ORP is back!

[dory36]

A great tax planning calculator is available at http://www.i-orp.com/ -- it was offline for a while.

It optimizes how you withdraw your funds (from Roth versus regular IRA versus after-tax savings) to minimize taxes.

Dory36

 

[wzd]

I'm 49, and the ORP calculator says to use 72t for 10 years, then Roth IRA monies, then IRA monies - which is different than what is advocated on many sites. Has anyone validated this and put any studies out?

Wayne

 

[dory36]

I'm not sure what there is to validate. ORP doesn't try to anything except minimize taxes over the remainder of the retirement plan term.

If the tax laws change, the strategy becomes moot, of course.

But the primary idea is that if you live on after-tax funds in the early years, you're abandoning unused deductions that you can't ever get back.

Dory36, tax averse since 1906

 

[RedOscar]

But the primary idea is that if you live on after-tax funds in the early years, you're abandoning unused deductions that you can't ever get back.

Dory, I'm confused by the statement above. Are you saying that you DON"T want to live on savings in non-tax deferred acounts before dipping into your tax-deferred assets? That is exactly opposite of what I've always heard.

My ORP report this morning shows AfterTax assets spent initially, and TaxDef assets spent beginning at age 70. One of my big concerns is that the MRD will be greater than I need, but force me into a higher tax bracket. I was hoping OPR might show me taking earlier withdrawals from TaxDef in the hope of minimizing my tax bracket. Of course I realize that the rules may change and a different strategy would have to be deployed.

Red

p.s. How cold did it get where you are this morning?

 

[dory36]

Are you saying that you DON"T want to live on savings in non-tax deferred acounts before dipping into your tax-deferred assets? That is exactly opposite of what I've always heard.

Exactly.

Take an unreasonably simple case to easily illustrate.

Case 1: You retire at 50, and draw $20,000 a year from after-tax portfolio that has been declining, so you're drawing only principle. You do that for 10 years. Because the money is after-tax, you pay no income tax.

Then you start drawing $20,000 a year from an IRA. Because it's taxable, you pay taxes. But you have roughly $15,000 a year exemptions and deductions if you're typical. So you pay only, say, $1,000 a year on the $20,000 a year withdrawal.

By age 70, you've paid $10,000 in taxes for the past 20 years.

Case 2: You retire at 50, and draw $15,000 a year from your IRA, and another $5000 from your after-tax portfolio that has been declining, so you're drawing only principle. You do that for 20 years. The IRA withdrawal is tax free because it is matched by your $15000 exemptions and deductions. Because the rest of the money is after-tax, you pay no income tax.

By age 70, you've paid nothing in taxes for the past 20 years.

Circumstances vary, and this is simplistic. ORP handles the complexity well I think, as a non-tax-guy.

But the moral is, take enough from your IRA to use up the deductions available to you, because they are "use it or lose it" tax breaks.

The downside is, you have to live within the discipline of a SEPP.

Does that help? Anyone else have a thought on this?

Dory36

 

[wzd]

Roth first vs. Roth last.

Well, I went ahead and put some spreadsheets together to analyze using money in the sequence aftertax, then Roth, then traditional, versus the sequence aftertax, then traditional, then Roth. They show it to be a wash in all the cases I ran. For example, one run exhausted funds in 24 years, with 36,600 that year from the Roth first method, and 36,400 from the Roth last method.

What I did was set a net income level, inflating at x% (i used 3.5 and 4) and a tax rate. I made the simplistic assumption that other (business, pension, etc.) income would put me in a tax bracket (I ran it with 15% and 28%), and the withdrawals would not bump me to the next one. I then withdrew enough to pay the net income needed plus taxes. Since withdrawals from the traditional IRA were larger to satisfy taxes and withdrawals from the Roth were smaller, taking money from the Roth first left more money in IRA's to grow, which offset the tax benefit of leaving the Roth for last. I can share them if anyone wants - they are simplistic, fixed tax rate, investment return, and inflation with no random variances.

More in a seperate post on why ORP had me take some Roth money out early.

