The Roth IRA: You’re Using It Wrong (Most Financial Advisors Are, Too)

Most Roth IRAs are used incorrectly. It’s not only some DIY investors that are getting it wrong, but, based on my experience, a good percentage of financial advisors, too.

In order to understand why most are getting it wrong, it’s important to know the three primary types of investment accounts and how they work. Here’s a quick overview (this is a simple overview. Please do not make any contributions or withdrawals based on it. Talk to your financial advisor and/or your CPA first):

Traditional IRA/401(k): You receive an income tax deduction in the year you contribute and the funds grow tax-deferred. When you make a withdrawal after age 59 ½, the amount withdrawn is taxed at your ordinary income tax rate.

Roth IRA/401(k): You receive no income-tax deduction in the year you contribute but the funds grow tax-deferred, same as in a Traditional account. When you make a withdrawal after age 59 ½, it is tax-free.

Brokerage/After-Tax: Any taxable activity (dividends, income, etc.) is taxed in the year it occurs, and investment gains will either be taxed as ordinary income or more favorable long-term capital gains rates.

Which account is best? Well, it depends because they play different roles. For someone in a higher tax bracket, a Traditional account might be best. For a younger, earlier-in-their-career saver, a Roth might be best, and for someone with a lot of pre-retirement goals, funding a brokerage account might be the way to go because there are no restrictions on early withdrawals.

Leaving aside the question of which is best, it’s undeniable that a dollar in a Roth account is more valuable than a dollar in a Traditional account because there’s no tax bill that at some point has to be paid. The same goes for the Brokerage account. Since the dollars in your Roth are most valuable, you want to concentrate as much growth there as possible, and yet, many are foregoing gains in one of two ways.

Here’s an example of the first way: Over coffee a few weeks ago, an acquaintance was telling me about some trading he was doing in his Roth IRA. All really small companies that he had learned about through friends, family or co-workers. A bio-tech company here, some real estate there, throw in a technology play, you get the picture. I asked him “How has it performed?” His response: “I’m not sure.” He couldn’t say how the account had done over the last year, 3 years, 5 years, nothing.

Trading individual stocks in your Roth IRA is a great way to miss out on growth. As I’ve written about before, going back to 1926, only half of U.S. stocks have returned more than government bonds, and only 4% of stocks have accounted for all the growth in the stock market! The likelihood that you will consistently pick the winners and grow your money faster than the overall stock market is slim. Instead, you should be broadly diversified to stocks in your Roth IRA, and the best way to do that is via a low-cost index fund. Skip the individual stocks.

The second way we get it wrong (and I say “we” because I’m referring to the broader financial planning/wealth management industry) is by investing all your accounts the same way. Here’s a simple example:

Imagine a client with $500,000 to invest spread across three accounts: $100K in a Roth IRA, $200K in a Traditional IRA, and $200K in a Brokerage account. Conveniently enough, the financial plan we created together calls for them to be invested in our Beacon 60 model, which places 60% of their funds in stocks and 40% in bonds (with some cash). Many in our industry will invest the three accounts the same–60% in stocks and 40% in bonds–depicted below:

The issue here is the bonds in the Roth IRA. Get them out! All they are doing is hampering the growth of your most valuable account. Instead, the Traditional IRA should have a heavier weighting towards bonds while the stocks should be consolidated in your Roth IRA and Brokerage account, as you can see below:

This is referred to as “Asset Location”, because it “locates” different investments in different accounts based on two criteria: tax-efficiency and growth potential. The assets that tend to grow more, stocks, go into the accounts you want to grow more: Roth accounts, primarily, and Brokerage accounts, secondarily. The more tax-inefficient assets, bonds, go into Traditional accounts to shelter you from taxes. So, while each account looks different, your overall allocation remains pegged to the investment model that gives your financial plan the most confidence.

So, what do you do with this information? First, if you (or your advisor) are trading stocks in your Roth IRA, considering ceasing or at least using a different account; your Traditional IRA is probably a better choice. Second, look at how your accounts are invested. If all of your accounts are invested the same, ask your advisor why, and if there are bonds in your Roth IRA, definitely ask why. While there are a few reasons to hold bonds in your Roth accounts, like maintaining the proper asset allocation, by and large it should be avoided.

My experience tells me that most investors and financial advisors miss this kind of low-hanging fruit. Don’t squander your Roth IRA. Use it right.

Have a great weekend!

Ryan Smith
[email protected]

Born and raised on the North Shore of Massachusetts, I moved to Raleigh in 2011 to marry my wife, Emily. We have two kids, Jack and Gwen, a golden retriever named Olly, and are members of Church of the Apostles. I have been a Financial Advisor since 2005 and earned a Master’s of Science in Financial Planning from Bentley University in 2007. I became a CFP® professional in 2009, a Retirement Income Certified Professional® in 2015, and a Certified Tax Specialist™ in 2023.