Issue: Roth IRA Strategy Lacks Punch
If you apply the same strategy in your Roth IRA as you do in your other investment accounts, you're hamstringing long term returns in your most tax-efficient account.
Why It Matters:
Most investors decide on an asset allocation (% of stocks vs. bonds) and apply the same formula to all of their investment accounts.
Roth IRAs are typically the last investment account an investor taps into during their lifetime. This means the time horizon until someone actually takes a distribution is usually a long way down the road.
A lengthy time horizon is a key determining factor in how aggressive an investor should be. The longer the time horizon, the more appropriate it is to embrace short term volatilty in exchange for the benefit of capturing higher long term gains.
What smart investors do is adjust the asset allocation on each of their accounts; essentially, where can we be aggressive, where should bonds & cash live, and where can we realize tax efficiencies.
This general concept is known as Asset Location and you can read more about it HERE if you're interested.
Because Roth IRA distributions are tax free, an investor should seek investment strategies with higher expected long term returns in these accounts.
This means favoring investments like stocks, or better for diversification, stock-based funds.
Imagine you're 60 years old and thinking about retiring in the next couple of years. You have $100,000 in a Roth IRA, $315,000 in a rollover IRA, $900,000 in a 401(k) plan, $275,000 in a joint taxable account.
You might think "well, I'm getting older and will stop working soon, I better go with that 60% stock / 40% bond "balanced" portfolio I've heard so much about.
Using a 100% stock-based strategy in your Roth IRA enhances your overall return after taxes.
Comparing a 60/40 asset allocation with a 100% stock-based asset allocation works out like this:
Here's the magic- had you simply applied 60/40 thinking across the board with your accounts, you'd have $290,736 less in your Roth IRA.
But I would have allocated those same Roth IRA stock-based investments somewhere else in my portfolio. This makes us even.
From a pure rate of return standpoint, sure. But not when you factor in taxes.
Let's assume you made that $290,736 up from somewhere else in your portfolio such as your 401(k). I don't think you would have but I'll give you the benefit of the doubt.
401(k) assets are taxed at ordinary income rates. This means that $290,736 is reduced by 22% federal taxation* & 4.4% if you live in Colorado.
This brings your $290,736 statement balance down to $213,982 from an after-tax standpoint.
You're now 85 years old, everything hurts, and it feels like healthcare costs are out of control. Wouldn't it be nice to have an additional $76,754 in tax free income to use for medical expenses?
Right, got it!
TAKEAWAY & DISCLAIMER:
Even though you might not be an "aggressive" investor, you probably should be in your Roth IRA.
If market volatility really keeps you up at night, then don't go all the way to 100% stocks in your Roth IRA.
At Aspen Leaf Wealth Management, I consider time horizon, risk capacity, asset location, income need, and tax impact into each of my client's different accounts.
Rates of return, time elapsed, and tax bracket all influence the numbers presented in this blog post.
If you've never thought about your Roth IRA like you are right now or you're not sure what you're doing in your Roth IRA, reach out!
Just click the CONTACT link at the top of this page and send me a note to start a discussion. If I can help, I definitely will whether you become a client or we determine it's not a good fit.
Either way, I want you to get the most out of your Roth IRA.
* This is a common rate. Your actual rate could be lower or higher depending on your unique income circumstances.