Stocks or Bonds in Roth?

[This is a guest post from Bogleheads investment forum participant Bob’s not my name.]

A number of spurious arguments are made for holding riskier assets in your Roth IRA as opposed to a Traditional IRA. Let’s examine them. For simplicity, we’ll refer to risky assets as stocks and less risky assets as bonds, but the arguments get more specific than that, arguing for small cap stocks and REITs in Roth, for example.

Myth #1: The Roth is a Magical Tax Kingdom

Some people believe that if you hold stocks in your Roth you’ll pay less in taxes. This is utter nonsense.

Their argument goes like this: if I hold a $5,000 Roth (post-tax) IRA and a $5,000 traditional (pre-tax) IRA, and stocks triple in value by my withdrawal date while bonds only double, it will be better to have held the stocks in my Roth because then I have $10,000 taxed at withdrawal (from bonds in Traditional IRA) and $15,000 tax-free (from stocks in Roth).

The fallacy of this argument is that $5,000 of post-tax savings and $5,000 of pre-tax savings are obviously not equivalent, so what you’re really doing when you make your Roth all stocks is taking on a riskier asset allocation.

It’s easy to prove this to yourself by considering the outcome if stocks drop by half instead of tripling. Now your stocks-in-Roth plan would leave you with $10,000 taxable and $2,500 tax-free, whereas the stocks-in-Traditional-IRA alternative would leave you with $2,500 taxable and $10,000 tax-free.

If you tax–adjustyourassetallocation the perceived difference is eliminated. Is that necessary? For most people, tax-adjusting your Asset Allocation won’t make a very big difference. It’s just important to recognize that the false advantage of holding stocks in Roth is entirely eliminated if you make a true comparison by tax-adjusting your asset allocation.

Sticking with our simplistic example, a 20% tax rate on withdrawals would make a $5,000 Traditional IRA equivalent to a $4,000 Roth, so a 50/50 stock/bond asset allocation would compromise, e.g., $5,000 of bonds in the Traditional IRA, $4,500 of stocks in the Roth, and $500 of bonds in the Roth.

Myth #2: Stocks in Roth Protect You from Tax Changes

It is argued that, since a Roth is post-tax, holding stocks in Roth will protect you from changes in the tax code. This is also false.

As illustrated above, to avoid false conclusions about asset placement you have to assume some tax rate on your Traditional IRA withdrawals. You don’t know what it will really be, so you make your best guess. If your tax rate turns out to be higher than your best guess, it will have been better to have had your higher-growth assets (stocks) in Roth. However, if your tax rate turns out to be lower than your best guess, it will have been better to have had your higher-growth assets in your Traditional IRA.

Note that this is all relative to your best guess, not to your current rate, or rates in general. By definition, your best guess is your best guess, which means that there are equal probabilities of it being too high or too low. Therefore, where you place stocks offers no protection from tax changes.

Myth #3: Stocks in Roth Protect You from Social Security Taxation

Social Security taxation is just one of a thousand elements of the tax code. There’s no reason to single it out from all the others.

Sure, many non-retired taxpayers are ignorant of the rule, so their best guess at their future tax rate may be too low. But one can also argue that most taxpayers overestimate their current tax rate, overestimate the rates retirees pay, don’t know that their state exempts a lot of retirement income from taxation, and discount the possibility of being laid off, sick, or disabled in the future, all of which combine to make their best guesses too high.

We come back to the same conclusion: your best guess is your best guess.

Myth #4: Stocks in Roth Reduce Your Required Minimum Distributions (RMDs)

This is the only stocks-in-Roth argument that survives a little scrutiny, but it can’t stand a lot of scrutiny.

The argument is that if you hold stocks in Traditional IRA and the stock market does well, you’ll have large RMDs, which is undesirable. However, if you are within a decade of making withdrawals, the risk that stocks will do worse than bonds can’t be ignored, so holding stocks in Roth IRA could backfire on you.

Another way to look at this is to consider what would happen if you held stocks in your Traditional IRA and your seventies (viz., the first decade of RMDs) turned out to be a long bull or bear market. A bull market would trip larger RMDs, but you could afford them. On the other hand, a bear market would reduce your RMDs when you most need to husband your resources and mitigate taxes.

If you are more than a decade from withdrawals, it is an imprudent bet that RMD rules will remain unchanged. I believe the 2009 RMD holiday was a portent – RMD rules are going to change during the first two decades of boomer retirement.

Valid Reasons for Asset Placement

You should really place your assets according to where you can get the best funds at the lowest expense ratios to make up your portfolio. Most 401k’s have at least one low cost stock index fund, but many do not have a low cost bond option. Therefore, a low cost portfolio is often constructed by concentrating stocks in your 401k (meaning a traditional 401k, which is pre-tax like a Traditional IRA) and bonds in your Roth.

Another reason to hold bonds in your Roth IRA is if you are depending on your Roth for an emergency fund. Roth contributions (but not earnings) can be withdrawn at any time for any reason, tax- and penalty-free, so a Roth IRA can be a good back-up emergency fund, especially if you couldn’t otherwise afford to contribute to a Roth. In this case, it’s important not to hold risky assets in your Roth.

If neither of these reasons applies to you, then it doesn’t matter what you hold in Roth vs. Traditional IRA.