I take far more risk in my tax deferred IRAs than my taxable accounts because losing the money in the IRAs will not have an immediate negative impact on my lifestyle and can hopefully be replaced over the next few decades. (I’m currently using a leveraged ETF strategy in my IRA.)
My taxable accounts are invested in bond funds and low risk equity funds. It’s what I draw on if I need to make a large purchase, lose my job, get really sick, etc. It seems most people I know take a ton of risk with their taxable accounts while taking relatively little risk with their retirement money in their IRAs.
I do have a riskier position in my Roth IRA, but it’s relatively small. The reason I follow the conventional and non-blackomen thought process is a) any capital losses in an IRA aren’t tax deductable to cushion the blow of losing that money. b) contributions to the Roth are capped, so if I lose capital I can’t just replenish it. I guess regular IRAs are a bit easier to replenish via 401k rollovers, etc.
It is very tempting though to make lots of tax free/deferred cash using options in my roth IRA.
Makes complete sense! Theres a reason they cap how much you can contribute a year. So the compounding effect of the small-cap indexes the last 2 years was sweet! I’m hoping to use mine for a first home purchase though, not retirement.
Watch those leveraged ETFs. They are not the best long term hold. I was at an iShare conference years ago where the fund manager explained they should be used as trading positions, not buy and hold. Too many retail investors get it twisted and think if the SP500 returns 10%, then the 2x leveraged fund will then return 20%. This is not the case. Someone probably can share a recent paper on the subject.
Suppose that you purchase a leveraged ETF for 100.00 and it ends the day up 10% at 110.00 and you realize a 2x profit of 20%. The next trading session, the leveraged ETF falls 9.1% from 110.00 to 100.00 and you realize a 2x loss of 18.18%. While this doesn’t sound all that bad on the surface, an 18.2% loss on 120.00 amounts to $21.84, which puts the position at just 98.16. In effect, you’d realized a loss on what would have been a neutral position [see How To Swing Trade ETFs].
Compounding Works Both Ways
As the example above illustrated, volatile markets can lead to big losses for leveraged ETFs due to the fact that compounding works both ways. Suppose that the aforementioned leveraged ETF sways by the same 10 points every two days over a 60-day period and you continue to hold it. While the underlying index may be dead even at 100.00, your leveraged ETF position would be down by more than 50%, if repeated 30 times, resulting in a significant loss.
Yes, you get higher volatility drag with levered ETFs. So you think you are getting 2x over the long term, but it’s only something like 1.6x, because the drag from higher volatility eats into that 2x return.
For some people, that’s still the only way they are going to be able to lever up, so maybe they decide to do it; the mistake is to assume that they are going to get 2x the S&P and make their financial plans (and portfolio construction) based on that assumption. It may still make sense in some situations, but only if there is no other way to get higher returns, and you are willing to tolerate the lower long-term sharpe ratio (or other risk adjusted measure).
But if you are holding long term, you do basically have to assume that there is a long-term positive total return. If you are going to get flat markets out for 10 years (which is a possibility in today’s environment), then the volatility will eat up a lot of your capital.
Segregating your different “risks” into different “pools” doesn’t really change your risk at all. It just changes how you view it. Losing money is losing money, no matter how you look at it.
The taxability of the cash flows, gains, and losses is really what you need to look at. You have all your cash-generating assets (bonds and high dividend stocks) in taxable accounts, so you have to pay taxes on all those cash flows. And you have all your potential losses in your IRA, so you WON’T get to deduct your losses on those. In other words, you’re in the worst of all possible worlds.
It’s easy to think “risky assets should be long-term assets, and therefore should go in the long-term bucket because I know I won’t touch them”. But in reality, all things equal, it’s better to have risky assets in taxable accounts so you can take advantage of capital losses.
It’s also easy to think “I want access to the low-risk assets in case I get sick or need to buy a house”. But the IRS will allow you to withdraw funds for medical expenses (if they’re in excess of the 10% of AGI threshhold, that is) or to buy a house. And if you really need funds outside of the IRA, then you can always just sell your risky assets. If you’re lucky, you’ll owe taxes on the gains. If you’re unlucky, you’ll get a capital loss that you can carry forward indefinitely.
