 to invest
- The desired asset allocation is a 50/50 split between bonds and stocks
- The tax rate on withdrawal of a Traditional IRA is 25%
- Fund A (Stocks) return 100% over an arbitrary time period
- Fund B (Bonds) return 50% over an arbitrary time period
Example 1. You place Fund A in a Roth IRA account and place Fund B in a Traditional IRA account. At the end of the time period, Fund A is worth $2,000 and Fund B is with $1,500. Your total after tax wealth is $2,000 + $1,125 ($1,500 minus 25%) which equals $3,125.
Example 2. Reverse Example 1. You place Fund A in a Traditional IRA account and place Fund B in a Roth IRA account. At the end of the time period, Fund A is worth $2,000 and Fund B is worth $1,500. Your total after tax wealth is $1,500 ($2,000 minus 25% in taxes) plus $1,500 which equals $3,000.
It would seem obvious that Example 1 produces a better return (which it does). But it has nothing to do with asset location and everything to do with increasing risk.
The reason for this common misunderstanding is that we’re not treating the accounts on an after-tax basis. If you treat all of your accounts on an after-tax basis, there is no difference in placing assets inside a tax-deferred or tax-free account. None.
The key point to remember is the assumption that we wanted a 50/50 split between bonds and stocks. Example 1 and Example 2 do not adhere to this assumption.
Let’s run through the same examples looking at the accounts on an after-tax basis.
Example 3. The Traditional IRA holds $1,000 of Fund A (stocks). The Roth IRA holds $750 of Fund B (bonds). This is a true 50/50 asset allocation because we’ve already paid taxes on the money deposited into the Roth IRA but we haven’t yet paid taxes on the money in the Traditional IRA. The arbitrary time period passes. The Traditional IRA is now worth $2,000 and the Roth IRA is worth $1,125. Your total after tax wealth is $1,500 ($2,000 minus 25% in taxes) + $1,125 which equals $2,625.
Example 4. Reverse Example 3. The Traditional IRA holds $1,000 of Fund B (bonds). The Roth IRA holds $750 of Fund A (stocks). The arbitrary time period passes. The Traditional IRA is worth $1,500 and the Roth IRA is worth $1,500. Your total after tax wealth is $1,125 ($1,500 minus 25% in taxes) + $1,500 which equals $2,625. Your total after-tax wealth is the same as in Example 3.
In other words, if you’re placing assets with a higher expected return in your Roth account you’re kidding yourself because the higher resulting value is directly related to shifting your asset allocation to more aggressive assets. It has nothing to do with the Roth being better for aggressive assets. You can put tax-inefficient assets in either the Traditional or the Roth accounts. If you manage your asset allocation on a pre-tax basis, you can take on more risk by putting your higher returning assets in a Roth IRA. If you manage your asset allocation on a post-tax basis, it doesn’t matter where you place the assets.
Example 1 had a $125 greater return than Example 2 because Example 1 is a 57/43 split between stocks and bonds on an after-tax basis, whereas Example 2 is a the exact opposite 43/57 split between stocks and bonds on an after-tax basis. Asset allocations with more risk should have greater returns. But the key is making sure you understand your tax-adjusted asset allocation or else you’re skewing the numbers.
Any reason to put higher-yielding asset in Roth IRA?
Despite the fact that as long as you’re managing your asset allocation on a post-tax basis, it doesn’t matter where you place the assets, there are still a few minor reasons that you may prefer to put the higher yielding asset in the Roth IRA if all else is equal.
For one, you may have better options in a 401(k) or a Roth IRA. If the only good option in your 401(k) is a low-fee index fund tracking the S&P 500, then you should hold that fund in the 401(k) and put bonds and international stocks in your Roth account. The same is true vice-versa.
Second, the Roth IRA is currently exempt from required minimum distributions unlike a Traditional IRA. Since you won’t be forced to empty your Roth account, you can keep more of the unneeded money growing for future years which could be beneficial vis-a-vis being forced to liquidate a Traditional IRA account with a higher balance.
Third, it’s possible that putting assets with a higher expected return in your Traditional IRA could result in required minimum distributions that shift you into a higher tax bracket, thus causing you to pay a higher percentage of your retirement income towards taxes than would otherwise be the case.
Does tax-adjusting your asset allocation matter?
So, if you made it this far in the article you understand that there’s two ways to look at your asset allocation. You can either just look at the actual dollar numbers and decide you have a certain allocation. Or, you can look at each dollar on a tax-adjusted basis and then calculate your asset allocation.
This is certainly an advanced look at your portfolio and one that is relatively new to the investing scene (with the advent of Roth 401(k)s we’re only now getting to the point where people have meaningful conversations about the asset location of Traditional vs Roth accounts). Remember, we’re not talking about the difference between a taxable account and tax-protected accounts, we’re talking about the differences between two types of tax-protected accounts: tax-deferred and tax-free.
The essence of the question boils down to whether you want to look at your asset allocation for what it truly is or whether you’re fine fudging the numbers a bit and not getting into the granular details. I tend to think either proposition is fine and certainly can’t imagine that most lawyers are calculating their tax-adjusted asset allocation.
Just keep in mind that it can make a big difference in your portfolio.
Let’s say a lawyer is 40 years old and wants an asset allocation of a 60 / 40 split between stocks and bonds. If he has $60,000 in a Roth IRA and $40,000 in a Traditional IRA, his tax-adjusted asset allocation would be 67/33 if he held all stocks in the Roth IRA or a 55/45 allocation is held all stocks in a Traditional IRA. Both are decent portfolios but the 12% spread between the two asset allocations warrants a second look as you could be taking on more risk (or less risk) than you intended.
For that reason, if your asset allocation is in the 60/40 or 70/30 range, it’s probably worth taking the time to figure out your asset allocation on an after-tax basis. I’m not sure it matters as much if you’re at a 90/10 split but could still be relevant if you’re “tilting” your portfolio and intending for something like 20% or more of your portfolio to be allocated toward a particular asset class. After reading this article, you should be curious if you’re really achieving that intended asset allocation after all.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.