Tax-deferred vs taxable savings

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WiseOne
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Tax-deferred vs taxable savings

Post by WiseOne » Sat Apr 30, 2016 9:01 am

This topic has been discussed before, but I thought it would be useful to resurrect it.  I am currently operating on the assumption that I should max out all tax-deferred accounts before saving a dime in Roth or taxable accounts, once the emergency fund is in place.  Thoughts??

I'm aware that it's good to have a mix of accounts, but what precisely that mix should be is open to question.  For example, is it ok to have ~80% of your long-term savings in tax-deferred accounts, or should you aim for something like 50/50?  Or perhaps set a cap of 20-25x expected expenses in tax-deferred, so you aren't completely toasted by RMDs?

Also I am aware that the government introduces wildly unpredictable variables into this equation, and could at any time raise rates, impose a wealth tax, etc etc.  Fun to discuss but probably not helpful for answering the above question.

What didn't get discussed enough in the earlier thread, I think, is that tax deferral is powerful enough that it still wins over taxable investing even if state + federal tax rates during retirement are substantially higher than during working years.  However, the advantage is small enough that it may be worthwhile to forgo some of it in order to get a better balance between accounts.

Here are the numbers.  I ran a simulation tracking a $10,000 initial investment in tax-deferred vs taxable, making the following assumptions.  All taxes are federal + state.

Current marginal tax rate:  38.5%
Tax rate during retirement:  35.5%
Capital gains tax rate:  20%
Annual investment growth:  6% including dividends; assumes dividends are reinvested.
Annual dividends:  2%.  For Taxable investments, dividend reinvestment is reduced by the amount of tax.

After 10 years, the tax deferred account yields $11,640 and the taxable account yields $10,002.
After 20 years, the tax deferred account yields $20,846 and the taxable account yields $16,612.

The tax deferred account only loses if the tax rate in retirement goes up to 50%.  But, note that the taxable account might benefit from tax loss harvesting early on.

Here's the link to the previous discussion:

http://gyroscopicinvesting.com/forum/pe ... e-savings/
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Re: Tax-deferred vs taxable savings

Post by Pointedstick » Sat Apr 30, 2016 9:43 am

Personally, I max out tax-deferred accounts before contributing to taxable. If you have the ability to, it's a no-brainer IMHO. The big question I think is whether to contribute to a Roth IRA or 401k over a Traditional one. The Traditional account wins if you anticipate that your retirement tax rate will be lower than your working tax rate, since you can convert to a Roth at a potentially very low tax rate (10 or 15%) after having avoided a much higher 25 or 35% tax rate while employed. But if your tax rate is already 10 or 15% while working, then the Roth is probably a better bet since your tax rate is probably never going to be much lower.
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Re: Tax-deferred vs taxable savings

Post by ochotona » Sat Apr 30, 2016 9:44 am

My 2 cents' worth

1. max out your HSA first, and don't forget age 55+ catch-up contributions

2. If you expect to be in a lower marginal  tax bracket at retirement, max out tax-deferred 401(k) and regular IRA space

3. If you expect to be in a higher marginal tax bracket at retirement, max out Roth 401(k) and Roth IRA space

{for 2. and 3., at least do enough to capture 100% of the employer match. No brainer}

4. Then do taxable accounts, with the thought in mind that it's probably best for many people to take Social Security at 70, therefore retirement to age 70 will likely be low income years. Put those low income years to work by taking long-term cap gains then, and doing some Roth conversions. if you can keep in the 15% tax bracket or below, your long-term cap gains rate is zero. Taxable accounts could hold things like equity index funds with a potential for cap gains. I also keep the tax bite down by using or tax-exempt Municipal bonds or bond funds (I use $TFI, trades free in the Schwab universe).

That's how I'm structured.
Last edited by ochotona on Sat Apr 30, 2016 9:47 am, edited 1 time in total.
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Re: Tax-deferred vs taxable savings

Post by dualstow » Sat Apr 30, 2016 9:48 am

WiseOne wrote: This topic has been discussed before, but I thought it would be useful to resurrect it.  I am currently operating on the assumption that I should max out all tax-deferred accounts before saving a dime in Roth or taxable accounts, once the emergency fund is in place.  Thoughts??
Wait, why is the Roth grouped with taxable? Because you have to pay up front to fund it?

