Alan: Asset Allocation (AA)
Alan et all:
Would like your opinion on the following thread copied from another forum-Bogleheads.com. The post is part of a thread trying to help people decide what assets to put into either a ROTH or tIRA and the tax consequences. Their experts say–doesn’t matter overall. I disagree, the more Roth I have, the more control I have of the tax brackets and RMD’s. And I am sure my heirs will be happier.
[quote]Tax-adjusted asset allocation didn’t use to matter much because investors held most of their assets in taxable (preferably stocks) and traditional 401k/IRA (preferably bonds), and the tax effects on stocks in taxable and bonds in 401k/IRA aren’t so different as to throw off your AA. However, with the increasing prevalence of Roth 401k’s, converted Roths, and back door Roths, tax-adjusted asset allocation becomes more important.wiki wrote:
Why to Adjust
It is easiest to see why the adjustment is necessary by comparing traditional and Roth accounts. For example, suppose you have $4,000 in a 401(k) and $3,000 in a Roth IRA, and you will be in a 25% tax bracket when you retire. You might choose to invest the entire 401(k) in stock and the entire Roth in bonds. If you do this, and the stock market gains 10% while the bond market gains 5%, your 401(k) would be worth $4,400, and your Roth would be worth $3,150. The IRS will take 25% of your 401(k) when you withdraw it , so you could now withdraw your investments for $6,450. Similarly, if you invested the 401(k) in bonds and the Roth in stock, your 401(k) would be worth $4,200, and your Roth would be worth $3,300. After taxes, you would have the same $6,450. Since both portfolios give you the same 7.5% return that you would expect from a portfolio which was 50% stock and 50% bonds, it is reasonable to treat both portfolios as having a 50/50 asset allocation, rather than the 57/43 and 43/57 which would result from the nominal values.
The tax adjustment also adjusts for the effective difference in risk between the two accounts. In the example above, suppose that the stock market loses half its value. If your 401(k) was entirely in stock, it would drop from $4,000 to $2,000, which would cost you $1,500 in after-tax value; if your Roth was entirely in stock, it would drop from $3,000 to $1,500. Either way, you lose 25% of the value of your portfolio, so your portfolio has the risk of a portfolio which is 50% stock.
Consequences [/quote]Asset Location (following is still part of the quote)
Once you adjust for the after-tax value, it does not matter which assets you put in a traditional IRA or 401(k) and which you put in a Roth. If you are in a 25% tax bracket, investing $4,000 in the 401(k) or $3,000 in the Roth in the same investment will give you the same after-tax value.
If all else is equal (and it often isn’t because of limited 401(k) options), it is slightly better to put assets with higher expected returns in the Roth. The Roth is protected against potential changes [increases, they mean] in tax rates [your projected tax rate, they mean], has more flexible rules for required minimum distributions, and is not counted as income for making Social Security taxable [I think this is just another element of tax rate].
It still does matter which assets you put in your taxable accounts; see Principles of Tax-Efficient Fund Placement for details.
The ugliest part of the matter is making an assumption about what the tax rate will be on your future 401k/tIRA withdrawals, but this is an assumption you have to make already for the much more important decision of whether to go Roth or traditional, so the ugly part’s done — after that it’s just a matter of putting a multiplier in your spreadsheet. [/quote]
jerry
Permalink Submitted by Alan Spross on Wed, 2011-01-26 00:40
The numbers in the example come out exactly equal because of the assumptions he made of IRA values and asset allocation. For example, if you double the size of the TIRA to 8k, keep the bond vrs stock allocation the same at 50-50, the example where you make the Roth 100% stock comes out higher after tax (9694 vrs 9675 when each type IRA is invested 50-50 stock vrs bonds).
Obviously, no one should change their asset allocation between stocks and bonds based on the relative TIRA vrs Roth size, so the only true variable should be the relative account size balances. Most people have a much higher TIRA balance than a Roth. Per last survey conducted, only 7% of all IRA assets were in a Roth. Perhaps the 2010 conversion opportunity will boost that to 8%. That would indicate that most taxpayers could fund their Roths 100% with stocks and offset that with an appropriate increased bond allocation in the TIRA to keep the total at 50-50. But the resulting advantage would be very small.
Given that historic stock and bond gains fluctuate considerably over short periods of time and the small amount of benefit from loading up the higher return asset in the Roth, I would tend to agree that it probably does not matter how the assets are split. Over time there should be a very small difference had you allocated differently.
More important is having the tax diversification advantage of having both IRA types so you can take your distributions where best suited (other than RMDs) in any given year based on the different characteristics of each type of IRA.
Permalink Submitted by george collins on Wed, 2011-01-26 14:25
Thanks Alan,
Must run now and will get back to you this evening.
By the end of the year I plan on being 50/50 everywhere. including ROTH/IRA balances. So the quoted thread drives more consternation for me on AA.
I will send you more details but would like your opinion of the following;
I finished Bill Bernstein’s Manifesto book last summer and he contends the following. Those of us who have deferred our SS to 70 have built a significant equivalent TIPS portfolio.
his example: 30,000 SS / 7% inflation-adjusted annunity = 400,000 equivalent TIPS portfolio
This has made a hudge change in my AA wrt my investments and my Roth and IRAs specifically
ps he gives great advice on the relative assets he recommends for tax deferred accounts.
jerry
Permalink Submitted by Bruce Steiner on Thu, 2011-01-27 03:34
He is correct that a Roth is essentially the same as a traditional IRA except that the Roth is all yours, whereas a share of the traditional IRA (equal to the tax rate) belongs to the government.
