When all of your investments are in an IRA, managing your portfolio is simple:
- Choose an asset allocation that fits your needs,
- Find the lowest-cost way to implement that allocation (this usually means index funds or ETFs),
- Stick with it.
For many investors, however, things are complicated by the fact that their portfolio spans multiple providers. For example, they may have their IRA with one investment firm and their 401(k) with another. And the 401(k) may not even offer any low-cost options.
Consider the Whole Portfolio
The trick to keeping things simple and minimizing your costs is to remember this: It’s all one portfolio. And the steps to implementing it are exactly the same as those described above. The only difference is that Step #2 becomes a two-step process itself:
- Look for low-cost options in your 401(k) that can satisfy parts of your target asset allocation,
- Use your IRA to fill in the gaps.
For Example…
Imagine Jason, an investor who has $60,000 in his 401(k) and $40,000 in a traditional IRA. Jason’s target allocation is as follows:
- 50% U.S. stocks
- 25% international stocks
- 12.5% intermediate-term Treasury bonds
- 12.5% TIPS
Jason is one smart cookie, so his IRA is with a company that gives him access to as many low-cost index funds as he pleases. His 401(k), however, only has two reasonably low-cost choices: an S&P 500 index fund and an inexpensive international stock fund.
Because the S&P index fund is the cheapest option in his 401(k), that’s where Jason should start. He can use it to satisfy the entire U.S. stock component of his portfolio ($50,000). After that, he’ll invest the remainder of his 401(k) in the inexpensive international fund. Finally, he can use his IRA to plug the remaining holes.
The final breakdown looks like this:
In the 401(k):
- $50,000 in the S&P 500 index fund
- $10,000 in the international stock fund
In the IRA:
- $15,000 in a low-cost international stock ETF or index fund,
- $12,500 in a low-cost intermediate-term Treasury fund or ETF, and
- $12,500 in a low-cost TIPS fund or ETF
Potential Complicating Factors
Of course, Jason’s situation was still relatively simple. Things can become slightly more complicated if:
- There’s a total of 3 or more providers due to you and your spouse having 401(k) plans run by different companies, or
- You have a more complex target asset allocation than Jason’s.
But in any case, the basic process is still the same: Determine your target asset allocation, then find the least expensive way to implement it.
Tax-Adjusted Allocation
If you have tax-free accounts (Roth IRA) as well as tax-deferred accounts (401(k), traditional IRA), you may want to tax-adjust when determining your allocation. That is, you may want to account for the fact that you get to keep everything in your Roth, while a portion of your traditional IRA and 401(k) are each going to Uncle Sam when you start making withdrawals.
Keep It Simple
It can feel a bit overwhelming to be faced with 30 investment choices in your 401(k) and several hundred more in your IRA. The trick is to remember that it’s all one portfolio, and to go about dealing with it as such.
- Determine your asset allocation,
- Look for low-cost options in your 401(k) that can satisfy parts of that allocation,
- Use low-cost index funds/ETFs in your IRA to fill in the gaps,
- Stick with the plan.
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{ 10 comments }
Mike,
Ever use Morningstar’s Free XRAY product to determine those gaps:
http://www.myjourneytomillions.com/articles/using-morningstars-free-instant-x-ray-tool-to-evaluate-your-portfolio/
Mike,
In the simple world it is a good strategy, but in real world I think there are a lot more complications. When you have disproportionate amount in each of the accounts (401k, Rollover IRA, Roth IRA, regular IRA for spouse, taxable account) AND disproportionate ongoing contribution limits, it can become really complicated. To keep it simple, wouldn’t it be better to have the same allocation for each of your portfolios? I understand the tax implications, but you can potentially reduce that by using muni bonds in your taxable portfolio.
Evan: You’re right. Morningstar’s portfolio x-ray is a great tool.
GoYanks: Admittedly, ongoing contributions do complicate things.
If an investor has good options for each asset class in their 401k, then sure, having the same allocation in each account could make sense.
If, however, it means having to use high-cost funds in your 401k, I think it can be worth the effort (especially for larger portfolios). Or perhaps a hybrid strategy something like this:
Thanks, Mike. I think this is an important topic that I have not seen mentioned much in discussions of investments, but practically speaking it’s one of the bigger challenges in creating a portfolio.
