This question may or may not stray into IMHO territory, but I hope there is a GQ-style, mathematical answer.
Say I own two funds: a high risk/possibly high return stock fund, and a relatively low risk index fund such as one tracking the S&P 500. Does it make more sense to:
[ul]
[li]keep the low risk fund in a tax shelter (such as a Roth IRA), enjoying a relatively stable tax-free return; and keep the high risk fund in a taxable account[/li][li]keep the high risk fund in the shelter, and pay taxes on the lower risk fund[/li][li]a combination of the two.[/li][/ul]
A consideration: if the high risk fund is sheltered from taxes, I’ll possibly shelter a lot of gains; but if I have losses, the shelter will have done me no good. The lower risk fund will produce more consistent returns–I will shelter less money, more often. Furthermore, the high risk fund is more likely to produce losses, with which I can offset my gains in other areas–how is this affected by using a tax shelter?
I’m curious if there’s a mathematical/statistical answer to this. Obviously, much would depend on the assumptions of mean/std deviation of returns–but perhaps the spread would only have to be small before one option was clearly better than the other. (Please no discussion about how index funds are not ‘low risk’, or about stocks vs. mutual funds. My question is about the relationship between risk characterstics and the benefit of using a tax shelter.)
There’s no real statistical answer, since It All Depends. The high risk fund may be a big winner, or you may lose your shirt. A statistical analysis might possibly be used to determine what your chances are, but the variables are so complex (what is high risk? What did the market do? How good is the fund manager? What outside factors might affect the fund?), that is wouldn’t be useful for any given fund.
In general, since an IRA is for retirement, you want it to be as safe as possible. If you want to take the extra risk for a higher return, put a portion into the high risk fund and keep the rest in the one with lower risk.
Generally you use the Roth IRA (pre-taxed income goes in, all withdrawals after age 55 are tax-free) when you anticipate that the tax you pay on the principal will be small relative to the taxes on the earnings. So calculate the current tax bill (let’s assume 28%) on the principal going into the Roth; to put the maximum in this year’s Roth, you’re “investing” $3,840 – $840 of which goes to tax and is “lost.” Depending on what percentage you expect your investment to earn and how long it is until you turn 55 (we’ll call the yield Y and the number of years n and your future tax bracket T), your answers might vary. Generally, though, even if you’re paying $840 in tax before you can invest that $3000, that still only sums to something like $29,400 over 30 years – if your Roth is earning 7% (an old rule of thumb for the S&P) then you’ve got almost $450,000 tax-free after 30, even though you only put in $90,000. The portion you leave in will keep growing at 7%.
If you used a regular IRA, that $450k would be taxed as you withdrew it, so even if you took the smallest amount and managed to pay only 15% in taxes, you’re losing 15% regardless (on the order of $60,000). Because the amount you can place in an IRA is capped at $3,000, the other $29,400 you “saved” up front by using a non-Roth IRA is still taxable, so if you invest it, you need to pay capital gains on the interest. That hurts your rate of return, but you still might come out on top.
Basically, you need to sit down with an Excel Spreadsheet and the tax codes, make some educated guesses, and run the numbers yourself.
My best guess is:
aggressive stocks / funds in the Roth IRA
S&P 500 fund in the regular IRA
invest an additional $840/yr (at least) and plow the after-tax dividends and gains right back into the third pile – bonds are a bad idea for the next few years, but a money market fund could do well.
It sounds like you’re looking at both of these investments as long term savings. What’s the point of keeping any of this money out of a tax deferred vehicle? Obviously your particular circumstances would dictate whether a traditional or a Roth IRA would be more advantageous. In general, the longer time you have to let the money grow, the more a Roth tends to be a better choice.
Your analysis of offseting gains and losses is not applicable when dealing with tax deferred investments. Amounts in a traditional IRA are taxable in full
upon withdrawal. Whether you’ve suffered a capital gain or loss on that investement is irrelevant.
A Roth works the other way. You get no deduction when making a contribution, but the entire amount is tax free at withdrawal. If you think your high risk invetment may produce exceptional returns, you may do well to have that in a Roth, as you would escape any tax on capital gains.
Actually, it’s fairly straightforward. I’m assuming you’re in a regular IRA not a Roth IRA. That is I’m assuming you’ve put in money you’ve not paid income tax on. In that case all money you withdraw will be taxed as ordinary income at the time you withdraw it.
Now assume for the moment, the mutual fund received no dividends and realized no capital gains (They bought and held non-dividend paying stocks). An assume you start with $1000 pre tax. Then with an IRA you’d have have taxes
1000 x (1+ rate of return on the mutual fund) * (1- ordinary tax rate at retiremnt )
With a regular investment you’d have
1000 x (1 - ordinary tax rate at retiremnt ) x (1+ rate of return on the mutual fund) - taxes on the capital gains.
So you “win” with a IRA by escaping the capital gains tax and if your tax rate after retirment is less than now. (The rate of return on the mutul fund is of course teh same for a given mutual fund.)
If the high risk fund earns more on average it will have more capital gains and you’d do better putting your IRA there and your non IRA investments in low risk fund.
However, this it probably more than offset, by dividends. For the same tax avoidance reasons, you’d like the high dividend paying stocks in the IRA. Unfortunately high dividend payers tend to be low risk.
One thing for sure though. If you hold taxable bonds, those shoudl be in the IRA
How you invest should be dependent on your age. The younger you are the more risk you’ll be able to take. If you are older, stick to conservative strategies.
Because contributions are limited. I can only put $3000, or however much, in the tax-deferred vehicle, but I’d like to save a lot more than that.
My thread’s unfortunately getting sidetracked from what I wanted to talk about, which is probably my fault for being unclear. So I’ll restate:
I’m limited to (say) $3000 a year in contributions to my Roth. How do I make the absolute most out of this sheltered $3000? In other words, will I save more in taxes by sheltering the high risk or the lower risk instruments?
The overall portfolio composition does not factor into this at all. The discussion is about the distribution of a fixed portfolio between taxable and tax-free accounts. Any more thoughts?