In deciding which assets to put in your IRA (whether Roth or traditional) and which assets to put in your taxable account, you should keep in mind that different types of income and gains in the taxable account have different tax treatment, whereas in the IRA it only matters how much money you end up with, not how you got there.
I understand the argument for tax diversification, but there is a countervailing factor, namely that the income and gains on your share of your traditional IRA are effectively tax-free, and all of the income and gains in your IRA are tax-free.
Permalink Submitted by george collins on Thu, 2011-01-27 14:10
[quote=”[email protected]“]He is correct that a Roth is essentially the same as a traditional IRA except that the Roth is all yours, whereas a share of the traditional IRA (equal to the tax rate) belongs to the government.
In deciding which assets to put in your IRA (whether Roth or traditional) and which assets to put in your taxable account, you should keep in mind that different types of income and gains in the taxable account have different tax treatment, whereas in the IRA it only matters how much money you end up with, not how you got there.
I understand the argument for tax diversification, but there is a countervailing factor, namely that the income and gains on your share of your traditional IRA are effectively tax-free, and all of the income and gains in your IRA are tax-free.[/quote]
Yes, understand and agree with your comments and have assets allocated for tax efficiency. Your last sentence is correct, but the future RMDs drive this secodary part of AA, and is the purpose of this thread
.
Since tIRAs belong to you and the gov. the “experts” say to optimize total AA—adjust your principal in the IRA for your expected RMD tax rate.
ex. 400K IRA(1-RMD tax rate) = 300k IRA in my case(25% tax). This is then AA(asset allocation) wrt Roths and taxable accounts.
Futher complications include those of us with large SS(defer to 70), Bernstein equates this to a significant TIPS porfolio.
This drives an even larger optimized change and allows for either more agressive allocations to the other components or reduces the AA risk you have presently.
So, looking at all assets as a whole and then allocating assets, I believe the following is the way to optimize?
Tips = annual SS / 7%(annunity)= 700k
Roth ========================500k
IRA(1-0.25)===================300k(if this effective reduction is real, I may rechar more than I had planned)
taxable=====================1000k
Pensions–base for calculating asset draws
Now take the total and tax efficient AA to your desired ratios
jerry
Permalink Submitted by Bruce Steiner on Thu, 2011-01-27 14:24
It’s easy to compare the traditional and the Roth. The Roth is essentially the same as the traditional IRA, except it’s all yours.
Comparing the traditional to the taxable account is more complicated. On the one hand, the traditional is pre-tax. But on the other hand, the traditional enjoys the benefit that the income and gains on your portion of it are tax-free.
Bernstein’s analyses are generally excellent. If you’re working with them, they should be able to help you decide on an asset allocation based on the specifics of your situation and your objectives.
Social security benefits are larger than many people realize. But for most of our clients it isn’t that large an asset. You can’t simply apply a capitalization rate to the social security payments, since (ignoring survivor benefits) they end at death.
If you have enough money in your taxable account to pay the tax on the conversion, you may want to discuss with the attorney who handles your estate planning whether to convert the rest of your traditional IRA to a Roth. The period between when you retire and when you have to take distributions might provide a window of time over which to convert some or all of your traditional IRA without it pushing you into “too high” a tax bracket.
Permalink Submitted by george collins on Thu, 2011-01-27 15:36
[quote=”[email protected]“]It’s easy to compare the traditional and the Roth. The Roth is essentially the same as the traditional IRA, except it’s all yours.
Comparing the traditional to the taxable account is more complicated. On the one hand, the traditional is pre-tax. But on the other hand, the traditional enjoys the benefit that the income and gains on your portion of it are tax-free.
Bernstein’s analyses are generally excellent. If you’re working with them, they should be able to help you decide on an asset allocation based on the specifics of your situation and your objectives.
Social security benefits are larger than many people realize. But for most of our clients it isn’t that large an asset. You can’t simply apply a capitalization rate to the social security payments, since (ignoring survivor benefits) they end at death.
If you have enough money in your taxable account to pay the tax on the conversion, you may want to discuss with the attorney who handles your estate planning whether to convert the rest of your traditional IRA to a Roth. The period between when you retire and when you have to take distributions might provide a window of time over which to convert some or all of your traditional IRA without it pushing you into “too high” a tax bracket.[/quote]
Thanks,
Considering I have intentions of leaving the balance of the Taxable account to my heirs(cost basis), annual gifting to control principal, and I have a 500k loss carry over, my only tax on the taxable account is the dividens–which I manage via asset catagories, ETFs, tax managed MF, etc. I feel my taxable account is very similar to my Roths wrt taxes.? Maybe I am trying for analysis paralysis?
In my case I am only using my SS which will continuue as survivor bene(main driver to delay SS to 70). So I still think it is appropriate for my case to consider it a TIPS equivalent as Bernstein points out.?
I have converted my entire IRA to multiple ROTHS( US, int, bonds, SC), will piecemeal rechar to control tax bracket and may add additional conversions as you recommended before RMDs.(I am 66)(deferred SS to 70 for survivor bene and window pre RMD for Roth conversions)
Working with this forum in the past I am also planning to maintain an IRA for future tax unknowns, a LTC insurance policy, and income for survivor or heir in low tax rate)
thanks again
jerry