I don't recommend my setup to anyone, but my accountant talked me into stopping funding my solo 401(k). I fund only my Roth IRA and my taxable account and the solo now only grows if I make the right trading choices. That's kind of the opposite of your strategy, isn't it?

With that high tax bracket, could you just explain whether or not you're fully funding your Roth, (whether or not it comes after other retirement accounts)?
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Re: Tax-deferred vs taxable savings

Post by Pointedstick » Sat Apr 30, 2016 10:14 am

Another thing to keep in mind is that there's an income limit for contributing to a Traditional IRA. If you're over that limit but don't realize it, then your contributions won't actually be deductible on your income tax returns, and in effect you'll have made taxable contributions instead. If you're close to this limit or your income fluctuates around it a lot, it may be safer to contribute to a Roth IRA rather than risk losing most or all of the tax savings entirely.
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ochotona
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Re: Tax-deferred vs taxable savings

Post by ochotona » Sat Apr 30, 2016 10:24 am

Pointedstick wrote: Another thing to keep in mind is that there's an income limit for contributing to a Traditional IRA. If you're over that limit but don't realize it, then your contributions won't actually be deductible on your income tax returns, and in effect you'll have made taxable contributions instead. If you're close to this limit or your income fluctuates around it a lot, it may be safer to contribute to a Roth IRA rather than risk losing most or all of the tax savings entirely.
If you're on the borderline of deductibility, it helps to complete your tax return quickly, then make the IRA contrib for the prior year once you know 100% for certain what your AGI was for that year. You have until April 15. I'm not always sure what I make from year-to-year, due to bonuses, so I do this.
Last edited by ochotona on Sat Apr 30, 2016 10:32 am, edited 1 time in total.
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Re: Tax-deferred vs taxable savings

Post by Tyler » Sat Apr 30, 2016 10:27 am

Generally speaking, I'd recommend that most people max out a cash emergency fund first, their  tax-deferred space second, and put any remainder in taxable.

There will always be exceptions based on personal goals. If you plan to save for a house, for example, you might cut back the tax-deferred contribution for a little while. And for the small subset of people planning to retire very early, thinking about what percentage of your assets are easily accessible before 59.5 with no accounting gymnastics required is a good idea.
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Re: Tax-deferred vs taxable savings

Post by ochotona » Sat Apr 30, 2016 10:34 am

You can always pull your contributions out of a Roth for any reason at any time without penalty... you already paid taxes on those! Roth space can be part of your emergency fund. Also you can use some of a Roth for 1st home purchase, or higher ed.
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Re: Tax-deferred vs taxable savings

Post by curlew » Sat Apr 30, 2016 11:01 am

Maxing out your tax-deferred 401k and also a Roth IRA if you can has always seemed like a no-brainer to me. This is what both my wife and I do. With a Roth IRA I don't know why you would even need a separate emergency fund - as it would seem to fit that purpose quite well.

I'm going to retire next year at 68 and delay SS until 70 but my wife is younger and plans to keep on working for quite a few years. I still intend to max out her 401k and both of our Roth IRA's however (as I understand it only one needs earned income for both spouses to contribute). I will make up the shortfall in income from cash savings until I start SS.

My biggest worry however, is that the year I turn 70 and start taking SS will also be the year I have to start taking RMD's so with my wife still working the taxman cometh. I'll have to do the math, but maybe some Roth conversion from 68-70 might make sense for me.
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Re: Tax-deferred vs taxable savings

Post by MachineGhost » Sat Apr 30, 2016 11:21 am

Just by chance I came across this last night that addresses the question:

https://www.google.com/patents/US6240399

I think topic this is especially timely because Slick Hilly wants to add a 4% surtax on ordinary income, add a 4% surtax on capital gains plus raise capital gains taxes almost 90% with a new medium-term capital gains tax of 24% to 39.6%.  Still, this isn't as "bad" as Obummer's almost 190% tax increase on dividends and short term gains (not counting his additional 3.8% ObummerCare surtax).

