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Paying It Forward

Jonathan Clements

ROUGHLY A QUARTER of my investment portfolio sits in three Roth retirement accounts. Ever since I first funded a Roth a dozen years ago, I’ve thought of this as money I’d avoid spending for as long as possible, so I milk maximum gain from the tax-free growth. But lately, it’s dawned on me that it’s highly unlikely I’ll ever dip into these accounts—and that realization has triggered a slew of investment decisions.

My three Roth accounts are all at Vanguard Group. They consist of a solo 401(k) that I continue to fund each year, a nondeductible IRA I converted to a Roth in 2010, and a rollover Roth 401(k) from my time at Citigroup. Because a Roth’s growth is tax-free, that’s the place where you want to earn your portfolio’s highest returns—and that’s why I have my Roth accounts invested 100% in stocks.

But until December, I managed my Roth accounts as part of my overall investment portfolio. That meant I used my Roth to own part of my portfolio’s allocation to, say, small-cap value stocks, small-cap international stocks, emerging markets and so on.

Now that I realize I’ll almost certainly never spend my Roth accounts, and instead they’ll go to my two children, I’ve changed my approach. In essence, I’m now managing two portfolios—the Roth accounts that my kids will inherit and the rest of my portfolio, almost all in a traditional IRA, which will fund my own retirement.

To be sure, a Roth isn’t quite as good an inheritance as it once was, now that Congress has nixed the ability for many beneficiaries to draw down inherited IRAs over their lifetime. Still, for my kids, my Roth accounts will come free of income taxes, plus they could get 10 more years of tax-free growth from the accounts after my death.

Meanwhile, as I’ve written about before, I’m aiming to simplify my investment portfolio—and, indeed, my overall financial life—as I look ahead to retirement. In my recent portfolio revamping, I didn’t change my asset allocation. I still have the same percentage in U.S. stocks, foreign shares and bonds, and I kept my various portfolio tilts, such as overweighting smaller companies, value stocks and emerging markets.

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But I moved all of these portfolio tilts to my traditional IRA—and invested each of my three Roth accounts entirely in one fund. It’s a fund I believe I’ll be happy to hold for the rest of my life, and this part of my portfolio shouldn’t require any maintenance whatsoever. The fund: Vanguard Total World Stock Index Fund, which is available both as a mutual fund that charges 0.1% in annual expenses and as an exchange-traded fund that costs 0.08%.

The fund represents, I believe, the ultimate in stock market diversification. With it, you get exposure to every stock around the world of any significance. Right now, the fund has roughly 60% in U.S. stocks, 30% in developed foreign markets and 10% in emerging markets. It represents the global market portfolio for stock investors—a single fund that holds what all other stock investors hold and in the percentages that they collectively hold them.

Does my strategy have drawbacks? I can think of five:

  • I may be wrong and end up needing the money. This doesn’t strike me as a huge issue. Until I shuffle off my mortal coil, the money remains mine and, if it looks like I’ll need to tap my Roth, I should have plenty of warning, so I can dial down the risk level.
  • In terms of fund expenses, it would be slightly cheaper to own a separate total U.S. stock market index fund and a total international stock index fund. But I’m happy to pay a few more pennies each year per $100 for simplicity.
  • I’ll miss out on the potential performance bonus that could come from earmarking, say, 60% for U.S. stocks and 40% for foreign stocks, and thereafter regularly rebalancing back to those target percentages, thus selling high and buying low. But again, for this money, my goal is simplicity, plus zero ongoing maintenance.
  • My less rational side—the part that thinks it has some sense for where markets are headed—feels Vanguard Total World is too exposed to the U.S. market and to the biggest U.S. stocks, especially tech companies. But the fact is, Vanguard Total World reflects the collective judgment of all stock investors around the world. They’ve voted with their buys and sells, and this is what they’ve chosen to own. Who am I to question their judgment?
  • Congress could institute required minimum distributions for Roth IRAs, which means I’d be forced to draw down the account. I hope that doesn’t happen, but there isn’t a whole lot I can do about it.

