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Should I Put Stocks in My Roth IRA and Bonds in My Traditional IRA?

A reader writes in, asking:

“If I have a Roth IRA and traditional IRA, is it better to put my stock funds in the Roth and the bond funds in the traditional IRA? That seems preferable, because as long as stocks do earn more than bonds it would leave me with more money down the road because the Roth is tax-free.”

Yes, it is often preferable to put your investments with higher expected returns in Roth accounts rather than tax-deferred accounts — but not for the reason you mentioned.

Loading up your Roth accounts (as opposed to tax-deferred accounts) with investments with higher expected returns will (assuming “expectations” pan out) leave you with more money to spend after taxes than if you had taken a different approach. But that’s simply because you took on more risk.

By putting your high-risk investments in a Roth, you expose yourself to more risk than you would if you had an equal allocation in both tax-deferred and Roth. The reason for this is that you feel the full effect of fluctuations in the balance of your Roth IRA, whereas you only feel a portion of the effect of fluctuations in the balance of tax-deferred accounts.

For example, imagine that you expect to have a marginal tax rate of 25% during retirement. If your Roth IRA’s value changes by $20,000, that changes the amount of money you have available to spend by $20,000. In contrast, if your traditional IRA’s value changes by $20,000, the amount of money you have available to spend only changes by $15,000 (because $20,000 in the traditional IRA is only worth $15,000 to you, given a 25% marginal tax rate).

In other words, using your Roth IRA entirely for high-risk investments is very similar to just bumping up your allocation to high-risk investments in the first place — it will likely result in more money in the end, but at the cost of higher risk.

Now, having said that, it does typically make sense to prefer to use the Roth for investments with higher expected returns.

Why?

Because Roth IRAs Have No RMDs

As long as a Roth IRA is owned by its original owner (as opposed to being owned by a beneficiary after the death of the original owner), RMDs do not have to be taken from the account at any point.

So, in that sense, you would prefer to have a Roth IRA of a given size rather than a proportionally-larger traditional IRA, because the Roth gives you better control over your money.

For example, you would rather have $75,000 in a Roth IRA than $100,000 in a traditional IRA with a 25% marginal tax rate, despite the fact that the two amounts are functionally equivalent in terms of how much they leave you with after taxes.

For that reason, it does typically make sense to use your Roth accounts for the investments with the highest expected return. But you should be aware that in doing so, you increase your overall risk, so you may want to compensate by reducing risk slightly in some other manner.

Investing Blog Roundup: Actuaries Longevity Illustrator

One of the most critical questions in retirement planning is how long you expect to live. Longevity expectations affect everything from how much you can spend per year, to tax planning decisions, to Social Security decisions.

It’s easy to look up your life expectancy in a table. But all that tells you is the average outcome. It’s also very helpful to see somewhat more detailed information (e.g., how likely it is that you — and/or your spouse, if married — will live to various ages).

This week, via Walter Updegrave, I encountered a new, easy to use tool from the American Academy of Actuaries and the Society of Actuaries that can give you such information:

http://www.longevityillustrator.org/

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Social Security is a Year-by-Year (or Month-by-Month) Decision

For simplicity’s sake, writers and financial advisors often compare claiming Social Security at 62 to claiming at 70, in order to show the difference between the two extreme strategies. But in reality, the decision should be made step-by-step along the way. (“Do I want to wait a year? Do I want to wait another year?” And so on.)

This is important because many people look at waiting until age 70, decide that 70 is too far in the future, and therefore default to claiming as early as possible at 62. That’s unfortunate because, even for people for whom claiming at 70 doesn’t make sense, claiming at 62 is still usually a mistake.

For example, if you are an unmarried person, currently age 61 and trying to decide whether or not to claim Social Security ASAP at 62, you don’t want to compare claiming at 62 to claiming at 70. You want to compare claiming at 62 to claiming at 63. When we do that, we can calculate that the breakeven point is age 78. (That is, if you live to age 78, you are better off having claimed at 63 than having claimed at 62.) Using the 2011 actuarial tables from the SSA, we can calculate that for an average 62 year old male, there is a 67% probability of living to age 78. For a 62 year old female, there is a 76% probability. Conclusion: For most unmarried people, it makes sense to wait at least until 63, because there is a much greater than 50% probability of living to the breakeven point.

Then, at age 63, we would want to see if it makes sense to wait until 64. The breakeven point between claiming at 63 and claiming at 64 is age 76. Using the same actuarial tables, we can calculate that for an average 63 year old male, there is a 74% probability of living to age 76. For a 62 year old female, there is an 82% probability. Conclusion: It probably makes sense to wait another year.

And then you would repeat this analysis every year. (In theory, you should actually do the analysis every single month to see if it makes sense to wait one more month. But that would be a heck of a lot of work. In my opinion, it makes sense to reassess annually — or whenever you get new information about your life expectancy.)

