After-Tax Asset Allocation: Is there a gremlin lurking in your 401(k)?


As Roth IRA and Roth 401(k) retirement plans gain in popularity, unsuspecting investors may fall prey to a potentially expensive mistake. Money in a Roth 401(k) or Roth IRA account can be withdrawn tax free, assuming the withdraw meets IRS requirements. In contrast, withdrawals from traditional 401(k)s and deductible IRAs are taxed as ordinary income when when you take the money out.

As a result, a dollar in a Roth account is worth a dollar at retirement. But a dollar in a traditional retirement account is worth a dollar minus the taxes you’ll pay when you withdraw the money. So what’s the potential gremlin lurking in your 401(k)? It’s treating Roth retirement savings the same as traditional retirement savings when making your investment decisions.

Let’s look at an example to see how this mistake could impact your investments.

After-Tax Asset Allocation – An Example

Let’s assume the following three things for our example:

  1. you have $200,000 in retirement savings, $100,000 in Roth 401(k)s and Roth IRAs, and $100,000 in traditional 401(k)s and deductible IRAs;
  2. You have decided to invest 50% in stock mutual funds and 50% in bond mutual funds (your asset allocation may be different, but using a 50/50 split makes this example easier to follow);
  3. You will pay 25% in taxes when you withdraw funds from your traditional 401(k) and deductible IRAs during retirement.

Now with these assumptions in mind, let’s look at the following example:

You invest $100,000 in stock funds in your traditional retirement accounts; you invest the other $100,000 in bond funds in your Roth retirement accounts.

Have you achieved your desired 50/50 split between stocks and bonds? It may look like you have, but the answer is no. Why?

While your traditional retirement accounts have a balance of $100,000, you will eventually pay Uncle Sam $25,000. So after factoring in taxes, you only have $75,000 invested in stocks. In other words, what you thought was a 50/50 split between stocks and bonds actually is a 43/57 split between stocks and bonds on an after-tax basis.

After-Tax Asset Allocation in Action

So how do we fix this problem? The answer is really simple–implement your asset allocation plan based on after-tax dollars. To do this, you ‘ll need to make an estimate of what percentage of your traditional retirement accounts you’ll pay in taxes. This is very much a guestimate, particularly if you’re young, but I think a reasonable estimate can be made. I’ve chosen 25% for these examples; you may decide on a different estimate that is more appropriate for your situation.

Once you’ve decided on an estimate for future taxes, deduct this from your traditional account balances, and then calculate your asset allocation. In our above example, we want a 50/50 split of the after-tax balance of $175,000. This would mean that we invest $87,500 in stock funds and $87,500 in bond funds, on an after-tax basis.

How do we do this? Well, since no taxes are paid on Roth retirement accounts, we could reduce the $100,000 we currently have invested in bonds in the Roth account down to $87,500. The remaining $12,500 in the Roth accounts would be allocated to stock mutual funds, as would all of the traditional retirement account investments.

At first glance this may seem odd. Under this scenario, we have a total of $112,500 in stocks. But if we subtract the $25,000 in taxes we’ll eventually pay from the traditional retirement accounts, our after tax investment in stocks hits are target asset allocation of $87,500 ($100,000 – $25,000 + $12,500).

Is life too short to worry about after-tax asset allocation?

Particularly if math was not your favorite subject, fussing with after-tax asset allocation may seem like more trouble than it’s worth. That’s my view when it comes to comparing traditional retirement accounts with my taxable accounts. I may pay slightly more in taxes on my traditional retirement accounts, but not enough to worry about, in my opinion.

After state tax, my retirement accounts will get hit with about 21% in taxes. And while the initial investment is not taxed, the vast majority of what I have in taxable accounts is unrecognized capital gains. Why? Because I’m a buy and hold investor who keeps investments for decades.

But now that I’ve just started investing in a Roth 401(k), I believe that after-tax asset allocation is an important consideration. And calculating an after tax asset allocation only takes a few minutes. Here are the steps:

  1. Estimate your future tax rate to be applied to your traditional retirement accounts.
  2. Calculate your total after-tax retirement account balances by subtracting your estimated tax rate from your traditional retirement accounts.
  3. Using the after tax balance, determine how much of each asset class you need to implement your asset allocation plan (you do have an asset allocation plan, don’t you?).
  4. If the investment is held in a Roth account, the amount invested will simply be the amount calculated in step 3, because no taxes will be paid on this money when you take it out.
  5. If the investment is held in a traditional retirement account, divide the amount you calculated in step 3 by the following number: 1 – your estimated tax rate.

A quick example for this last step. Let’s assume your asset allocation calls for 10% to be invested in REITs, and your total retirement funds on an after-tax basis equal $175,000. Thus, you need to invest $17,500 on an after-tax basis in REITs. If the REIT were held in a Roth account, you’d simple invest the full $17,500.

But if it’s held in a traditional account, divide $17,500 by 1 – your tax rate, or in our example, 1 – 25%. Thus, we would divide $17,500 by .75, resulting in an investment of $23,333. And just to confirm that this works, you can subtract our estimated tax rate of 25% from $23,333, resulting in our after tax allocation goal of $17,500.

Some articles on after tax-asset allocation

Here are some articles on after-tax asset allocation that are worth reading if you are interested in pursuing this approach:

Published or Updated: March 19, 2014
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

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