Please Don't Put Bonds in Your IRA!

The popular financial advice is to put bonds in your IRA (or 401(k)). (Frankly, I would never recommend owning these slow-growth "securities" for other than short periods in unusual market conditions, but that's a topic for another rant.) The reasoning goes like this: IRAs are tax-deferred accounts, meaning that the contents within grow tax free; since taxable accounts tax interest, they will result in slower-growing bond balances.

The reasoning is correct: if one reinvests interest from bonds in the purchase of more bonds, then bond balances will indeed grow more slowly in a taxable account rather than a tax-deferred account. So why would I recommend that you pay the tax? Because by paying taxes on these low-return securities, you will be able to leave your high-return securities in the IRA, to grow taxfree. Yes, over time, your bond holdings will occupy an increasingly small proportion of your portfolio. If you believe in dilutive diversification (in which your portfolio's high-return securities are constantly diluted by its low-return securities as a result of goofy "rebalancing" manoeuvers recommended by your broker), then this is a problem. But your lack of courage does not deter me; I'm here to tell you how to supercharge your IRA. If you can't ride this bull, then watch your friends get rich and enjoy the entertainment.

Let's do the math.

If you're lucky, bonds have a 7% pretax yield. (These days, with the Fed funds rate under 1%, this is dreaming, but they've been there before and will again.) After taxes at the 25% bracket, we're down to 5.25%.

The S&P 500 has averaged around 10% pretax, included reinvested dividends, for all of its history. After 25% taxes on dividends (nevermind the current rate of 15%, which is a historical anomaly), it's close to 8.5%. (It's not 7.5% because some of the gains is capital appreciation, which is untaxed until sale. Bonds held to maturity don't have capital appreciation, by definition.)

In the limit of a long time horizon, we know that one of these investments will outstrip the others by an increasing margin. Why? Because that's what different exponents do as they grow toward infinity: their ratio also grows toward infinity. So we have 2 choices: (1) An 8.5% stock growth rate in a taxable account and a 7% growth rate in a tax-deferred account or (2) A 10% stock growth rate in a tax-deferred account, and a 5.25% growth rate in a taxable account.

Assuming that we invest equally in both (because, after all, our lame investment advisor told us to "diversify"), I choose #2. The reason is that, over time, a 10% return will beat an 8.5% return plus a 7% return -- even without any help from the 5.25% aftertax bonds! How much time depends on your contribution pattern. But the point is that, eventually, the 10% return will dominate your portfolio, and more importantly, your portfolio will be larger than if you had dumped the stock into the taxable account.

But it's better than that: if you ever sold any of the stock in the taxable account, you would be taxed on growth at the capital gains tax rate, which is currently 15% and probably due to rise to 20%. This taxation, which might occur several times before retirement, would lower the 8.5% posttax growth rate to something less. So by keeping the stock in the IRA, we eliminate this problem entirely. We need only worry about bid/ask spreads and commissions. (Better yet, buy highly efficient index funds and never sell. More on that in another article.)

It gets better still. History has shown that if you invest in certain asset classes -- in general, those that are more volatile but contain companies with large earnings and/or dividends relative to their stock prices -- you will be rewarded over time with substantially higher returns. Mostly, I'm talking about smallcap value (small stocks with attractive earnings) and emerging markets (wild, unregulated, and sometimes dishonest companies in banana republics whose only way to get investors to trust them is to pay fat dividends). Do this, and your 10% goes to 14%, or perhaps 17%. Granted, these numbers are all historical. In the future, the hot money might be made in Moon real estate. But generally speaking, the more volatile the underlying security, the greater the longterm return, provided that you purchase it at a sufficiently low valuation ratio (price-earnings ratio, yield, or similar metric).

Yes, you do have to pay taxes when you cash out of the IRA. But, given enough time, this one-time hit does little to affect your longterm growth exponent, or more to the point, your net cashout value. And if you follow my recommendations for slowly converting to a Roth, your tax burden should be low.

Why is it so simple to make so much money?! I have wondered this for a long time. I think the reason is that most people -- even young people with plenty of time to recover from stock market crashes -- mistake volatility for risk. Volatility has nothing to do with risk, in the longterm. Yes, in the shortterm, it's risk. But over the longterm, the risk vanishes into a fairly consistent return.

Now, to be fair, there are some assets which are highly volatile, but offer little longterm reward, such as small "hot growth" companies that have no earnings; and gold, which is virtually the definition of "inflation" magified by tons of random noise. There are also relatively stable asset classes with very attractive longterm growth rates, such as some real estate invesmtent trusts (REITs). But, generally speaking, the stock market pays people to endure volatility. Some people think that the stock market pays people to take risk. I don't think that this is true, in the big picture. It's just that most people confuse longterm volatility with longterm risk. In my view, there's nothing risky about investing in an asset class that has returned 17% annually for decades running, provided that one is investing for the longterm, and enters the market at a sane price relative to earnings.

Now, you might ask, what if you don't have a longterm horizon before retirement? In this case, you might not want to invest in volatile asset classes. (This is the conventional wisdom, with which I don't agree, but I'll explain that in a later post. I just put it out as a warning for investors who fear taking loans to supplement income during downturns, and would rather live a predictable life in bond-induced poverty.) Nevertheless, I think that you will probably fare better with your stocks in an IRA and your bonds in a taxable account, as opposed to the other way round.

What's that? You have 7% taxfree muni bonds? Good for you. Leave them in your taxable account because, well, they aren't taxed anyway. Now, if you have bonds yielding 26% because you bought them from some bankrupt company that came back from the dead, then, OK, leave them in your IRA.

By the way, sell your slowest- growing assets first for the most stable retirement. (I want to give you better advice, which is "don't invest in anything but the assets most likely to produce the highest returns over the longterm". But most people can't take that. So at least, do yourself a favor and liquidate the money market account before the IBM shares, OK?) Conveniently, this usually means selling your most taxed assets first. Isn't it amusing how the most taxed assets also happen to be the slowest-growing to begin with? Is life unfair, or what? The sucker who lends money to his bank at 2% gets hit with a 25% tax bill, whereas his friend makes 12% in stock apprection and dividends, and keeps 11% after taxes on the latter. What can I say? It pays to have an iron stomach. (I say that as though it takes courage to lose money on longterm high-growth assets. It doesn't, unless you're ignorant of longterm trends and don't understand the difference between volatility and risk. I've lost 65% in this crash and I'm feeling fine, because I understand that eventually the market will turn higher, and the longterm return trends will resume, more or less. If I can earn a buck on this blog, I'd be more than happy to buy some of the downtrodden index funds out there.)

If you don't want to take my advice, then diversify: Own stocks, bonds, dirt, outdated milk, soda cans, buttons, and broken car parts. Make sure that stocks compose a tiny percentage of your portfolio, so that you'll be protected from any negative move in the markets. And if there's ever a shortage of buttons, you'll be covered. Oh, and put the soda cans in the IRA. That way, you'll be able to trade the aluminum market with no tax ramifications!