Wayne

 

[wzd]

Ok, I examined the ORP output very carefully to see what it did and why. Dory has exactly the right idea in his reply above. What it did was vary the percentage from traditional and Roth to keep me just below the 28% tax bracket as long as possible. So it was using the deductions, and 15% tax bracket to the max in the early years and keeping income just below the 28% bracket. It also looks like it assumed inflation adjusted tax brackets, with no deductions other than the standard deduction/exemption. Since some of my income is from rental property that has tax deductions associated with it, I'll have to look at the rules it's pattern suggests and figure out how to actually implement them. I also had optimistic rental income put it to force the high tax bracket...I'll have to be more realistic. But the lesson here is to pay significant attention to the income by tax bracket report from ORP

Red - you may want to look at ORP's last income by federal tax bracket report and see if it is really doing what you were hoping for! It may be not doing any early withdrawals because the larger MRD's are not pushing you into a higher tax bracket in it's model. Remember that it adjusts tax brackets for inflation using the inflation number you give it.

Wayne

 

[Mr._johngalt]

Yep! Dory got it right. Alas, I have no personally owned
already taxed base that I can draw down to "mix and
match", thus maximizing my usage of tax deductions and
exemptions. It's the smart way to work it though.

 

[RedOscar]

Does that help? Anyone else have a thought on this?

Thanks to all for clearing up this concept for me. I now see the light and it certainly helps. I suppose my pension greatly influences the options and opportunities available to me at this time.

I will certainly put this little tidbit into my bag of tricks for possible future use.

Cheers,

Red

 

[RedOscar]

Red - you may want to look at ORP's last income by federal tax bracket report and see if it is really doing what you were hoping for! It may be not doing any early withdrawals because the larger MRD's are not pushing you into a higher tax bracket in it's model. Remember that it adjusts tax brackets for inflation using the inflation number you give it.

As you noted, indeed my tax bracket does not show creeping above the 15% bracket. In fact, because of the AfterTax withdrawals made between age 62 and 70, it even suggests I may be staying within the 10% bracket during those years.

That's good news to me!

Red

 

[Kevin]

By taking money out of an IRA early aren't you possibly giving up some potential tax deferred gains down the road?

I understand that when you take the money out of an IRA early you are avoiding some taxes, but if the market has some hefty gains in the following years, you will be subject to more taxes in your taxable account and will lose out of these tax deferrals in the IRA account.

 

[dory36]

But the capital gains are tax deferred anyway, until you sell the securities. Unless they are distributed automatically, as with some funds. ORP's model has you taking cash from the IRA yearly, in many cases. Presumably, you invest the cash savings you WOULD have taken out into similar securities.

Taking some $15,000 (my number, anyway) of income that is tax-free out of the IRA, when it would be taxable except that I'm using up each year's exemptions, times 20 years, for example, means I've taken $300,000 income without taxes. Had I taken the same amout out of after-tax savings etc, I would have abandoned those exemptions, and, when I DID withdraw it, paid perhaps $75,000 in taxes on those same funds.

Dory36, partway back from a system crash

 

[RedOscar]

Dory36, partway back from a system crash

Bummer! Hardware or software?

 

[dory36]

Software. I was visiting family over Father's Day weekend and had access to a fast line, and so downloaded a few large updates to Windows, etc.

My system froze during installation of one of these, and would not reboot.

No problem, thinks me, as I back up all the time.

Turns out that I can't restore my entire system when the Windows XP version on the computer is one service pack back from the version in the backup -- I had to restore Windows (which is where I am now), get to another high speed line and download and install Service Pack 1, and THEN restore my system.

So I'm sort of in limbo until sometime in a few days to a week when I get to a high speed line again. I have slow access to the internet and email, but none of the accumulated stuff on my hard disk.

Dory36

 

[bongo2]

The ORP calculator seems to assume that you can withdraw money from your after-tax accounts completely tax-free until they are depleted. This seems a little optimistic.

Also, instead of pulling enough money out of your Trad IRA to use up your low tax brackets, wouldn't it be better (if you can) to do a roth conversion for that amount each year?

 

[haha]

Relative to money in an after-tax personal account, are there any disadvantages, definite or possible, to a Roth?

