Where to put index stock funds, Roth IRA or 401k?

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opus360
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Where to put index stock funds, Roth IRA or 401k?

Post by opus360 »

I am thinking hard about this for a long time and no solution came to my mind. :oops:

Let us say you have $100,000 in ROTH IRA, and $125,000 in 401k. At retirement, expected overall tax rate is 20%. So, the 401k can be viewed as having a value of $100,000 relative to the ROTH IRA. Let us assume no rebalancing and you hold until retirement. If you want to hold 50% stocks and 50% cash/bonds, where would you put the stock? $100,000 of stocks in Roth IRA or $125,000 of stocks in 401k?
Flyer24
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by Flyer24 »

You want to maximize tax free growth potential so put the stocks in your Roth IRA.
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by arcticpineapplecorp. »

opus360 wrote: Fri Oct 15, 2021 3:04 pm I am thinking hard about this for a long time and no solution came to my mind. :oops:

Let us say you have $100,000 in ROTH IRA, and $125,000 in 401k. At retirement, expected overall tax rate is 20%. So, the 401k can be viewed as having a value of $100,000 relative to the ROTH IRA. Let us assume no rebalancing and you hold until retirement. If you want to hold 50% stocks and 50% cash/bonds, where would you put the stock? $100,000 of stocks in Roth IRA or $125,000 of stocks in 401k?
I'd do $100k stocks in Roth and $125k in bonds in 401k.

why?

You want to reduce RMDs so you want the lower yielding assets in 401k and the higher yielding assets in Roth.

Since you won't rebalance between these accts, you'll start at 50/50 (after tax) but since stocks grow more than bonds and with RMDs taken from 401k (while Roth does not have to be drawn from), your allocation will become more risky over time unless you start rebalancing between stocks and bonds in your Roth.

If you don't have to spend the RMD, you could put that back in bonds to keep the allocation roughly similar (depending upon stock performance though), but bonds aren't as great in taxable as they are in tax deferred.
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opus360
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by opus360 »

Flyer24 wrote: Fri Oct 15, 2021 3:08 pm You want to maximize tax free growth potential so put the stocks in your Roth IRA.
Please let me play devil's advocate. Let us say the stocks gain 100% in value at retirement vs 10% for the cash/bonds portfolio.

1. $100k in Roth holding stocks becomes $200k. $125k in 401k becomes $110k ($125 x 1.1 x 80% haircut for taxes). Total is $310k.

2. $100k in Roth becomes $110k. $125k in 401 holding stocks becomes $200k ($250 x 80% haircut for taxes). Total $310k.

So, won't I get the same value at the end? Is my view too simplistic? What am I missing there?
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AnnetteLouisan
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by AnnetteLouisan »

To the extent one has the option, I think they like equity indexes in taxable brokerage and Roth accounts, and to the extent you have fixed income, in tax deferred accounts (such as a traditional 401k). And they like ETFs in taxable brokerage rather than IRAs for tax loss pairing.

But i‘m new here. I dont even know what the wash sale rule is. Or an IRMAA cliff. But by golly by year end I will!!
Last edited by AnnetteLouisan on Fri Oct 15, 2021 3:50 pm, edited 1 time in total.
Flyer24
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by Flyer24 »

You have two different stock/bond allocations in your example. A 50/50 allocation means that you would need $112,500 in stocks with a $225K total. Your Roth would be filled and the rest would be in your 401k. In your first example, you are showing a 45/55 allocation. So you are negating the additional 5% gain of the stocks. Your first example would have been worth more because your 401k final amount is too low.
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by sycamore »

opus360 wrote: Fri Oct 15, 2021 3:28 pm
Flyer24 wrote: Fri Oct 15, 2021 3:08 pm You want to maximize tax free growth potential so put the stocks in your Roth IRA.
Please let me play devil's advocate. Let us say the stocks gain 100% in value at retirement vs 10% for the cash/bonds portfolio.

1. $100k in Roth holding stocks becomes $200k. $125k in 401k becomes $110k ($125 x 1.1 x 80% haircut for taxes). Total is $310k.

2. $100k in Roth becomes $110k. $125k in 401 holding stocks becomes $200k ($250 x 80% haircut for taxes). Total $310k.

So, won't I get the same value at the end? Is my view too simplistic? What am I missing there?
You'd get the same value, but only under the assumptions you gave. What would happen if stocks only gained 50% and cash/bond gained 20%?
Or stocks gained 200% and cash/bond only 5%?

I wouldn't make my decision based on a single case.

In general, I agree with the previous posters that putting stocks in the Roth will work out best.

