Gyroscopic Investing

Suppose you run a VP alongside the PP. This post argues the best place (Taxable, Roth, or Tax-Deferred) to put the VP relative to the PP depending on an investor's circumstances. Please review my logic, critique, and leave comments/questions.

Imagine these possible investors:

INVESTOR 1:
Has little to no taxable investments. Everything is between Roth and Tax-Deferred retirement accounts.

INVESTOR 2:
Has taxable investments. Also has Roth accounts and Tax-Deferred retirement accounts.

INVESTOR 3:
Has taxable investments. Also has Roth accounts. No Tax-deferred.

INVESTOR 4:
Has taxable investments. Also has Tax-deferred accounts. No Roth.

(NOTE: Ignoring the possibility of someone with only Taxable, only Roth, only Tax-deferred because there's no decision to be made as this investor only has one place to put both their VP and PP.)

KEY CONCEPTS:

1) A Roth account makes sense, when available, to put the highest returning investment due to all earnings being tax-free.

2) A tax-sheltered account (whether it be Roth or Deferred) makes sense relative to taxable, for positions you rapidly trade and do not hold longer than one year, due to the higher short-term capital gains tax rate. A VP is likely something that falls under the category of positions that will be held under one year.

3) An investor/speculator expects the VP to outperform the PP. Otherwise, that person wouldn't be putting money into a VP. If you expect your VP will underperform your PP, you would be 100% PP except in rare specialized cases discussed in an end note of this post.

RECOMMENDATIONS:

INVESTOR 1: No Taxable, Yes Roth, Yes Deferred

Put the VP in the Roth as much as possible because it has a higher expected return from the PP and the gains are tax exempt. Possible consideration is that this investor may be using the Roth IRA for emergency funds because this investor has no taxable savings and Roth contributions can be removed tax/penalty free. If the Roth assets are small relative to the size of an appropriate emergency fund, then it might be wiser to put the VP in tax-deferred and put safer assets in the Roth, to ensure they are available in case of an emergency.

INVESTOR 2: Yes Taxable, Yes Roth, Yes Deferred

Consider splitting the VP between the Roth and Taxable accounts depending on the VP speculation. If the speculation is an individual stock, put it in the Roth. If the speculation is an index fund, put it in taxable because there are opportunities for tax-loss harvesting that don't exist for individual stocks.

INVESTOR 3: Yes Taxable, Yes Roth, No Deferred

Same recommendation as Investor 2, however add in the factor of PP tax efficiency. It may be desirable (in higher interest rate environments) to put PP Cash assets within the Roth as opposed to VP assets. While it's true the VP has a higher expected return than the PP and would better benefit from long-term tax exemption provided by the Roth, the immediate tax hit of cash yield may make it worthwhile to preferentially place cash into the Roth. This differs from Investor 2, who has tax-deferred space and would be able to place cash in that location.

INVESTOR 4: Yes Taxable, No Roth, Yes Deferred

Recommend using index fund speculations in taxable and individual stock speculations within Tax Deferred, with the consideration that cash, in a high interest rate environment, should take preferential position within tax-deferred.

NOTE ON TAX LOSS HARVESTING:
If you speculate that real estate is going to go up, then you may choose to invest in a REIT index fund such as Vanguard's VNQ. If you do, and if you're an investor with taxable investments, it makes sense to place this speculation in a taxable account. If VNQ declines in value, you can sell it, realize an immediate tax benefit, and immediately repurchase a similar, but unidentical REIT index fund, that will likely be 99% of the same stuff, but will not trigger an IRS wash sale.

If you speculate in an individual stock position, then you're unable to Tax Loss Harvest in a "safe" way.

NOTE ON VP DEFINITION:
My use of VP is defined as a pure speculative "investments." I am ignoring the rare case of someone who may be using a specialized "hedge" position such as a small business owner that is significantly impacted by the price of gasoline but unable to "legitimately" hedge using financial derivatives in the business because the business is too small (thanks Federal government for keeping us all safe from the whims of the market) - thus his solution is to take some personal money and buy an appropriate ETF because his personal income is highly correlated to the small business and holding a personal investment in an oil ETF will smooth his personal volatility. These rare cases will need to be evaluated on a one-on-one basis due to the complexities involved.

Ideally you want everything in a Roth, but you probably can't do that.  There is no reason I know of to choose tax-deferred vs Roth or Roth vs tax-deferred other than taxed now and tax free later vs tax deferred.  For the rest, when I say "tax deferred" assume it applies equally to a Roth unless stated otherwise.


The first criteria is which alternatives are available to you.

The next criteria is what kind of investments.


Generally you want investments that generate "regular income" to be tax-deferred because deferring regular income doesn't change its tax status.  Anything else you tax-defer you lose some tax advantage and deferral may or may not be sufficient advantage to offset that loss.  (Roth obviously doesn't lose tax advantage.)

Generally you want less risky investments in tax-deferred.  It is hard to get money into tax-deferred accounts (you are limited each year) and you cannot write off losses or use them to offset income if they occur in a tax-deferred account.  A Roth is (at least for me) even harder than general tax-deferred so I want most to avoid losses in my Roth.

There are some specific types of investments that can be problematic in tax-deferred accounts (such as Master Limited Partnership units, MLPs, which can generate Unrelated Business Taxable Income, UBTI, which if it exceeds $1000 requires your IRA to file an Unrelated Business Income Tax return (UBIT return) and possibly pay taxes.

Other types of investments you cannot hold tax-deferred according to IRS rules.  Most typically found and asked about are collectibles (most silver and gold coins and bars which do not meet good delivery standards, stamps, artwork, etc).

Investments which have current tax advantages include real estate, stock shares held for capital gains, dividends (at least until the end of the year), partnership units, private business shares, and most likely more.  If you tax-defer those, you turn all those gains and income into regular income taxed at your marginal rate at the time you withdraw it from the tax-deferred account.  (Roth is obviously better.)


In light of the preceding, I see no value in your 4 investor scenarios.  They are all covered by the general philosophy above.


As for the key concepts...

1) only if the highest return is also low risk.  losses are less painful in a taxable account.  Personally I find them most painful in a Roth, because that is the hardest account to get money into.

2) yes, except frequent trading is generally more risky so losses are more likely.  Also frequent trading is more expensive.  In a taxable account you can write off or use losses to offset gains and even regular income.  Also if you spend enough doing your frequent trading you can deduct investment expenses (that exceed 7.5% of AGI if I remember).

3) temper expectations with experience and reality.  Consider losses.  Do your risky behavior in a taxable account so it isn't a total loss.