Mikey

 

[haha]

Dory discussed the idea of always taking at least enough from a tax deferred account to use up one's no-tax amount of (for a couple) of roughly $15,000. What I am wondering, how likely would someone be retired without more obligatory taxable income than that?

Unless social security is enough to live, would not pension income alone put you over? Also, even the 30% or so in cash, of a 70--30 allocation, in normal times would likely provide $15,000 or so of interest. I am assuming the frequent "need $40,000 income, 4% cap rate equals $1million."

I keep a spreadsheet to try to stay in the 15% bracket. Which today is much more important, because it keeps eligible dividends and LT cap gains in their lowest bracket of 5%.

I do not completely subscribe to EMH, so I own individual stocks, and at times I take gains if I feel the stock is quite a bit overpriced. I also take losses to offset gains, or if I think I made a mistake when I bought the company shares. My justification for this is that the market still seems considerably overvalued, but I am willing to buy apparently undervalued stocks when they become available. I would not be willing to hold them forever, since if (IMO, when) the general market resumes its downward path, many reasonably valued stocks will go along. Therefore, I am willing to hold from undervalued to reasonably valued, then I will likely sell. Unless it is a stock I have held for many years, and my gains make up a large part of the price. For these in taxable accounts I may at times hedge by buying S&P puts.

It is true that this is less tax efficient than selling depreciated Index Funds, but it might be more effective overall, since this method has to some degree spared me from market losses. I believe (no proof!) that we are probably at most half way done with the eventual losses of this bear.

Another feature of this approach is that I tend to have a fair amount of dividend income. To me, although the long term record shows that real dividends can go down for fairly long periods, they don't do so by as great a % as do the prices of stocks. The new tax law makes this aspect much more appealing too.

Mikey

 

[dory36]

Dory discussed the idea of always taking at least enough from a tax deferred account to use up one's no-tax amount of (for a couple) of roughly $15,000. What I am wondering, how likely would someone be retired without more obligatory taxable income than that?

Unless social security is enough to live, would not pension income alone put you over?

You're probably right, for most traditionally-retired people. And ORP, I believe, allows for pension input, as I recall. But I was referring to the situation for those of us who retired too early to get the pension, and are living off of our own savings and investments.

In these cases, or at least mine, the primary taxable income is the IRA withdrawal. The nontaxable income is the principle from after-tax savings and investments. Selling the losers, if you're buying individual stocks, is one way to do this. Or, in the recent past, selling just about anything created no gain.

Dory36

 

[Ted]

As some one with a background in (a) engineering, specializing in water resources management and (b) economics, I can't resist adding a few qualifying remarks to this discussion.

In the jargon of water resource professionals, "ORP" stands for "Oxidation-Reduction Potential." It is a measure of the power of an aqueous solution to either oxidize or reduce a chemical that is added to it. Don't worry if you find this uninteresting, because it's irrelevant here anyway .

In the jargon of the financial planning afficionados who, I presume, more frequently visit this site, "ORP' stands for "Optimal Retirement Planner."

Basically, this is a computer program that seeks to "optimize" a retiree's after-tax return from their investments by minimizing the taxes that they would pay on their income, most of which is presumably "unearned." The program is based on the assumption that tax laws will not change in the future, which is doubtful but nevertheless about the best guess that most mortals can make.

I mentioned in other posts that I have intentions of becoming an investment advisor, and it is certainly an obligation of such people to advise their clients of legal means of tax avoidance.

What bothers me, however, is the realization that whatever taxes are avoided by one class of citizens creates the need for government to collect more taxes from another class of citizens -- given the political "disconnect" between government expenditures and taxation.

As an economist, I understand that "brilliant" efforts that permit individuals and corporations to minimize their taxes -- such as the ORP software -- are actually a horrendous waste of intellectual resources. The "big picture" on tax policy is that, as a nation, we are like a dog chasing its tail. We spend an excessive amount of effort determining "who will pay for government services," that could better be spent producing goods and services of real value to consumers. Just think how much better it would be for society if most accountants and tax attorneys were employed as teachers or engineers!