Thank goodness these are just marginal rates, but I still feel ill.  These throwbacks to the 20th century need to be disposed of.
Last edited by MachineGhost on Sat Apr 30, 2016 11:35 am, edited 1 time in total.
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Re: Tax-deferred vs taxable savings

Post by Mr Vacuum » Sat Apr 30, 2016 1:11 pm

Pointedstick wrote: Another thing to keep in mind is that there's an income limit for contributing to a Traditional IRA. If you're over that limit but don't realize it, then your contributions won't actually be deductible on your income tax returns, and in effect you'll have made taxable contributions instead. If you're close to this limit or your income fluctuates around it a lot, it may be safer to contribute to a Roth IRA rather than risk losing most or all of the tax savings entirely.
This is tricky. The traditional IRA has phased income limits on deductibility. The Roth IRA has income limits (pretty high) on even contributing.

Then if you have an SEP IRA at work and the company pays 0 some year, your tax deferred options can get limited.
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Re: Tax-deferred vs taxable savings

Post by Libertarian666 » Sat Apr 30, 2016 8:54 pm

If anyone wants to run some simulations on this topic, they can beta test my retirement tax/income analyzer.

But it is a Windows-only program at the moment, although it should run on "boot camp" or whatever the Mac Windows emulator is called.

If you're interested, message me.
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Re: Tax-deferred vs taxable savings

Post by WildAboutHarry » Sat Apr 30, 2016 10:06 pm

Your working years tax status versus retirement years tax status makes a difference.

Working in a high-state -income-tax state (e.g CA, NY) and retiring in a state with lower state tax rate favors full tax deferral via 401(k) or IRA.  You get to defer the higher rates and withdraw at lower rates.  Sweet.  Roths make less sense in this case, though.

HSAs generally make sense, but remember CA (and a few other states, I think) do not allow HSA deductions (for both contributions and earnings on HSAs).
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Re: Tax-deferred vs taxable savings

Post by Libertarian666 » Sun May 01, 2016 10:03 am

WildAboutHarry wrote: Your working years tax status versus retirement years tax status makes a difference.

Working in a high-state -income-tax state (e.g CA, NY) and retiring in a state with lower state tax rate favors full tax deferral via 401(k) or IRA.  You get to defer the higher rates and withdraw at lower rates. Sweet.  Roths make less sense in this case, though.

HSAs generally make sense, but remember CA (and a few other states, I think) do not allow HSA deductions (for both contributions and earnings on HSAs).
You should get competent tax advice before counting on this. It has been quite awhile but IIRC (at one time at least) NYS wanted to tax emigres (to another state, that is) on their "windfall tax reduction" when doing this. Other than state employees, of course, whose pensions weren't taxed at all at the state level!
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Re: Tax-deferred vs taxable savings

Post by Tortoise » Sun May 01, 2016 1:20 pm

As far as Roth vs. traditional tax-advantaged accounts, I currently split my contributions about 50/50 between them to hedge my bets. I can't predict the future, especially not when it involves government policy and macroeconomics.
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Re: Tax-deferred vs taxable savings

Post by Mr Vacuum » Sun May 01, 2016 1:21 pm

Well played, Tortoise.
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Re: Tax-deferred vs taxable savings

Post by barrett » Sun May 01, 2016 1:53 pm

WiseOne wrote: Also I am aware that the government introduces wildly unpredictable variables into this equation, and could at any time raise rates, impose a wealth tax, etc etc.  Fun to discuss but probably not helpful for answering the above question.
One of those variables currently is the ACA subsidies. At least for the moment - and yes, I realize this could change at any time - contributing a big chunk to tax-deferred can help bump middle income people down to an AGI that is low enough to trigger a subsidy.
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Re: Tax-deferred vs taxable savings

Post by WiseOne » Sun May 01, 2016 6:44 pm

Pointedstick wrote: Personally, I max out tax-deferred accounts before contributing to taxable. If you have the ability to, it's a no-brainer IMHO.

The big question I think is whether to contribute to a Roth IRA or 401k over a Traditional one. The Traditional account wins if you anticipate that your retirement tax rate will be lower than your working tax rate...
These two statements are, in a nutshell, exactly the issue I've been puzzling over.  Obviously, if it's a no-brainer to max out tax-deferred accounts, then you would also want to maximize your traditional IRA contribution and forgo the Roth, if you can.  Note also that it's not necessary for your retirement tax rate to be lower than your working tax rate in order to win with tax deferral.  In my simulation scenario, tax deferral won even when the retirement tax rate was greater than the working tax rate by ~10%.  The effect of years of investment gains on the untaxed amount is quite powerful, compared to starting with a lower amount due to the initial tax hit.

