I read that I should put stocks in my Roth IRA and bonds in my 401K.  Is that true?


There is an immense amount of misunderstanding, even among financial advisers, with regard to this topic.  Asset location is a very important topic that has real impact on the accumulation of wealth.  But it isn’t quite as simple as some would have you believe.

Tax-Protected Vs Taxable

For years those in the know have put tax-inefficient asset classes like bonds and REITs preferentially into tax-protected accounts (Roth IRAs, 401Ks etc) and tax-efficient asset classes like stocks (especially in total market stock index funds) into taxable accounts if necessary.  In our current historically-low interest rate environment, and especially given the spread between tax-free municipal bonds and other bonds, this doesn’t seem to make nearly as much difference as it used to, and some have even argued that the situation has reversed.

Tax-Free Vs Tax-Deferred

But that’s not the question you’re asking.  Most investors have both tax-free investing accounts (like Roth IRAs, Roth 401Ks, and perhaps even HSAs and 529s) and tax-deferred investing accounts (like traditional IRAs, 401Ks, and most other types of retirement accounts) and want to know how to allocate their assets between them.  Some well-meaning financial advisers tell them to put the asset classes with the highest expected return into the tax-free accounts.  Since you expect this asset to grow faster, then it’s easy to see that after years of compounding, you want the bigger account to be the tax-free one.  The reasoning goes like this:

Your portfolio is 50% in a Roth IRA and 50% in a traditional IRA (let’s say $100K in each).  You have one asset class that you expect a 8% return from (let’s call this one stocks) and one that you expect a 5% return from (let’s call this one bonds).  Let’s assume you’ll pay 20% in taxes on average while withdrawing money from the traditional IRA.  Which asset class should you put into which account?

Stocks in Roth

After 20 years, you have $466K in the Roth and $265K in the traditional IRA.  After taxes, there is $212K in the traditional IRA for an after-tax total of $678K.

Bonds in Roth

After 20 years you have $265K in the Roth and $466 in the traditional IRA.  After taxes, there is $373K in the traditional IRA for an after-tax total of $638K.

See!  You should put stocks in Roth, says the adviser.  This approach, however, is misleading.

It Doesn’t Matter

The truth is it doesn’t matter AS LONG AS you adjust your asset allocation for the effects of tax.  The reason the “Stocks in Roth” approach earned you more money is that you took more risk.  You could have ended up in the same place by putting stocks in your traditional IRA and taking on a more aggressive asset allocation.  Since 20% of that traditional IRA actually belongs to the government, the “Stocks in Roth” approach was really an asset allocation of 56/44 and the “Bonds in Roth” approach was really an asset allocation of 44/56.  Which one do you expect to have a higher expected return?  The one with the more aggressive after-tax asset allocation of course!

After-Tax Asset Allocating

If you really wanted to get your 50/50 asset allocation right on an after-tax basis, then you’d put $90K into stocks and $10K into bonds in your Roth IRA, and then $100K into bonds in your traditional IRA.  Or, alternatively, you’d put $90K into bonds and $10K into stocks in your Roth IRA and $100K into stocks in your traditional IRA.  It doesn’t matter.  You’d have the same outcome.

Few people actually do this, of course, since it’s a bit of a pain in the butt.  The math is a little more complex and introduces an unknown variable- your average tax rate on future IRA withdrawals.  But that doesn’t mean you can ignore the fact that a “Stocks in Roth” approach is riskier than a “Bonds in Roth” approach.  I confess I don’t try to figure out my asset allocation on an after-tax basis.  It gets especially tricky when you have a taxable account too since taxes on withdrawal are now at a different capital gains rate, there is additional tax drag as the investment grows, calculating the effects of tax-loss harvesting is nearly impossible, and your basis is constantly changing.  But I do realize that when I put stocks in Roth preferentially then I’m actually taking on more risk than my Investment Policy Statement prescribes due to my more aggressive after-tax asset allocation.

The Bottom Line

If you put your riskier, higher-expected return, asset classes preferentially into tax-free accounts, you will probably have a bigger nest egg in the future.  However, that is because you took on more risk, not because there is some magic free lunch there.