# Tax efficiency and Roth IRAs

I have a question relating to avoiding investment taxes as compared to maximizing tax free growth in a Roth IRA.

Suppose you have:

• \$10000 in a Roth IRA
• \$10000 in a taxable brokerage account

and your desired asset allocation is:

• 50% S&P 500 ETF
• 50% bond ETF

Are you better off putting the S&P 500 ETF in the Roth IRA to maximize the tax free gains over the long haul?

Or are you better off putting the bond ETF in the Roth IRA to avoid income taxes on bond investment gains?

• You can have your cake and eat it too, by putting the bond money into an ETF which invests in tax-exempt bonds (think VWITX). Jan 17, 2020 at 16:07
• Would you be open to a solution that involved owning actual bonds as opposed to bond funds? Jan 17, 2020 at 22:45
• @Vality, sure! Make a case for it. Jan 18, 2020 at 4:55

## 2 Answers

The answer to this question depends on many variables, including stock and bond returns, your investment timeline, your tax rate, your future contributions, your withdrawal strategy, etc. So I'm using the following assumptions:

• stock return: 2% qualified dividends + 8% appreciation
• bond return: 3% non-qualified dividends + 0% appreciation
• investment timeline: 30 years
• tax rate: 15% on qualified dividends, 22% on non-qualified dividends

Using Excel you can calculate the end balance quickly.

Stocks in Roth, bonds in taxable

• stocks in Roth: `=FV(2%+8%,30,0,-10000,0)`=\$174,494.02
• bonds in taxable: `=FV(3%*(100%-22%),30,0,-10000,0)`=\$20,015.31
• total: \$194,509.34

Stocks in taxable, bonds in Roth

• stocks in taxable: `=FV(2%*(100%-15%)+8%,30,0,-10000,0)`=\$160,767.71
• bonds in Roth: `=FV(3%,30,0,-10000,0)`=\$24,272.62
• total: \$185,040.34

The stocks in Roth, bonds in taxable strategy gives you a larger overall balance, but also leaves you in a better position to make withdrawals. With the majority of your money in Roth, you can take money out with no tax consequences. The downside is your Roth money is effectively locked up until age 59.5.

Also note this analysis does not consider rebalancing to maintain your 50/50 asset allocation, which could change the conclusions.

Since the S&P 500 ETF will probably have more gains, it would benefit more from being in the tax advantaged account. Personally I prefer to have all of my accounts balanced. But based on the parameters of your question, it would most likely be optimal to have the entire Roth IRA invested in S&P 500 ETF and the entire taxable brokerage account invested in the bond ETF.

• I thought bonds were generally the less tax efficient due to the interest they provide every year and therefore should be in the tax-advantaged account. Bogleheads wiki: "Some fund types, like total market stock index funds, are extremely tax-efficient, because they produce low dividends (that are mostly qualified) and capital gains. By contrast, bond funds can be extremely tax-inefficient, because the interest they produce every year is taxed at your full marginal tax rate." Jan 17, 2020 at 19:51
• @clcto, that is why I asked the question! Hopefully someone will respond with more details. Jan 18, 2020 at 4:53
• @clcto but the amount is much smaller - bonds typically produce lower gains. I'd rather max 10% and pay maximum taxes on it than get 2% and pay small or no taxes. It is a very common error to accidentailly optimize 'total taxes paid' instead of 'income after taxes'. Jan 18, 2020 at 22:28