Dualstow, I am burning with curiousity...what did your accountant tell you that made you stop contributing to tax-deferred accounts entirely?  If you can say so on the board, of course.
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Re: Tax-deferred vs taxable savings

Post by barrett » Sun May 01, 2016 7:35 pm

WiseOne wrote: Dualstow, I am burning with curiousity...what did your accountant tell you that made you stop contributing to tax-deferred accounts entirely?  If you can say so on the board, of course.
I'm curious as well. I know that it made sense for my wife to do this one year when she had enough earnings to do a full solo 401(K) Roth contribution, but enough deductions that a tax-deferred contribution did not lower her tax hit at all.
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Re: Tax-deferred vs taxable savings

Post by dualstow » Sun May 01, 2016 8:43 pm

Hey, no one has answered my question in Reply #3 yet.

But the answer to question I've been asked has to do with the fact that my tax bracket is low and I pay close to nothing on dividends and interest AND that my bracket will probably be higher, not lower, in the future.

If that doesn't make sense, I'd love to hear counter-arguments. I actually haven't missed that many years contributing to the solo 401(k). Maybe two, although I put in less than I could have the past few years.

I should also mention the following:
- The solo was dreamt up by a previous accountant.
- I was putting in so much each year, that I began to wonder if I would eventually tie up too much money in tax deferred.
- The above might be less of a concern now that renovation is done, but still. I like that I can draw on my sizable taxable account if I have an emergency.

So basically my taxable account is kind of like a retirement account, but with no forced RMDs and no early withdrawal penalties.
I insist on putting money into Roth, but that's only a few thousand a year anyway.

Finally, you covered this, WiseOne, but I do expect tax laws to change.
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Re: Tax-deferred vs taxable savings

Post by MachineGhost » Sun May 01, 2016 9:01 pm

Desert wrote: Another way to look at this:  Tax-deferred accounts win if your effective tax rate (average tax rate on total income) in retirement is lower than your marginal tax rate in your working years.  A good portion of the dollars I'll withdraw from traditional IRA/401k accounts in retirement will fill out the lower tax brackets.
Please elucidate why comparing apples vs oranges applies here.
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Re: Tax-deferred vs taxable savings

Post by WiseOne » Sun May 01, 2016 9:29 pm

OK, my best shot at answers below: 
dualstow wrote:
WiseOne wrote: This topic has been discussed before, but I thought it would be useful to resurrect it.  I am currently operating on the assumption that I should max out all tax-deferred accounts before saving a dime in Roth or taxable accounts, once the emergency fund is in place.  Thoughts??
Wait, why is the Roth grouped with taxable? Because you have to pay up front to fund it?

I don't recommend my setup to anyone, but my accountant talked me into stopping funding my solo 401(k). I fund only my Roth IRA and my taxable account and the solo now only grows if I make the right trading choices. That's kind of the opposite of your strategy, isn't it?

With that high tax bracket, could you just explain whether or not you're fully funding your Roth, (whether or not it comes after other retirement accounts)?
I grouped Roths in with taxable because contributions to both come from after-tax money.  Also Roth contributions can be taken back out without penalty so they're not locked up quite as tightly as, say, 401K accounts.  Yes, I'm aware that back-door contributions are actually conversions, so the money has to "age" for 5 years before you can withdraw it.

I fully fund my Roth via the back-door method every year, which is in addition to maxing out tax deferred contributions (403b and solo 401K).  Well, every year since I learned about this trick anyway.  I don't have the option to contribute to a traditional IRA.  So the Roth money comes out of taxable contributions, not from potential 401K contributions.
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Re: Tax-deferred vs taxable savings

Post by dualstow » Sun May 01, 2016 9:33 pm

Ah, thank you!
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Re: Tax-deferred vs taxable savings

Post by WildAboutHarry » Sun May 01, 2016 10:26 pm

Libertarian666 wrote:You should get competent tax advice before counting on this. It has been quite awhile but IIRC (at one time at least) NYS wanted to tax emigres (to another state, that is) on their "windfall tax reduction" when doing this. Other than state employees, of course, whose pensions weren't taxed at all at the state level!
I think California fought and lost this battle some time ago.  State pensioners who relocate outside of CA are NOT subject to CA income taxes on their pension income if they are located outside of CA.  According to the Supreme Court.
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