For somebody with a full retirement age of 66, the year-by-year breakeven ages would be as follows:

Claiming Ages
Breakeven Age
62 vs. 63 78
63 vs. 64 76
64 vs. 65 78
65 vs. 66 80
66 vs. 67 79.5
67 vs. 68 81.5
68 vs. 69 83.5
69 vs. 70 85.5

And for somebody with a full retirement age of 67, the year-by-year breakeven ages would be as follows:

Claiming Ages
Breakeven Age
62 vs. 63 77
63 vs. 64 79
64 vs. 65 77
65 vs. 66 79
66 vs. 67 81
67 vs. 68 80.5
68 vs. 69 82.5
69 vs. 70 84.5

To be clear, the above discussion is a simplification, meant to illustrate the general concept that the decision should be made year-by-year rather than simply asking “Should I claim at 70 or at 62?” A real-life analysis of your personal situation should ideally include a few other factors:

  • Investment return earned on early-received benefits. In the above discussion, we’re assuming that early-received benefits earn a 0% real return (i.e., they precisely match inflation). Given that the yields on TIPS (i.e., the investment with a risk level most similar to that of Social Security) are currently at or near zero, that’s a pretty reasonable assumption. If real interest rates were higher, the breakeven points would be pushed back somewhat.
  • Tax planning. The specifics vary from person to person, but in most cases tax planning is a point in favor of waiting to claim benefits, because of Social Security’s tax-advantaged nature.
  • Spousal and survivor benefits for married couples. (As we’ve discussed before, for married couples, at least one spouse usually should be using one of the “extreme” strategies of filing at 62 or at 70.)
  • Longevity risk. For anybody who is concerned about running out of money due to a very long retirement, delaying Social Security is often a good decision, even if there is a less than 50% probability that they will live to the breakeven point in question.

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  • How Social Security benefits are taxed and how that affects tax planning,
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Investing Blog Roundup: Insurance is Tricky Business

Insurance is one of the trickier areas of personal finance. The problem isn’t just that insurance is complicated — it’s hard to make the case that insurance is decidedly more complicated than tax planning, for instance — but rather that it’s hard to get good information due to conflicts of interest. (That is, most professionals in the field are compensated via commissions, so they have an interest in getting you to take one specific course of action rather than another, regardless of what is best for you.)

For somebody who is not an insurance professional, author Jim Dahle spends a lot of time researching and writing about insurance. I frequently find his articles to be refreshing, because a) he’s willing to take a look at any proposed strategy or product and b) he has no significant conflict of interests. This week, he takes a look at annually renewable term life insurance and options for getting rid of a whole life policy.

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Investing in Healthcare Stocks to Offset Healthcare Risk

A reader writes in, asking:

“What would you think about buying a healthcare mutual fund to reduce the risk of healthcare costs rising as I age? Or in a similar vein, what about buying stock in long term care facilities to reduce the financial risk of needing long-term care?”

In short, I would say that that idea makes no sense.

There is no particular reason to think that the performance of a healthcare mutual fund will be highly correlated to your personal healthcare costs. Nor is there any reason to think that the performance of a collection of long-term care stocks will be highly correlated to your personal need for long-term care.

In other words, neither one can function anything like an actual insurance product that directly reduces your out-of-pocket costs for care.

A line of thinking that I’ve seen from many investors is that healthcare stocks are in for several years of excellent performance because our aging population will cause healthcare companies to experience strong profits over the next couple of decades. And such stocks are therefore a safe holding for retiring baby boomers.

But as we’ve discussed here in the past, the performance of a given stock is determined by how that company’s earnings compare to the market’s expectations for that company’s earnings. So a company (or industry) can have good earnings growth over a given period, yet experience poor stock performance if the earnings growth isn’t as good as the market expected it to be.

For example, Morningstar reports that Vanguard Health Care Fund has a P/E ratio that’s about 25% higher than that of Vanguard Total Stock Market Index Fund. In other words, based on their current earnings, the Health Care fund is significantly more expensive — presumably because the market already expects the stocks owned by the healthcare fund to have higher earnings growth than the average stock in the U.S. stock market. So it’s entirely possible that healthcare stocks experience high earnings growth yet still perform poorly because the earnings growth isn’t as high as expected.

In summary, healthcare stocks — like stocks in general — are risky. And holding them as a way to reduce risk (including the risk that your personal healthcare costs will rise) is nonsensical.

Investing Blog Roundup: Early Retirement and Comparative Advantage

Ever since taking my first economics course in high school, I’ve found the concept of comparative advantage to be both fascinating and informative, in terms of explaining why people do the things they do. This week, Harry Sit uses the concept to discuss why an extremely early retirement is often economically inefficient, even for people who can afford to do it.

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