Roths Challenge the Conventional Wisdom on What to Put in an IRA

In recent months, financial columnists nationwide have quoted experts suggesting that income investments belong in tax-favored accounts, since these benefit relatively more from the tax savings than do equity investments.

A new study questions this reasoning, at least for long-term investors. The Roth individual retirement accounts add a powerful new twist to the calculation.

The conventional wisdom has been that investments that throw off annual income--bonds, high-dividend stocks or money market funds--are particularly good for IRAs or 401(k) accounts, since the regular income they produce would otherwise be fully taxed every year.

The reasoning goes that it’s better to keep equities or equity funds out of IRAs because tax rates on capital gains are lower than on interest income, and stock dividends usually are a minor factor.

Additionally, losses--more likely in equity funds--can be deducted from regular income only if they are incurred in a taxable account. And finally, the investor has control over when to take a capital gain in a stock or, to a lesser extent, a stock fund, and can hold such investments in a taxable account indefinitely, without paying a gains tax.

But with the arrival of the Roth IRA, some question this wisdom. “That thinking still holds with a traditional IRA,� said Joel Dickson, an investment analyst at Vanguard Group in Valley Forge, Pa. But not for the new Roths, he said.

Steve Norwitz, a vice president at T. Rowe Price Associates, a Baltimore fund group, said T. Rowe Price ran some numbers to compare taxable accounts and Roth IRAs.

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The firm’s analysts found that the tax-sheltering effects of the Roth make it a better spot for equities and equity funds--assuming, of course, that they continue to outperform bonds in the long run.

The study supposed that you owned both a typical growth stock fund and a bond fund for 20 years, earning the same returns you would have reaped in the 20 years ending Dec. 31, 1996.

It further assumed that you fell into a 28% federal tax bracket for ordinary taxes and that you placed either fund, but not both, in a Roth account.

If you had invested a $2,000 lump sum in a bond fund in a Roth IRA and another $2,000 in a growth fund in a taxable account, your total portfolio would have swelled to nearly $33,400 after 20 years. But if you had switched the order, putting the growth fund in a Roth and keeping the bond fund unsheltered, the portfolio would have been worth $41,400.

Although you would have paid taxes each year on the bond fund’s dividends and capital gains, you would have reaped a greater benefit by sheltering the growth fund’s greater profits.

“It’s most important to take those higher returns on a stock fund and compound them in a tax-free account,� Norwitz said.

It should be noted that the typical growth fund probably will not continue to earn the 15.36% average yearly rate that was generated during the last 20 years. Nor will the average bond portfolio score an 8.68% annual compounded gain, as happened over the two decades ended Dec. 31, 1996.

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But as long as the stock fund beats its bond rival by roughly 2.5 percentage points a year or more--the historical pattern--the strategy outlined above would work, Norwitz said. A growth and income fund would make sense for Roth IRAs under the scenario above if it beat a bond fund by about 2 percentage points annually, Norwitz said.

Ed Slott, editor of a new newsletter on IRA investing and a certified public accountant in Rockville Centre, N.Y., agrees with the conclusion of the T. Rowe Price study. “I’d want to be most aggressive in the Roth IRA,� Slott said.

Both the Roth IRA and a regular taxable account have advantages when it comes to capital gains. But funds taken from a traditional IRA at retirement face ordinary income taxes, often at higher rates than capital gains taxes. That is an argument for putting bond funds, if you decide to have any, in a traditional IRA.

The decision of what assets to put in what kind of IRA is also complicated by other factors--future tax rates and the length of time your money will accumulate.

Slott also pointed out that Roth IRAs offer an estate-planning edge over regular IRAs, because no taxes would be due at death (although the account would be included in a person’s asset total, so estate taxes could apply).

Similarly, some individuals may still find benefits in holding equities outside an IRA, especially stocks or funds with large unrealized capital gains. For example, these holdings can be used for charitable donations or, like a Roth, escape regular income taxes after death.

The notion of what to put in a Roth IRA is likely to remain subject to individual situations. Tiburon, Calif.-based investment advisor and author Stephen Janachowski said he agrees that T. Rowe Price’s line of reasoning makes sense, but he still favors holding funds that pay generous dividends and income “within Roths, or any other type of IRA for that matter.�

That sentiment was echoed by Margie Mullen, a certified financial planner in Los Angeles. “I belong to the school that does recommend keeping bond funds in IRAs,� she said.

The study certainly is another argument for taxpayers opening a new IRA to consider a Roth if they are eligible. (Income limits apply.) “With a Roth IRA, you don’t have to worry about turning capital gains into ordinary income,� said Dickson.

And as long as you believe stocks will significantly outperform bonds between now and the time you need your retirement funds, the T. Rowe Price study certainly suggests that you should juggle your assets so that equities are in a Roth IRA. The case for doing so with a traditional IRA is weaker. And the question of whether to roll over a traditional IRA into a Roth, which requires paying regular income taxes if you are eligible, is more complicated still. If you have a long time horizon, the study suggests that even this may be worthwhile.

But while you may decide to be fairly aggressive in a Roth IRA, your more speculative investments might still be better in a regular taxable account.

“If you do suffer a loss inside an IRA, it’s not deductible,� said Slott.

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Daniel Gaines is The Times’ Markets Editor. He can be reached at [email protected]. Russ Wiles is a mutual fund columnist for The Times and co-author of “How Mutual Funds Workâ€� (Simon & Schuster). He can be reached at [email protected]