Many—and perhaps most—parents strive to leave behind something of value for their kids. Still, I consider myself to be in a privileged position. I can’t give my kids full financial security and, in any case, I’m not sure that’s desirable, because we all need something to strive for. But I can give them the sense that, down the road, a financial safety net awaits them. It’s my gift to my kids. My hope: They’ll pay it forward to their children.

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.

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Art Lyle
Art Lyle
4 months ago

Regarding “ROUGHLY A QUARTER of my investment portfolio sits in three Roth retirement accounts.”: Why did you chose this fraction?

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  Art Lyle

I didn’t choose that fraction. That’s just how things have turned out. If Roth accounts had been available from early in my career, I’d have probably aimed for more like 50% Roth-50% traditional retirement accounts.

John Enright
John Enright
4 months ago

Thanks for the informative post Jonathan. I really like the concept of carving out the Roth savings that my wife and I can earmark for our kids from the rest of the portfolio that we will most likely use and need to balance.

May I ask what rough stock/bond mix you target in your portfolio? I apologize if I missed that somewhere in another post.

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  John Enright

Today, I’m at roughly 80% stocks and 20% bonds — probably a bit high for somebody who is almost 60. But I’m still working, plus I have two pools of cash that aren’t included in those percentages: the mortgage I wrote for my daughter and the proceeds from selling a piece of real estate that I hope to receive in the weeks ahead.

John Enright
John Enright
4 months ago

Thanks for sharing that. I’m at 60/40 stocks/bonds but already into the official retirement phase. With the bond outlook seemingly not so great, I’ve been considering taking on a bit more risk by shifting slightly. That is also why I liked carving out the Roth part of the portfolio that is looking like it could go the kids. That way I can keep “our” part at 60/40 and feel like I’m at least being a little more aggressive with the Roth portion.

Harold Tynes
Harold Tynes
4 months ago

Jonathan, Thanks for the great article. This affirms my strategy of converting my IRA’s (Roth and Regular) to all equity. I previously included my IRA accounts in my overall portfolio balancing of fixed income and equity. My financial advisor had suggested a “bucket” approach to portfolio allocation and if you don’t intend to spend down the investment, it belongs in an equity investment. I did not get it for several years. The light went on when it became apparent that I may not need to spend down my IRA accounts. I’m not sure if I’m ready to go to one fund, yet. I still like the Dimensional approach (especially with their EFT’s) with a value tilt and more international exposure.

steveark
steveark
4 months ago

I think the most likely thing for you, and for anyone who planned well, is not only will you not touch your ROTH accounts but you’ll also never decrease your other accounts. Anyone using a safe withdrawal rate has an excellent chance of doubling their money across their retirement since the safe withdrawal rate is based on an extremely unlikely set of worst case outcomes. Sounds like an excellent plan and your and my progeny will think back on us kindly some day!

booch221
booch221
4 months ago

So which bond funds do you invest in, Jonathan?

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  booch221

I split my bond money between a short-term inflation-indexed bond fund and a short-term federal government bond fund.

Brent Wilson
Brent Wilson
4 months ago

Great post. Your decision to invest in the Total World Stock Market fund reads like some threads I’ve read on bogleheads forums. But that’s not a bad thing!

I’m not retired, but I think about asset allocation similarly as it relates to our daughter’s 529 plans. As college approaches, these accounts will become more conservative than our other accounts earmarked for retirement. In the account aggregator I use, Personal Capital, when I consider our retirement asset allocation, I exclude the 529’s.