I have up to this point taken the strategy of “separate but equal” portfolios – 401k using Fidelity 60/40 stock/bond, with the stock fund @ an excellent .1 and the bond @ a decent .38, and tIRA using several funds from Vanguard in similar proportions. I could of course have all my US stock in Fido’s Total US Market and exchange out of VG’s Total Stock Market, but if I have only one fund in my 401(k) how do I rebalance it if the 401(k) grows too large for my targets? (I continue to contribute regularly to the 401(k) but not to the tIRA, as it’s not deductible, and I also feed the Roth.)
While I appreciate the simplicity argument too, VG’s Portfolio Watch (which is at least as useful as Morningstar’s, as the VG analysis gives you feedback on every aspect of your portfolio) makes tracking your investments a piece of cake. At worst, I have an extra fund or two, but as it’s all going to get rolled over into the tIRA come withdrawal time, is that such a big deal?
I like the Keep It Simple plan. You can make things way too complex with invesments.
@Mike: “If, however, it means having to use high-cost funds in your 401k, I think it can be worth the effort (especially for larger portfolios).”
@Ken: “I like the Keep It Simple plan. You can make things way too complex with invesments.”
Easy for Ken to say, but the problem is: what is “simple”? Is simple a matter of reducing the number of funds, or tracking the portfolio, or the easiest way to rebalance? But then Mike is proposing a strategy that may require a bit more “effort,” and effort is the opposite to simple.
For example: if I want a 60/40 s/b split, I can easily achieve it within each provider’s offerings. If (as is happens) my 401(k) has FUSEX and FBIDX @ .1 and .38 respectively, I get an average ER of .21 if I allocate 60/40, or $21 for each $10K in the account. Sure, I can allocate the 401(k) 80/20 for an average ER of 1.52, a savings of about $6 per each $10K, but then I have to re-allocate the IRA to compensate based on the overall percentages I wind up within my total portfolio. That seems to me more complicated than just allocating 60/40 within each account.
Maybe part of the question should be (and this would apply both to any individual account as well as the total portfolio): what is the upper limit of an acceptable expense ratio for any fund as well as overall? Obviously the lower the better, but if I have an ER of .2 in 90% of my funds, how much is the 10% I have with a fund of .5 in my 401(k) really hurting me if it gives me an average ER of .23?
Sorry if I’m writing too much here. If I am, I’ll back off.
Hopefully Mike is still following this little discussion, as I have just learned of an IRS provision that could help me and others over 59 1/2 big time. It must be a little-known aspect of the 401(k), as I can’t even find it mentioned in the two Boglehead books. Basically, if the 401(k) plan permits (and mine does), persons over 59 1/2 can do an in-service rollover of all or part of their 401(k) to a tax-deferred IRA while still working for the same company. I understand that some plans may impose restrictions on this move (such as, you may not be able to contribute to the 401(k) for a period after doing this rollover), but I can’t see that mine does and consolidating all or a good part of my 401(k) now with my Vanguard tIRA would solve all my problems. I could still keep a small balance in the 401(k) and make further contributions in order to take advantage of the low-cost FSTMX or FUSEX, while at the same time I open a lot of space in my tIRA to use any Vanguard funds I want.
Hi Larry.
That’s fantastic. It sure will simplify things for you! Thanks for bringing it up.
I tend not to remember to mention in-service withdrawals because a) you have to be the right age and b) from my anecdotal experience, most plans don’t offer them.
Perhaps I should rectify that with a post on the topic.
And just for reference, every comment on the blog shows up as an email to me. So I’m pretty much always following every discussion just by default.
Hi,
Thought you guys might have an answer for this one. I’m currently updating my IRA and 401K. I want the following distribution across the accounts:
US – 65%
– Large cap – 70%
– Mid cap – 20%
– Small cap – 10%
I’m splitting that between Doge & Cox and individual Vanguard large, mid, and small cap funds. I’ve played around on Excel trying to make the mix of funds match the 70/20/10 cap overall distribution, using Doge & Cox (86% – Large cap; 14% – mid cap) and Vanguard funds. Keep running into a wall. Can you recommend how to set it up? I would also consider the X-ray tool at Morningstar.com. Thanks for the help.
Hi Frugal.
I sent you a spreadsheet via email that might get you started in the right direction.
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