EDIT: See discussion below. It's not actually a fallacy. But it's still true that any time we ignore taxes in our asset allocation, by favoring stocks in a Roth vs a traditional, our portfolio is riskier than we intended (unless our tax rates over all withdrawals is zero). It may not be much riskier if our tax rate over all withdrawals is approximately zero, and in that case could safely be ignored. But it's something most people should consider in their asset allocation.
I've seen this numerous times on this forum and I'm getting tired of repeating myself, so I'm going to try to explain it clearly once here.
There is zero reason to favor stocks in a Roth IRA and bonds in a traditional IRA*.
Well that doesn't sound right does it? I mean, stocks have much more growth potential! Shouldn't they go into a Roth IRA because I won't be taxed on the withdrawals?
Those are all true statements. But that's not the point. The point is by doing so you're overweighting stocks and underweighting bonds on a tax adjusted basis, and thereby taking more risk than you intended.
By example:
You are 62 years old. You want to be 50/50 stocks bonds. You have $5000 in a tIRA and $5000 in a Roth IRA.
You put your stock allocation in your Roth and your bond allocation in your tIRA.
Well you now have an emergency and you want to withdraw all of your money. Now I'm going to make this example incredibly unrealistic. It makes it easier to see my point. Assume the tax rate on your tIRA withdrawal is 90%. So after taxes, you only have $5500.
Well, of the $5500, where'd the money come from? $5000 came from your stocks in your Roth IRA. $500 came from your bonds in your tIRA.
So were you really invested 50/50 stocks bonds? Not on a tax adjusted basis you weren't. You were 5000/5500 = 90.9% in stocks and 9.1% in bonds on a
tax adjusted basis.
To truly be 50/50 stocks/bonds here you would need to have $5500/2 = $2750 in stocks in your Roth IRA, $2250 in bonds in your Roth IRA, and $5000 of bond in your tIRA.
Another example. Let's throw in some market volatility. Because one of the biggest reasons to set an asset allocation between bonds and stocks is reduce the volatility of your portfolio.
Start with a desired 50/50 allocation of stocks and bonds. $5000 in the Roth and $5000 in the traditional.
You don't tax adjust your asset allocation so you have all of your Roth in stocks and all of your bonds in traditional.
The market tanks 50%. Now your Roth balance is $2500 and your traditional balance is $5000.
You withdraw everything. Again, for illustration purposes, the marginal tax rate on tIRA withdrawals is 90%.
You end up with $2500 + 0.1*$5000 = $3000.
Now, the entire point of having a 50/50 asset allocation is to reduce the volatility of your portfolio. Your portfolio was really worth $5500 to you
after taxes before the market crash. We established this in example 1. But you set your portfolio to be 50/50
before taxes. And now after the market crash you only have $3000. If you really had a portfolio
that had the risk of a 50/50 allocation, you'd have 75% of that initial tax adjusted $5500 (because 0.5*0.5+0.5 = 0.75). Which would be $4125. But you don't. You only have $3000.
So what was your tax adjusted allocation before the crash?
90.9% (5000/5500) stocks
9.1% (500/5500) bonds.
The stocks dropped 50%, so you'd have .5*.909 + .091 = 54.55% of your original tax adjusted portfolio value. Which is $3000.25. Which is the $3000 you have after your withdrawals (I rounded the 90.9% and 9.1% so there's 25 cents extra there). So you were not 50/50 on a tax adjusted basis. You were 90.9/9.1.
Now I calculated in the previous example that to be 50/50 on a tax adjusted basis, you'd need to have:
Roth:
Stocks $2750
Bonds: $2250
tIRA:
Stocks: $5000
Post market crash you have
Roth:
Stocks: $1375
Bonds: $2250
tIRA:
Bonds: $5000
You withdraw everything with the tIRA withdrawal taxed at 90%. So you have 1375+2250+.1*2500 = $4125. Which is exactly the amount I said you'd have if your portfolio had the risk of a 50/50 allocation. You have 75% of your initial tax adjusted $5500.
Now obviously, it's basically impossible to predict what your tax rate will be on your withdrawals. And nobody here is planning on withdrawing from their entire IRA all at once. But that's not the point. The point is that what you really care about in the end is how much money you have to spend after taking into account taxes, and the volatility of this after tax amount. Yes, many of us here are planning on using the Roth pipeline. But you pay taxes on that too*.
*The only time that the favor stocks in Roth and bonds in traditional isn't a fallacy is when your tax rate of your traditional withdrawals is zero**. But it has to be zero for ALL of your traditional withdrawals for that to be true. And for most people here, even with the Roth pipeline and whatnot, it will not be true. It may be close enough to being true that you can ignore tax adjusted allocation. And that's fine. But to blindly follow and give out advice that you should favor stocks in a Roth because of the tax free growth without considering taxes is not.
For more reading, see
http://www.bogleheads.org/wiki/Tax-adjusted_asset_allocation
