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StopSpending:

First, we need to distinguish between a traditional IRA and a Roth IRA. The numbers run very differently between the accounts. Second, the primary “value” of an IRA is the tax deferral (i.e., you don’t pay taxes on the income until retirement. However, when you pay the tax, you pay at your normal marginal income tax rate. (That is, you don’t get long-term capital gains treatment even if you hold stocks in the account. Everything is taxed at your ordinary tax rate.)

So, suppose that you have 50% of your money in a traditional (non-Roth) IRA and 50% of your money in a taxable account. Suppose also that you want to have 50% of your money in stocks (a broad-based index fund) and 50% in bonds (let’s say CDs at a bank). Suppose (for simplicity and you can easily generalize) that stocks pay no dividends and there is no turnover in the index.

Your choice is between putting stocks in your IRA or your taxable account with bonds going into the other account. This is what I consider to be the “baseline” decision. I attach a reference to an article in the June 2004 JOF for your perusal, but let’s try an example.

Suppose you will invest for 30 years. Your goal is pay all of your taxes after 30 years and have the most amount of money after-tax. (Optimal witthdrawal strategies are another subject.) Bonds earn 4% (like they do now). The expected return on stocks is 9%. (We will ignore risk. you can use simulation to get your hands around risk better.) Your ordinary tax rate today and in 30 years will be 40% (combined federal and state). Your capital gains rate is 20% (combined federal and state). You have $100,000 in your IRA and $100,000 in your taxable account.

If you put your bonds in the IRA and stocks in your taxable account, you will have $194,604 after-tax in bonds after 30 years and $1,081,414 in stock in your taxable account after 30 years. The total is $1.276 million.

If you put stocks in your IRA and bonds in your taxable account, you will have $203,704 in bonds after-tax and $796,061 in stock after-tax — $999,764 in total. Most of the $276,253 difference is dependent upon the difference between 40% and 20% tax on gains from your stock; however, about $40K of the difference is due to the fact that stocks are ALREADY tax-deferred, if you just don’t trade them.

Your wealth swings 25% based just upon where you LOCATE your assets. (You have the same asset allocation in each case.)

This analysis can be generalized for dividends, turnover in the stock portfolio, different expected returns, tax-loss harvesting, Roth IRAs, risk (using simulation), and a host of other issues. An important issue is that you would likely want to re-balance the stock/bond ratio in your portfolio back to 50% each year. However, this analysis provides an important rule of thumb.

Put low turnover stock funds in your taxable account and bonds in your IRA. In general, I stay away from high turnover funds because they “cost me space” in my IRA (you can calculate the value of the “space” explicitly).

Good luck.