SanLouisKid
SanLouisKid
4 months ago

We don’t have kids, so we probably have a lot more money saved up (humor intended). My part of our estate will go to charity. My wife is giving her part to a sister and also charity. I am tempted to draw down my Roth since it will probably increase my other investments (primarily in an IRA). Not drawing down my IRAs (other than RMDs) will let them grow and the eventual tax hit will be mitigated by it going to charity. That’s assuming my logic is correct. I’m open for comments.

graphex
graphex
4 months ago
Reply to  SanLouisKid

SanLouisKid, something to look at is that when you are 70.5, you and your wife can each make up to 100K donations from your IRA accounts. RMD’s must start when you’re 72 so these donations would reduce your account balances and in turn, reduce your RMD’s when you are required to take them. You don’t get any tax deductions for these donations (you got the tax benefits when the money went into the retirement accounts) but seeing benefits of your donations while you’re around might be cool.

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  SanLouisKid

That sounds like the right strategy — a charity won’t owe taxes on your traditional IRA (or anything else you leave the organization).

AnthonyClan
AnthonyClan
4 months ago

I plan to use my Roth to provide additional income when I approach the top of a tax bracket. It will be last bucket to spend from. So also part of my long term care self insurance.

An
An
4 months ago
Reply to  AnthonyClan

Tax deferred money should be used for LTC expenses instead of Roth money. That way can itemize the large LTC expenses to offset taxes on tIRA withdrawals.

Mike Feeney
Mike Feeney
4 months ago

Jonathan, I see another drawback, if I understand taxes/IRAs/inheritance correctly — a big “if”.

Assigning your stock allocation to the Roth (or, a regular IRA), means your bond allocation is in taxable accounts. Therefore, you pay taxes on the income generated from the bonds…that could be avoided on bond holdings in an IRA.

Of course, income from bonds, in current investing environment, is microscopic.

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  Mike Feeney

As I noted in the story, most of my money is in traditional IRAs. That’s where I hold my bonds. That money will be taxed eventually, but — in the meantime — everything grows tax-deferred.

Jim Burrows
Jim Burrows
4 months ago

If you are looking for simplicity, why three Roth accounts?

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  Jim Burrows

As I mentioned in the story, one’s a solo 401(k), one is a rollover from an old 401(k) and one is the result of an IRA conversion. The solo 401(k) is obviously a different sort of account. While I didn’t request that Vanguard separate the conversion Roth from the rollover Roth — Vanguard simply did it that way — my understanding is that there can be legal advantages to keeping a 401(k) rollover separate because it can potentially enjoy the greater legal protection accorded to accounts established under ERISA.

wtfwjtd
wtfwjtd
4 months ago

Only problem there is, 401k Roths are subject to RMD’s, which may or may not fit into your overall strategy. It’s definitely something else to keep in mind. As for a rollover 401k, it doesn’t matter where the funds came from–once it’s in a Roth IRA, it’s in a Roth IRA, and once you’re 59 1/2 AND the (Roth IRA)account has been open 5 years, there is no tax (or legal) distinctions to consider. You might have been thinking about the old “conduit” IRA concept, which AFAIK has been made a mute point with the slew of changes implemented by Congress in the last dozen years or so.

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  wtfwjtd

Because I’m still funding the solo 401(k) and because I’ve got a dozen years until I’m 72, the potential RMDs aren’t yet an issue. I plan to roll over the account to a Roth IRA long before then.

John Goodell
John Goodell
4 months ago

That is the same fund I use in the same account for effectively the same reasons.

William Perry
William Perry
4 months ago

Thank you for another thoughtful article. As a over age 70 CPA in public practice who still helps people with their personal income taxes I have been fortunate to observe how people choose to pass wealth and good financial habits to their children. Many of the success stories involve current gifting with an extracted moral, but not legal, promise by the adult child to fund their own retirement accounts on a regular basis for an extended period of time. That commitment is often in the form of a annual dollar for dollar gift match of the retirement contributions made by the adult child or a significant current cash gift of a home down payment or entire home purchase price cost with a commitment by the adult child to fund a maximum 401(k)/IRA contribution until they have contributed as much to their own retirement account as was gifted to them. A parent making such living gifts are usually happy with positive outcomes and if not happy with the financial outcome either the adult child has learned a valuable lesson before they inherit the bulk of an estate or if not the parent should have learned they need to change the manner of transferring any remaining estate assets. After years of funding retirement accounts by the adult children a lifetime habit is hopefully established and then passed on the next generation. The usual downside of making the large gifts is filing any required gift tax returns which usually end up being compliance only with no current tax, at least for federal gift tax returns.