Either way, it’s still better to have your cash-paying bonds and high-dividend stocks in a tax-free account, and to have the non-dividend paying stocks (small-caps and techs) in taxable accounts.
BTW–I didn’t want to cut Bchad and CvM off, but I really know very little about leveraged ETF’s, except most experts have warned against using them.
Although I wonder–do those leveraged ETF’s have high cash flows? I would imagine that they have very high turnover, which would cause high capital gains/losses. Am I right?
^That’s one common complaint about them, though I haven’t invested in any so I can’t say from personal experience. Also, your post above was interesting, thanks for that.
Isn’t this a Level Three topic that, like all topics, could show up on a test? And one that I would have looked at as a freebie.
IRA withdrawals are taxed at regularly rates. By putting risking assets, i.e. growth stocks, in an IRA you may actually be increasing your tax burden. Roth IRAs are a different animal. CFAI would state tax rates for gains and income given country rules are different, but the theory is all the same.
What is the expected return on options? Yeah, that might not be a good long term strategy to goose returns. Manage a risk/return profile, sure.
Yep. I keep my stocks that pay ordinary dividends and other non-tax advantaged things in my Roth IRA, while foreign stocks that have withholding taxes go in the taxable account so I can claim the tax credit. Just as an example…
As you should know by virtue of passing L3, there is no real economic difference between the Roth and Traditional IRA’s, as long as the tax rates stay the same.
In regard to my statement, putting a stock in a Roth IRA will not increase the tax burden. Putting a stock in a traditional IRA may increase the tax burden. I don’t think you are arguing that point.
You seem to be commenting on a different topic, comparing the tax consequences of contributing to a traditional or a Roth IRA. You are making the same mistake many “experts” make when writing on this topic. That mistake being that both deposits and withdrawals will be treated at the highest marginal rate for that individual. While true for deposits, all of the withdrawals may not be taxed at same marginal rate even if income and tax rates are the same. The effective tax rate of withdrawals in retirement will be lower than the marginal rate used for calculating the original deduction, assuming that the IRA is providing most of the income. In fact, all else equal, contributing to a traditional IRA can be the better economic decision. There usually is a theoretical difference. There are other differences that should be ignored for this discussion, such as the lack of a required Roth distribution and the larger effective deposit limits of the Roth, $5500 post tax is larger than $5500 pretax.
Greenie, school is out for now, but does the fact that you have gotten far more questions wrong than me ever cause you to qualify a statement in order to give yourself a little wiggle room when you attempt to call me out? Sorry, couldn’t resist.
^The underlying basis of your argument is that IRA contributions are contributed at the marginal level, distributions are also taxed at the “average” or “blended” level. There’s absolutely no reason to make that assumption.
Either both contributions and distributions are considered “incremental”, or they’re not. Either way you want to look at it, they’re the same thing. But you don’t get to cherry-pick which dollars you pay 39.6% rates on, and which ones you get to take deductions on. Income is income, and deductions are dedutions.
And you say that putting stock in a traditional IRA may increase the tax burden, then you later say that contributing to a traditional IRA can be the better economic decisison. These seem to be mutually exclusive. (Unless you thrive on tax revenues, of course.)
If the ever-so-wise teacher want to respond to the student, I’ll be here. Until then, I’ll assume that your argument has zero merit.
What assets to hold in a deferred account and the tax consequences of those decisions is different than deciding what vehicle to contribute to in the first place but it couldn’t hurt to consider both simultaneously if you have that much foresight. In regard to the roth or traditional contribution discussion, maybe this guy can help you, an older but relevant article. http://thefinancebuff.com/case-against-roth-401k.html
It’s possible to mitigate the volatility drag, at least from my backtesting, by holding 2 or more fairly uncorrelated 2x ETFs. So you won’t be able to do 100% 1 single asset class. But you can go, say 60/40 2x Stocks/Bonds and rebalance regularly (but not too often where commissions will eat away at your returns.)
Sure, volatility drag will kill some of your potential return. But it also makes it cheaper to repurchase shares when you rebalance.