Also, you may be interested in the Boglehead wiki article Tax-adjusted asset allocation.
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by Flyer24 »

Here is a good guide on fund placement. https://www.bogleheads.org/wiki/Tax-efficient_fund_placement
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by ruralavalon »

opus360 wrote: Fri Oct 15, 2021 3:04 pm I am thinking hard about this for a long time and no solution came to my mind. :oops:

Let us say you have $100,000 in ROTH IRA, and $125,000 in 401k. At retirement, expected overall tax rate is 20%. So, the 401k can be viewed as having a value of $100,000 relative to the ROTH IRA. Let us assume no rebalancing and you hold until retirement. If you want to hold 50% stocks and 50% cash/bonds, where would you put the stock? $100,000 of stocks in Roth IRA or $125,000 of stocks in 401k?
Stock index funds are very suitable for any type of account.

In general bond funds should be in tax-advantaged accounts preferably tax-deferred accounts like a traditional 401k.

Stock funds are expected to have higher returns than bond funds. Morningstar (4/23/2020), "Experts Forecast Stock and Bond Returns: Crisis Edition", link. So in general prefer to use Roth accounts for stock funds.

Wiki article "Tax-efficient Fund Placement" .
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opus360
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by opus360 »

sycamore wrote: Fri Oct 15, 2021 3:58 pm
opus360 wrote: Fri Oct 15, 2021 3:28 pm
Flyer24 wrote: Fri Oct 15, 2021 3:08 pm You want to maximize tax free growth potential so put the stocks in your Roth IRA.
Please let me play devil's advocate. Let us say the stocks gain 100% in value at retirement vs 10% for the cash/bonds portfolio.

1. $100k in Roth holding stocks becomes $200k. $125k in 401k becomes $110k ($125 x 1.1 x 80% haircut for taxes). Total is $310k.

2. $100k in Roth becomes $110k. $125k in 401 holding stocks becomes $200k ($250 x 80% haircut for taxes). Total $310k.

So, won't I get the same value at the end? Is my view too simplistic? What am I missing there?
You'd get the same value, but only under the assumptions you gave. What would happen if stocks only gained 50% and cash/bond gained 20%?
Or stocks gained 200% and cash/bond only 5%?

I wouldn't make my decision based on a single case.

In general, I agree with the previous posters that putting stocks in the Roth will work out best.

Also, you may be interested in the Boglehead wiki article Tax-adjusted asset allocation.
Thanks for the article. It is a good read.

As far as the scenario of stocks gain 50% (or 200%) and cash/bond gain 20% (or 5%), it is the same result. This is from the article you gave me.

Why to make these adjustments
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.


The difference will occur when the tax rate assumptions do not came out to the ratio specified. So, for example, I assumed $125k in 401k is worth only $100k in Roth now. But, at the end of the day during retirement, it works out that 401k is really worth say only $90k after tax or $110k in after tax. Then, in that case it, the original assumption does not work out and you get different results.
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by mikejuss »

Wouldn't a person's yearly income before retirement--and thus the tax break involved in funding a 401(k)--come into play in this case?
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sycamore
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by sycamore »

opus360 wrote: Fri Oct 15, 2021 6:00 pm
sycamore wrote: Fri Oct 15, 2021 3:58 pm You'd get the same value, but only under the assumptions you gave. What would happen if stocks only gained 50% and cash/bond gained 20%?
Or stocks gained 200% and cash/bond only 5%?

I wouldn't make my decision based on a single case.

In general, I agree with the previous posters that putting stocks in the Roth will work out best.

Also, you may be interested in the Boglehead wiki article Tax-adjusted asset allocation.
Thanks for the article. It is a good read.

As far as the scenario of stocks gain 50% (or 200%) and cash/bond gain 20% (or 5%), it is the same result. This is from the article you gave me.

Why to make these adjustments
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.


The difference will occur when the tax rate assumptions do not came out to the ratio specified. So, for example, I assumed $125k in 401k is worth only $100k in Roth now. But, at the end of the day during retirement, it works out that 401k is really worth say only $90k after tax or $110k in after tax. Then, in that case it, the original assumption does not work out and you get different results.
Good point on the numbers working out the same. My math skills were on pause apparently :confused
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by grabiner »

mikejuss wrote: Fri Oct 15, 2021 6:12 pm Wouldn't a person's yearly income before retirement--and thus the tax break involved in funding a 401(k)--come into play in this case?
The OP's question is what to do with money that is already there. If you are in a higher tax bracket now than you will be in at retirement, then it is better to invest in a traditional account than a Roth account, whether the investment is in bonds or stocks. But once you have invested in both traditional and Roth accounts, you could hold stocks in either one. And as the discussion here shows, even after you have tax-adjusted the asset allocation (so that you compare holding the same after-tax value of stocks either way), there is a minor advantage to holding stocks in the Roth if all else is equal.

