Mailbag: How Should I Invest a Roth IRA that My Children Will Inherit?

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Roth Treasure

I have a question on how to structure the investments in my Roth IRA. I don’t plan on using it for retirement, and hope to pass it on to my children. Should it be invested aggressively, like 100% equities, or use the same split as my taxable investments, such as 50-50 stocks vs bonds? Another way to look at it is whether it stands on its own, or is considered as part of my overall portfolio.

Roth Happy

Great question! I’m going to try to answer it generally and then apply your situation.

Even if you needed all of the money in the Roth IRA for spending during your retirement, we would still recommend that the Roth be 100% in equities.

Even if your appropriate top level asset allocation were 50% bonds and 50% equities (e.g. age 85) we would recommend that the Roth be part of your 50% equities.

 

Taxes owed on the capital appreciation in various accounts are in this order:

  1. Traditional IRAs (ordinary income, e.g. 28%)
  2. Taxable account (capital gains rate, 15% (2012) 20% (2013))
  3. Roth account (0%)

Since Roth IRAs have no tax owed on capital appreciation, they should be invested aggressively.

 

Spending in retirement is usually in this order:

  1. Taxable account
  2. Traditional IRAs
  3. Roth IRAs

Since Roth IRAs are the last to be spent, therefore they have the longest investment horizon and should be invested aggressively.

 

Finally, there is no reason that money you aren’t going to spend in your lifetime needs to grow more conservative as you age.

We recommend that you put 5-7 years of what you will be spending from your portfolio in bonds and the remainder in stocks. For those those are spending down their portfolio by age 100, this rule naturally grows more conservative. At age 65 you might have 25% of your portfolio in bonds in order to cover the next several years of safe spending rates. But by the time you are 95, you have everything in bonds as you have less than 7 years of spending remaining in your portfolio. For those who want to be very conservative, put 10 years of spending in bonds.

But if you don’t need to spend anything from your portfolio (say because you have a military pension sufficient for your needs) then you are free to put 100% of your portfolio in stocks at any age. You are in essence managing the money for your children or grandchildren. Oddly enough, you are also free to put the entire portfolio in bonds if you wanted to. You do not need the money and therefore you do not even need to keep up with inflation. You could put the entire portfolio in your mattress if it would help you sleep at night.

 

So to answer your question directly: I would recommend that you invest the Roth account mostly in equities and then invest the remainder of your portfolio according to appropriate asset allocation mix for your age and spending. That might be 50-50 or putting 5-7 years of spending in bonds. You might even put 10 years in bonds.

Finally, I would recommend reading Maximum Safe Withdrawal Rates in Retirement to see where you stand in withdrawals and stock-bond mix.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)