Paul Berkowitz: ‘A lot has been written about allocating funds between taxable and non-taxable accounts. But I haven’t seen any advice regarding allocation to Roth IRAs versus regular IRAs. Any suggestions as to which investments are optimum for each? Is it different depending on the time line? (I am 55 and within 5 years of retirement.)’

☞ Hmmm. Well, first let’s repeat what you already know with regard to taxable versus nontaxable accounts:

  • Put high-yield securities like bonds and REITs in tax-deferred accounts; likewise, tax-inefficient funds, if you buy them. (But why do you buy them? They also have higher fees and higher internal transaction costs weighing down their expected performance.)
  • Put low-yielding securities and tax-efficient mutual funds (like index funds) in taxable accounts. Also, perhaps, international stock index funds, because the “foreign tax credit” they pass through can only be taken when held in a taxable account.
  • Keep your risky holdings in taxable accounts, so that if you lose money, you can take the loss against your taxes, and if you make a big long-term gain, you get the nice low capital gains tax rate. (In a tax-deferred account, all the long-term gains ultimately get converted to ordinary income.)

But what about your question? If you had both a recently established Roth IRA and a longstanding traditional IRA, what should you put in which?

In the first place, I’d put all my new money into the Roth IRA as opposed to the traditional IRA. It will grow not just tax-deferred but tax-free. And there will be more flexibility (and less paperwork) when, sometime after age 59-1/2, you go to withdraw the money or pass it on to your heirs.

Beyond that, I guess I would argue that dollars within the traditional IRA are less valuable than Roth dollars, because they will be taxed as withdrawn. (Dollars in a Roth IRA are worth $1 when withdrawn; dollars in a traditional IRA may be worth only 75 or 80 cents, perhaps even less.) Being less valuable, it’s less awful if you lose them. So as between two investments of varying risk, maybe you’d put the one you perceive as riskier in the traditional IRA.

Then again, if the asset is riskier it may offer a higher hoped-for return. And if that materializes, you’d want to reap that higher return tax-free rather than have to share any of it with Uncle Sam.

So if you could know your winners from your losers in advance – which you obviously can’t – you’d put the winners in the Roth and the losers in the traditional IRA.

The one thing you can know is that risk diminishes with time. It’s quite risky to have your money in an index fund (say) for just a year or even three. It could drop precipitously. But over 25 years, if history is any guide, it is likely to do quite well – particularly if you are adding to it periodically, and thus reaping the advantages of dollar-cost-averaging.

This argues pretty strongly for putting the riskier assets – the stock index fund, say, versus the bonds or TIPS – in the Roth IRA, for two reasons. First, the stocks, over time, are likely to outdo safer investments. Second, with a Roth IRA there’s no requirement to withdraw funds. With a traditional IRA, by contrast, once you turn 70-1/2, you must begin withdrawals, even if the stock market is in a trough. With the Roth, you or your heirs (if you can live without the money and chose to pass it on to them) can wait for a market peak, instead.

Indeed, if you can afford to pay the taxes on the conversion, you might keep your eye out for a good year to convert some or all of your traditional IRA to a Roth IRA.

Yes, you would pay tax now to do it. But having done so, that money grows and is eventually withdrawn entirely tax-free. And with no time limit on when you must begin making withdrawals.

When to make such a conversion? Perhaps in a year when the value of your traditional IRA has been beaten down by a bad stock market. Convert it, paying the tax out of other savings; then watch it (eventually) grow back to where it once was, and beyond, forever free of tax.

Either way, as you near the age at which you plan to start withdrawing from the IRAs – which may be 59-1/2 but need not be until 70-1/2 for a traditional IRA or ever for a Roth – you might want to begin taking less risk in either one . . . and especially less risk in the Roth, as those dollars are more valuable.

Try to put winners in both, wish yourself luck, and go to the movies.

But not before you read John Bogle’s remarks referenced in yesterday’s column, if you missed them, because they go a long way toward demystifying finance.


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