In the late 1990s, PayPal co-founder Peter Thiel invested less than $2,000 in founder shares in his Roth IRA. Those shares reportedly have climbed to roughly $5 billion, and Thiel won’t owe taxes on the gain if he waits until age 59½ to withdraw the money.
A gain of that magnitude—featured in a recent ProPublica report based on Internal Revenue Service documents—isn’t likely to be replicated by ordinary investors. But they ought to follow Thiel’s lead in one respect: Roth accounts are a great place for high-risk, high-return investments. (Thiel hasn’t commented on the report.)
Unlike a traditional individual retirement account or 401(k), Roths are funded with after-tax dollars. All money you take out of a Roth individual retirement account is tax-free, as long as you’re at least 59½ years old and you’ve had a Roth account open for five years or more.
The Roth, because it can offer decades of tax-free growth, is typically the last account you should empty in retirement. That makes it a perfect place for volatile investments like emerging-market or small-cap stocks.
“Risky things should outperform over time, as long as you can stomach the ride,” says Ann Gugle, a certified public accountant and financial advisor in Charlotte, N.C.
Tax consideration shouldn’t determine your investment choices. The share of your savings you put in risk assets and the share you put in safe assets ought to be determined by your tolerance for risk, investment goals and stage in life. But once you have decided on a financial plan, taxes are key when deciding which assets go in which accounts.
Gugle says she typically separates her clients’ funds into three buckets: Roth accounts; tax-deferred accounts; and taxable accounts. She then begins filling up each bucket as if playing a “game of Tetris.” Risky investments are best for the Roth or, if they’re tax-efficient, for taxable accounts. Income-producing investments like bonds or real estate investment trusts, along with less volatile equities, or best for tax-deferred accounts.
Exactly which investments go in which accounts differs from person to person, financial advisors caution. For example, bond investments generally make more sense in a traditional IRA than a Roth IRA. That’s because they are slower growing than equities. You will eventually get taxed on withdrawals from a 401(k), so you’re better off putting your fast-growing assets in the Roth account, where you will pay no taxes when you pull out the money someday.
But if you’re a conservative saver heavily invested in bonds, you may end up holding bonds in your Roth if you run out of room in your 401(k) for them based on your target allocations. And if you’re an aggressive saver who is all-in on stocks, you may end up holding a volatile stock fund in your 401(k), because you’ve run out of room in your Roth account or taxable account for it.
If you have the choice between a very large Roth account, and a very large deferred account, I think we’d all choose the large Roth account.
— Mike Piper, St. Louis accountant
The limits for contributing directly to a Roth are relatively small, $6,000 per year for those under 50, and $7,000 for those older. And to make that full contribution, single people can earn no more than $125,000 while married couples can’t top $198,000.
But many employers now give workers the option of contributing money to a Roth 401(k) instead of the traditional tax-deferred 401(k). The Roth version makes particular sense for young workers or others who are in a low tax bracket; they often are better off paying taxes now instead of deferring them to the future. And the contribution limits are much higher for Roth 401(k)s than for Roth IRAs. Workers can contribute up to $19,500 a year to the 401(k) version, or $26,000 if they’re over 50 years old.
In addition, some retirement plans allow workers to make an after-tax contribution, then later roll it into a Roth account, in what is called a “mega-backdoor Roth.”
“It’s really important to look at the details of your plan,” Gugle says.
Many retirees, meanwhile, now own bulging Roth accounts thanks to Roth conversions. Congress removed the income caps for conversions in 2010, suddenly making the maneuver available for even wealthy seniors.
In these conversions, you move money from a tax-deferred account to a Roth account while paying income taxes on the money transferred. Conversions often make sense for people early in retirement who haven’t yet started collecting Social Security and are in a relatively low tax bracket. By moving money out of their tax-deferred accounts, they are lowering their minimum required distributions when they hit age 72.
“If you have the choice between a very large Roth account, and a very large tax-deferred account, I think we’d all choose the large Roth account,” says Mike Piper, a St. Louis certified public accountant who advises clients on tax planning.
Roths are also gaining popularity with retirees who want to pass wealth to the next generation. Money taken out of a Roth by your heirs is tax-free, and they have 10 years to empty it after you die. Spouses, minor children, and certain others aren’t subject to the 10-year limit.
Whether you’re 25 years old or 65 years old, the strategy doesn’t really change for which investments belong in a Roth. You want assets with the most growth potential during the rest of your life, and the decade that follows if you’re planning to leave it to your heirs. William Bernstein, a Portland, Ore., money manager and author of “The Investor’s Manifesto,” keeps only small-cap funds and value funds in his own personal Roth IRA.
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“The Roth should get the riskiest, highest-return (and least tax-efficient, within the aggressive category) assets, for two reasons,” Bernstein writes in an email. “1. It has the longest time horizon. 2. It avoids the most taxes.”
Leo Marte, a Huntersville , N.C., financial advisor, says Roths can also make sense for actively managed funds where the fund managers do heavy trading. If you hold such a fund in taxable account, you’ll pay taxes when the fund manager exits a winning position.
“You don’t want actively managed funds in a taxable account because you’ll get killed,” Marte says. “A lot of the returns will go to taxes.”
Taxable accounts are good places for tax-efficient funds, like total market funds, that have low turnover, says Larry Swedroe, co-author of “Your Complete Guide to a Successful and Secure Retirement.” Taxable accounts are also good for assets that can take big swings in value.
“The more volatile an asset is, the more valuable it is in a taxable account because of the ability to harvest losses for tax purposes,” says Swedroe, the chief research officer for Buckingham Strategic Wealth. “That way Uncle Sam gets to share the pain of the loss.”
Nonetheless, Swedroe says savers should max out tax-advantaged accounts, including Roths, before they fund taxable accounts because they are the best way to build wealth over time.
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