IRA vs. Roth IRA Investment Strategy

Transcript:

Roth IRAs and Traditional IRAs have polar opposite tax treatment and fill two different roles in retirement. So why would you invest them the exact same way?

Hey guys, Mike Frontera here, back with another Retirement Theory video. So if you are a regular viewer of these videos, you’re probably very smart and good looking. Also, you probably have heard me espouse the importance of diversification in your retirement portfolio through effective asset allocation. But while we’ve spent some time on asset allocation, we haven’t talked much about asset location. That is, how to position your portfolio based on the type of account you’re investing in. So today I’m specifically focusing on *why* and *how* to differently allocate between your IRA and your Roth IRA.

OK, let’s start with the “why”. So the biggest “why” we’d allocated differently between an IRA and Roth, is taxes. That is, the tax treatment for each account is the polar opposite of the other. As you may know, the most basic description of a Roth IRA is that it is an account in which you invest after-tax money, in other words no deduction, and in turn it can provide you with tax-free growth and withdrawals in retirement. A Traditional IRA, or just IRA, works the opposite way. You generally contribute pre-tax money, but your withdrawals in retirement are considered taxable income. By the way, for purposes of this video, when I say “IRA”, I generally mean all pre-tax retirement accounts so (401(k), 403(b), 457, SEP, SIMPLE, and Traditional IRA).

Now, remember that you’ll have required withdrawals from your IRAs starting at age 72. With Roth IRAs, there are no required withdrawals during your entire lifetime.

Ok, so what does all this mean in terms of portfolio allocation? Well, in the case of the IRA we know that the growth on our contributions will eventually come out as taxable income. With the Roth, our growth can come out as entirely tax-free income. So think about it-- with all else being the same, which account would you prefer to grow more?

Also, it’s generally wise to adjust your portfolio risk based on the amount of time you have before you start drawing from it. In other words, if I have a portfolio that I don’t plan to touch for, say 30 years, might I be able to withstand market volatility more so than a portfolio that I have to start pulling from in 6 months? With an IRA, even if I don’t need the money to make ends meet in retirement, the longest I can wait before I have to pull money out is age 72. With a Roth IRA, I never have to take a withdrawal during my entire lifetime.

So then, how do we use those tax differences to our advantage when we are creating our portfolio allocation? Well, like many things, it does depend on our goals. So let’s take a look at an example.

Alright, so here we are with our friends Jerry and Ginny. Jerry and Ginny are both 72 years old, and retired. They have modest needs that they’ve been able to meet with using just their Social Security benefits of $48,000 per year, $24,000 each. Jerry has an IRA and Ginny has a Roth IRA. Now, ten years ago both accounts were worth exactly $500,000. And both accounts had the same allocation, 60% in the S&P 500 and 40% in the Barclays Aggregate Bond index. Now, just a caveat, we can’t actually invest directly in an index in the real world, but Jerry and Ginny can because they live in hypothetical math world.

Now, over these 10 years, both accounts have grown to over $1.6M for a total between the two of them of just about $3.3M. Remember, Jerry is 72, so he will need to take required withdrawals on his IRA account. Ginny doesn’t have to. Now, assuming the year ended with the same exact values, Jerry’s age 72 required minimum distribution would be $64,391.

 

Ok now…let’s rewind the clock and pretend that Jerry and Ginny, with the same overall portfolio allocation, shifted the stock allocation to Ginny’s Roth and the bond allocation to Jerry’s IRA. So in aggregate again, they still have that 60/40 portfolio allocation, 60% to the S&P 500 and 40% to the Barclay’s Aggregate Bond Index.

So then, Ginny allocates her entire $500,000 Roth in the S&P 500 and Jerry allocates his IRA with the $400,000 Barclays Aggregate Bond Index, along with the remaining $100,000 in the S&P 500 Index. 10 years later, we still end up with the exact same total of about $3.3M between the two accounts.

However, Ginny’s tax-free Roth IRA now stands at nearly $2.3M, whereas Jerry’s taxable IRA is under $1M at $998,435. Again, assuming the year ends with the same values, his age 72 required minimum distribution is only $39,001.

What does this do for their overall taxes? Well, plugging this information into our income tax calculator, we see that Jerry and Ginny’s total tax burden with the $64k required withdrawal is $8,889, whereas with the $39K minimum  withdrawal it’s only $3604. Pay particular attention to their Social Security. Notice that with the larger required withdrawal, more of Jerry and Ginny’s social security becomes taxable too. Keep in mind too, that due to the smaller required withdrawal, there is over $25,000 more retained in tax-advantaged savings.

Now, I said before that it’s wise to consider your asset location in the context of your goals. Well clearly, for Jerry and Ginny, they didn’t need to live on their retirement savings and were basically just trying to minimize their overall tax burden.

Had they needed to draw on some income, might it still be advantageous for them to adjust what assets they had in Jerry’s IRA versus Ginny’s Roth? Absolutely! They simply need to be aware of how their income timeframe and overall needs, and appetite for risk, should help not shape just their asset allocation, but their asset location as well!

So, do you have questions for me? Come visit me at www.retirementtheory.com or send me an email at mike@retirementtheory.com. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning. Once again, thank you for joining me, we’ll see you next time.