Wednesday’s article about viewing your accounts as one portfolio rather than several separate portfolios drew more questions than any other article on this blog has. (At least I think so. I don’t actually keep a tally.) Mostly, people liked the idea, but had trouble figuring out how to implement it in their own situation.
No matter what accounts you have and how much you have in them, the process is largely the same:
- Determine your target overall asset allocation.
- Implement it in the lowest-cost way possible.
That’s what you do when you first implement the portfolio, and that’s what you do every time you rebalance.
Rebalancing Between Accounts
One sticking point many people had was that it doesn’t seem possible to rebalance between accounts (Roth IRA and 401(k), for instance) when you cannot move money between them. Fortunately, moving money between accounts isn’t really necessary.
Let’s use a simplified example: On January 1, 2011, Amanda had $100,000 in her 401(k) and $100,000 in her Roth IRA. She wants to use a 50/50 allocation between bonds and U.S. stocks. Amanda’s only low-cost option in her 401(k) is a bond index fund.
To meet her allocation, Amanda puts her entire Roth IRA into a U.S. stock index fund and her entire 401(k) into the bond index fund.
One year later, when Amanda goes to rebalance her portfolio, it looks like this:
- $125,000 in the stock index fund in her Roth IRA,
- $105,000 in the bond index fund in her 401(k).
Again, our approach is to:
- Determine the target overall asset allocation.
- Implement it in the lowest-cost way possible.
To rebalance her portfolio to the desired 50/50 allocation (which, with a total portfolio value of $230,000 would be $115,000 in each asset class), Amanda can simply sell $10,000 of the stock index fund in her Roth IRA and buy $10,000 of a bond index fund. Now her accounts look like this:
- $115,000 in a stock index fund in her Roth IRA,
- $10,000 in a bond index fund in her Roth IRA, and
- $105,000 in the bond index fund in her 401(k).
No need to actually move money between accounts.
Very Large 401(k) with Poor Choices
Of course, things don’t always work out as nicely as they did for Amanda. For example, if your 401(k) is the overwhelming majority of your portfolio, and you only have one low-cost investment option in that account, then it’s likely that the lowest-cost method of implementing your asset allocation will involve holding a high-cost fund (or two or three) in your 401(k).
For example, Paul has:
- $140,000 in his 401(k),
- $10,000 in a Vanguard Roth IRA, and
- $10,000 in a Vanguard traditional IRA.
Paul’s target allocation is:
- 25% U.S. stocks ($40,000 of his $160,000 portfolio),
- 25% international stocks ($40,000 of his $160,000 portfolio), and
- 50% bonds ($80,000 of his $160,000 portfolio).
The lowest-cost options in Paul’s 401(k) for each of his three desired asset classes are as follows:
- Vanguard Total Bond Market Index Fund (expense ratio 0.22%)
- American Funds Investment Company of America (expense ratio 0.61%)
- Oppenheimer International Growth Fund (expense ratio 1.34%)
In Paul’s situation, the international fund is clearly the worst. As such, Paul should do what he can to hold as much of his international allocation outside of his 401(k) as possible. To do so, Paul could allocate his portfolio as follows:
Roth IRA:
- $10,000 Vanguard Total International Stock Index Fund
Traditional IRA:
- $10,000 Vanguard Total International Stock Index Fund
401(k):
- $20,000 Oppenheimer International Growth Fund
- $40,000 American Funds Investment Company of America
- $80,000 Vanguard Total Bond Market Index Fund
Result: To meet his desired allocation, Paul still has to hold high-cost funds in his 401(k), but he’s minimized the damage as much as possible.
Sometimes It Doesn’t Matter
Also, a few readers correctly pointed out that the benefits of looking at everything at a portfolio level (as opposed to an account level) vary from person to person.
For example, if all of your accounts are tax-sheltered, and they’re all with brokerage firms that have low-cost options in every asset class, then it doesn’t matter a great deal whether you implement your desired allocation at the portfolio level or the account level. Just do whatever you find easiest.
Hi. I'm Mike Piper, the author of this blog. I'm 
Mike, how do you feel about considering the tax treatment of each account when implementing your asset allocation? That is, since Roth dollars are “bigger” than 401(k) dollars because Roth dollars are post-tax, you overweighted stocks a little bit in example 1.
I went through the calculation with my portfolio, and (speaking from the 15% bracket here) decided it was too small an effect to bother with. If I were in the 35% bracket, though, I’d definitely want to take it into account, although I might be too busy piloting my boat.
Thanks Mike! Excellent article that I am sure a lot of people need (myself included).
Good question, Matthew.
I wrote a bit about it here a couple years back. I think it certainly makes sense to at least be aware of the concept. Like you though, the difference for us (or, my estimate of the difference) is so slim that I don’t actually make any adjustments.
“Good question, Matthew. I wrote a bit about it here a couple years back. ”
Be sure to read the comments too! 😉
Whew! Sorry to reopen that barrel of worms.
Great follow up article. I am assuming when you rebalance by selling and buying different ETFs in the same account; you do not have any tax implications for ROTH IRA, Traditional IRA and 401(K)?
John: That’s correct. Buying/selling within a Roth IRA, traditional IRA, or 401(k) does not have any tax consequences.
When a taxable account is involved, things can be trickier sometimes in that, when rebalancing, you may want to leave the allocation in the taxable account in place and do the rebalancing elsewhere in order to avoid realizing capital gains. (Of course, if there are unrealized capital losses instead of gains, the opposite may be true.)
To me, the important thing is to be aware of the portfolio’s overall asset allocation. Otherwise you won’t know how much risk there is in the portfolio. Beyond that it’s a matter of optimization, which is sometimes more necessary than others.