But often all else is not equal, because of the options in your employer plan. If the only low-cost fund in your 401(k) is an S&P index fund, that is where you should hold your US stocks. If you have the TSP G fund or TIAA Traditional Annuity, which are better fixed-income options than any retail bond funds, that is where you should hold your bonds.
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by Scoop21 »

In a flat tax system, there is no benefit to asset location for a given tax adjusted asset allocation, as shown by the OP's simple example. With the simple assumption the OP specified of 20% tax rate on the tax-deferred balance, I would expect to see no benefit from putting high return assets in Roth vs tax-deferred.

The benefit from asset location is due to the progressive taxation system. By placing high return assets in the Roth account, you can avoid the tax-deferred balance growing large enough to bump you into a higher marginal tax rate for a given after tax withdrawal amount (or increasing RMDs to the point of seeing a high marginal tax rate).

Even if both scenarios (stock funds in Roth or stock funds in tax-deferred) result in the same marginal tax rate, there may still be a benefit to asset location if the distributions from tax-deferred straddle a tax bracket, because really the comparison is effective tax rate on the distribution from tax-deferred.
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by illumination »

You'd want the assets that you expect to have the highest amount of growth to be in the Roth IRA.

That being said, I think it's a bad idea to have 100% bonds in a 401k account to balance out a Roth IRA if you have decades in front of you before retirement. I even think its (usually) a bad idea if you're actually in retirement to have 100% bonds in your 401k/IRA But that's not a tax efficiency issue.

Just don't let the tax tail wag the dog. There's more to retirement goals than paying as little tax as possible.
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by David Jay »

illumination wrote: Sat Oct 16, 2021 5:26 pmThat being said, I think it's a bad idea to have 100% bonds in a 401k account to balance out a Roth IRA if you have decades in front of you before retirement. I even think its (usually) a bad idea if you're actually in retirement to have 100% bonds in your 401k/IRA But that's not a tax efficiency issue.
Fund allocations are fungible inside tax-advantaged accounts. One can exchange funds at any time within either the 401K or the Roth, so why would having 100% bonds in your 401K and 100% stocks in your Roth be a bad idea?
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by Running Bum »

opus360 wrote: Fri Oct 15, 2021 3:28 pm
Flyer24 wrote: Fri Oct 15, 2021 3:08 pm You want to maximize tax free growth potential so put the stocks in your Roth IRA.
Please let me play devil's advocate. Let us say the stocks gain 100% in value at retirement vs 10% for the cash/bonds portfolio.

1. $100k in Roth holding stocks becomes $200k. $125k in 401k becomes $110k ($125 x 1.1 x 80% haircut for taxes). Total is $310k.

2. $100k in Roth becomes $110k. $125k in 401 holding stocks becomes $200k ($250 x 80% haircut for taxes). Total $310k.

So, won't I get the same value at the end? Is my view too simplistic? What am I missing there?
$250K of income in scenario 2 might put you in a higher tax bracket than $137.5K does in scenario 1, especially if you hit a new IRMAA tier or make more SS taxable. If under 65, it could reduce any ACA subsidy.
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opus360
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Re: Where to put index stock funds, Roth IRA or 401k?

Post by opus360 »

grabiner wrote: Fri Oct 15, 2021 10:23 pm
mikejuss wrote: Fri Oct 15, 2021 6:12 pm Wouldn't a person's yearly income before retirement--and thus the tax break involved in funding a 401(k)--come into play in this case?
The OP's question is what to do with money that is already there. If you are in a higher tax bracket now than you will be in at retirement, then it is better to invest in a traditional account than a Roth account, whether the investment is in bonds or stocks. But once you have invested in both traditional and Roth accounts, you could hold stocks in either one. And as the discussion here shows, even after you have tax-adjusted the asset allocation (so that you compare holding the same after-tax value of stocks either way), there is a minor advantage to holding stocks in the Roth if all else is equal.

But often all else is not equal, because of the options in your employer plan. If the only low-cost fund in your 401(k) is an S&P index fund, that is where you should hold your US stocks. If you have the TSP G fund or TIAA Traditional Annuity, which are better fixed-income options than any retail bond funds, that is where you should hold your bonds.

Agreed. I think overall, Roth still will have the advantage (better flexibility in timing of withdrawals, potentially estate taxes or withdrawal choices for inherited IRA, changes in tax rates/estate rates which seem to mostly go higher).
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