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Sunday, March 25, 2007
What investments to hold in your IRA?
I wrote a post to recommend Roth IRA earlier. Another article The Best Investments for Your IRA let me recall a class I took.

I took a PhD level tax class cross-listed in the finance department two years ago. I've forgotten most things learned in the class, since it's pretty theoretical. However, sometimes the professor discussed some very practical questions at the request of the students. Think finance or economics PhD students are all financially savvy? Some students didn't know what IRA was and asked this question to the professor.

There is no absolute answer. The common wisdom is to hold bonds and CDs in tax sheltered account since dividends and interests are usually not deferrable and taxed as ordinary income's higher marginal rate. On the other hand, a buy-and-hold strategy for stock investments could defer the capital gain from price appreciation almost forever, which is much more tax efficient (same effect as a 401K type of tax deferment without employer matching). As a famous example, Warren Buffet argues that dividend is much worse to a shareholder than stock price appreciation, thus Berkshire Hathaway does not distribute any dividends despite being one the most profitable companies in the world.

However, some people argue that stocks should be kept in tax sheltered account because the expected annualized return for stocks is much higher than savings and bonds over the long term (>20 years). Given same contributions, stocks grow much faster. Therefore, this strategy gives more assets the tax benefit. This strategy makes even better sense for Roth IRA, since its future earning is tax-free, not tax deferred.

Assuming you have a portfolio of $10,000 bonds and $10,000 stocks, with a marginal tax bracket of 33% (including both Federal and state income tax). The long term annualized return of bonds and stocks are 6% and 9% respectively. Compare strategy 1 of holding bonds in Roth, and stocks in regular account, and strategy 2 the opposite, what's the outcome in 30 years? To simplify, let's assume a passive stock investment using a highly tax-efficient ETF on market index, with 0.5% taxed on capital gain and dividends annually. Capital gains and dividends are reinvested.

Strategy 1 = 10000*1.06^30+10000*((1.085^30-1)*0.67+1) = 57.4K+80.7K=138.1K
Strategy 2 = 10000*1.09^30+10000*1.04^30 = 132.6K+32.4K = 165.1K

So keeping stocks in Roth IRA will win (Strategy 2). There are a few caveats on this conclusion:
This conclusion relies upon the 3% difference in annualized return between stocks and bonds. If as some authors have argued in their books that the future rates of return of stocks and bonds are about the same at 6-7%, you should hold bonds in Roth, and use a buy-and-hold strategy to defer taxes on capital gains from stock price appreciations.
The stock investment strategy is also critical. If we assume that the difference in the rates of return of the two are not that large, however, if you really trade your stocks frequently, then it's still advantageous to keep your stocks in Roth.
I also learned both in class and from my experience how tax policy exerted distortion in your trading decision. I had hold stocks just to get the long-term capital-gain tax rate even though the market condition for that stock had turned south. If you want pure undistorted trading decision for yourself, hold stocks in Roth. On the other hand, you lose the leverage on claiming loss on your trades as well.

I hold stocks in my Roth and have done some trading. I really love the tax-free capital gains. Roth IRA is really a very powerful tool for us to catch up.

I only discussed bonds versus stocks. People have used IRA holding to buy futures, options, land contracts etc., which enable them to have larger leverage and gain larger tax-free earnings. However, if you are old enough to believe no free lunch, you will probably want to think about the risk carefully before shooting for the "big gain"?.

Any questions and comments?

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posted by Yannick @ 4:31 PM   |

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2 Comments:
  • At March 25, 2007 at 6:51 PM, Blogger mOOm said…

    The most sensible approach is to include investments in each asset class in both a retirement and non-retirement account. But within each category it makes sense to put the more highly taxed ones in a retirement account. For example I invested in the TFS Market Neutral Fund and the Hussman Strategic Growth Fund. Both are long-short mutual funds. The latter has far more taxable distributions. So I put it in my Roth and the TFS I bought as a taxable investment. For example under the current tax law a REIT would make more sense in an IRA as it has non-qualified dividends. But I have one in a taxable account. I both buy long-term investments and trade in both sorts of accounts. In other words I don't pay a lot of attention to this. You want a good asset mix in both sorts of account IF you are planning on using the money in the accounts sequentially. For someone who plans to retire at 59 1/2 plus the optimal tax strategy might make sense.

     
  • At March 25, 2007 at 8:09 PM, Blogger Yannick said…

    mOOm:

    thanks for the comments. you said a very important point. i didn't make explicit the assumptions for this strategy. it's "the optimal tax strategy" for "someone who plans to retire at 59 1/2 plus":

    1. It's for qualified savers without the need to withdraw money for a long time.
    a. income > expense
    b. with emergency cash allocated already
    2. For long term investments only. It's not a strategy for you to save for your housing down payment. I'm quite risk averse. My opinion is that you want to always hold it in cash alike, such as savings or short term CDs.
    3. The goal is to have as much money as possible after tax at your retirement or after 30 years.
    4. Your IRA is smaller than your whole investment portfolio. Therefore, you do need to make a choice on which goes to where.

    moom's strategy is probably more practical in the sense that it's more flexible. holding some high grow positions in regular trading account will give you more money if you need to tap into it before your retirement. however, high return asset class usually means higher volatility, which means if you need the money in the short run, it may not have a positive return yet.

    as moom commented, REIT should always be held in an IRA as it gives tax-inefficient high return. thus, it is usually worth taking a closer look at the fund or stock's tax efficiency before allocating them. for mutual funds, annual turn over rate is a good indicator. I took the similar strategy as moom's, hold actively managed, high turnover funds, such as Vanguard Strategic Equity (VSEQX) in Roth IRA, while holding passively managed index funds outside.

    To study the tax efficiency of a fund, I use Morningstar "Tax Analysis".

    moom, I am looking forward to your comprehensive asset allocation series.

     
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