Jim Bourg
Jim Bourg
4 months ago

Our portfolio is roughly 1/3 each across Roth IRA, Traditional IRA and taxable accounts (took about 15 years of partial Roth conversions and willingness to accept income taxes over those years to get there).

For the last several years, we’ve been ‘paying it forward’ incrementally by dribbling our Roth funds to our kids each year in our Roth withdrawal amounts that equal the maximum that each child can contribute to a non-deductible Traditional IRA ($6000) followed by an immediate backdoor Roth conversion by them in their accounts. Maximal tax benefit of this approach for the recipients requires that each recipient child have zero existing balance in Traditional IRAs each year when the child makes the Traditional IRA contribution and subsequent immediate Roth conversion using our gifts.

It took a couple years worth of Roth conversions by our kids to get to the point of zero balance Traditional IRAs (we helped share the children’s conversion tax burden while their Traditional IRA balances were still low and it made tax sense). Once there, Roth funds targeted for kids in our accounts could be successfully transferred at zero/near zero tax cost to the recipient children thus extending the tax free growth period of our Roth funds from 10 years at our deaths to the children’s lifetime.

Our Roth position and the zero-balance Traditional IRA positions of our children allow this approach to work well (and it took work to get there), effectively bypassing the current 10-year distribution requirement of inherited Roth IRAs. Like Jonathan, we do not have the means to pass on full financial security to our children ( we are far from it). These annual incremental ‘pay it forward’ transfers feel right for us and our kids. Over time the annual incremental $6k/child moves have added up. When/if the back door Roth conversion regulations change, this particular jig will be up.

Jim Bourg
Jim Bourg
4 months ago
Reply to  Jim Bourg

Failed to explicitly state in the above that my 30-something, early career ‘kids’ have a first world problem of too-high incomes to make direct Roth contributions which requires the back door Roth approach.

R Quinn
R Quinn
4 months ago

Amen. My good fortune has no better goal in my opinion than to provide some assistance to our children and grandchildren. They won’t live on it, but hopefully will help with their retirement.

Donny Hrubes
Donny Hrubes
4 months ago
Reply to  R Quinn

Yes Sir Richard, I do agree with helping along when you can.
I’m 70 and I did turn on an income from my Roth, as my plan is a little different from what I’ve read here.

My Roth money goes in to my Trust account which also has paid off rental cash flow . I make a monthly gift transfer to my two sons with the stipulation, that amount is invested in their own Roth’s.
My Roth, with it’s gifts pays for theirs and in 30 years will be far far greater than what my own will provide if I just let it lay.

What? 30 years!!? Well, the Trust will still continue to hold homes that provide income. I’ve got free time to work on increasing the holdings. When I die and the ROTH payments discontinue, the boys are the trustees and simply let the automatic gift transfers continue.

Now, they don’t have to do that but hey, I tried! Of course it’s all about ‘Passing it Forward’. I do believe they’ll do what is right for the G kids and pass it on down.

AnthonyClan
AnthonyClan
4 months ago
Reply to  R Quinn

I received a small gift in my late 20’s from my grandparents that allowed me to purchase my first home. I used it as my down payment. This kick started an upward financial spiral that has culminated in a comfortable retirement that I now enjoy. Gifts at the right time can make a life changing difference.

Sabine Nooteboom
Sabine Nooteboom
4 months ago
Reply to  AnthonyClan

I totally agree: timing is so important. My sister and I each received an inheritance from our grandfather in our 30s that allowed us to purchase our first homes, ones that were nicer than we would otherwise have been able to afford in the high interest rate environment of the 1980s. My husband and I still live in that home. Later inheritances have made very little difference to the quality or trajectory of our lives, but did allow us to increase our charitable giving.

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