Before we jump into today’s topic: Last week, we discussed the different qualities and benefits of pre-tax accounts like Traditional IRAs and 401Ks compared to Roth accounts. Since then, there were a couple of media discussions that go more into depth on the tax implications of these decisions.

First, Merit Financial Advisors posted an excellent video breaking down the problems with taxable accounts, including the tax drag (on contributions and growth). While they didn’t draw much of a distinction between Roth and Traditional accounts, they used some clever math to estimate a tax drag of 0.7% for taxable accounts over Traditional ones.

In the exercise last week, I estimated that a pre-tax $20,000 investment in a Roth account grew to $40,000 (after-tax) after 20 years, while it grew to $42,766.93 in a Traditional account due to marginal taxation rates. Using Merit’s approach, the difference between those Roth and Traditional would equate to roughly 0.35% compounded over 20 years.

Merit assumed Roth and Traditional were equally beneficial, but based on this estimate (0.35%), Traditional over Roth tax benefits are roughly half of the benefits of Traditional over taxable accounts (0.70%) after compounding.

The other video that is worth checking out is Cody Garrett and Sean Mullaney’s appearance on the Bogleheads on Investing podcast. I just love these guys.

Cody calls out fear-based tax planning during the teaser, but it is worth listening to the entire episode. At about the 21 minute mark, Cody discusses how an earner in the 22 percent marginal tax bracket would need to take distributions of over $268,000 per year in retirement before they hit an effective tax rate of 22 percent.

As Cody says, “When you’re contributing to a traditional retirement account, you’re deducting those contributions top-down at your highest marginal tax rate. And when you’re retired, when you’re taking those distributions or converting to Roth, you’re going bottom-up through some of those lower brackets.”

This all points to Traditional retirement vehicles as the optimal strategy for most savers during accumulation. That doesn’t mean Roth contributions are not beneficial or even optimal—low earners with very high savings rates may benefit from Roth if they plan on spending a lot more in retirement—but investors should be careful about following advice that stokes fear with little to no evidence behind it.

On to this week’s topic…

The Asset Location Debate

Back in January, Rob Berger fielded a question about after-tax asset allocation. I felt a little unsatisfied by Rob’s response, but at the time, I didn’t give it much thought. Now that I’ve started to give asset location another look, I thought I’d review the concepts again.

The question was prompted by an article in The Financial Planning Association Journal by William Reichenstein and an after-tax asset allocation framework developed by Reichenstein and William Jennings. Reichenstein argues that a portion of Tradition and taxable accounts are technically the “government’s share” and should not be factored into an investor’s asset allocation.

For example, if an investor has a 60/40 portfolio (60% stock, 40% bonds), the common advice is to put the bonds in a tax-deferred account and the stocks in a Roth account. The thinking goes that the bond portion will benefit from lower growth tax-deferral in a Traditional account, while the stocks will benefit from higher tax-free growth in a Roth.

But Reichenstein argues that this is largely hocus pocus. The bonds in the Traditional account include an untaxed portion that technically belongs to the government (a “silent partner” of the investor). An investor with a 20% effective tax rate in retirement, for example, will only ever see 80% of the proceeds from the Traditional account, meaning their realized asset allocation is closer to 65% stocks, 35% bonds.

There are two implications of this that are worth exploring:

• Using pre-tax asset allocation may inadvertently expose investors to more risk than they intended.
• Proponents may be overselling the benefits of asset location as a portfolio growth strategy.

If asset location is a secondary decision made after the asset allocation decision, it is easy to see how these two mistakes go hand in hand. By placing high growth assets like stocks in taxable or Roth accounts and slower growth assets in Traditional accounts, investors are dialing up their after-tax risk level, which at least partially explains the higher after-tax returns.

Reichenstein recommends completing a Mean Variance Optimization (MVO) on the after-tax asset allocation to determine the appropriate portfolio weights. Despite the reduction in equity exposure, Reichenstein concludes that asset location strategies still provide better returns over equally distributed strategies with the same risk exposure (by about 30 basis point or 0.30%).

But other writers aren’t so sure. Joe Tomlinson cites a study by David Blanchett and Paul Kaplan that estimated a 23 basis point advantage but it included other tax-optimization strategies. Vanguard looked again more recently with Roth accounts in mind and found the benefits varied significantly depending on the asset allocation, but could be as low as 4 basis points.

For DIY investors, the question is whether 4-30 basis points (0.04% – 0.30%) is worth the effort of computing an after-tax MVO asset allocation. If you don’t use an after-tax asset allocation, it is unclear to me whether asset location strategies (particularly between Traditional and Roth accounts) will move the needle at all in after-tax risk-adjusted returns. You may outperform, but that will likely coincide with increased risk.

Clearly, there are benefits to holding assets in tax-favored accounts rather than taxable ones (which we discussed last week). There even may be a small premium for sensible asset location strategies when taxable accounts are involved.

That said, I’m not sure the added complexity of tax location strategies between Roth and Traditional retirement accounts is worth the extra headache. Ultimately, the conventional advice to hold high growth stocks in Roth accounts and bonds in Traditional accounts is probably misleading and exposes investors to higher risk than they intend. Of course, you could take the other side of that argument: Maybe there is no clear benefit, but it couldn’t hurt, right?