 

[dory36]

... The "big picture" on tax policy is that, as a nation, we are like a dog chasing its tail.  We spend an excessive amount of effort determining "who will pay for government services," that could better be spent producing goods and services of real value to consumers.  Just think how much better it would be for society if most accountants and tax attorneys were employed as teachers or engineers!

Ted is 100% correct. Unfortunately, complicated rules lead to complicated and costly solutions, often resulting in consequences unintended by those making the rules. (Remember the "luxury tax" a few years back? It caused most manufacturers of small planes and large boats to go out of business, displacing thousands of low and middle class workers, and produced diddly squat in new revenues.)

Just imagine how profitable many corporations would be if they didn't have to focus so much on the tax implications of their every move!

The best solution I've seen yet is a consumption tax. The only move in that direction I've seen with any apparent staying power is at http://www.fairtax.org/ -- but I'm pessimistic that we'll ever do anything to our tax system that reduces the ability of politicians to fiddle with the system for the purpose of getting votes.

Dory36

 

[Mr._johngalt]

Hi Dory! And just imagine how much time I'd have
if I did not have to focus on tax implications. I agree
with your prediction. With most politicians, the minute
they get elected they start figuring how to get reelected.
This leads to all kinds of mischief. On the other hand,
they would be causing trouble anyway. I would like
to send most of them home and tell them to do nothing at all. We will just mail their checks. That way we would all be better off.

 

[Cut-Throat]

(401 => IRA => Roth) Once in the Roth, future earnings become tax free. In addition, Roth's don't require minimum distributions when you're over 72 providing additional flexibility.

Don't quite follow you on this one. Could you elaborate? I thought when you converted from IRA to Roth you have to pay taxes on everything you take out? So are you saying just converting enough to not push you over the bracket? - You still have to pay some taxes and are losing some earning power when you do. Also in a Roth as I understand all withdrawels are tax free not just future earnings - correct?

 

[Mr._johngalt]

This is for Ted in re. his comments on taxes
and tax avoidance. I use every tax avoidance device
which can be conjured up. Always have. My opinion
is that the government will likely waste whatever
they manage to get their hands on, or even worse,
they will use it to promote some half-baked scheme
to damage the economy and subvert society in general.

 

[Ted]

This is for Ted in re. his comments on taxes
and tax avoidance.  I use every tax avoidance device
which can be conjured up.  Always have.  My opinion
is that the government will likely waste whatever
they manage to get their hands on, or even worse,
they will use it to promote some half-baked scheme
to damage the economy and subvert society in general.

I think that most people who read this forum recognize that government provides some benefits to them and is worth keeping.

Milton Friedman has pointed out the economic truism that the real cost of government to the American people is what government spends. The correct implication is that if the American people don't pay this cost through taxes, they will pay it through another mechanism (i.e., devaluation of their financial assets).

JohnGalt and Dr. Friedman would use this as an argument for reducing government as much as possible. I regard it as an argument for making government as efficient as possible, and (in effect) distributing the "savings" among people of all income levels. And part of this process is to reduce the "overhead" cost associated with the incredible complexity of the tax system.

This overhead cost is as high as it is because virtually everyone, like JohnGalt, has to "jump through hoops" to minimize their tax bill. This is particularly true of corporations, which (of necessity) simply pass the cost of the tax itself, and the cost of the efforts to calculate it and minimize it, on to consumers. This is sheer economic lunacy, driven by the liberal notion of "taxing giant corporations" rather than "people."

I would replace the corporate profits tax with a national sales tax. I think that a move like that could eventually be politically possible if it is "revenue neutral."

 

[wzd]

Cutthroat says

You still have to pay some taxes and are losing some earning power when you do

Yes, but others have asserted that it is the tax rate you pay, and the difference between paying 15% now, vs. 15% later is zero. I.e., if my money is to double in 10 years and I have 1000 now in an IRA, I can convert it to a Roth IRA and have $850 in the roth (assuming the 15% tax rate under discussion). Then the Roth doubles and I have $1700. Or the IRA doubles to $2000, and I take it out, pay 15%, and net.... $1700. There was a web site with a name like gummy that had equations that proved this instead of examples, but I seem to have lost track of them.

ORP also confirms this. If you run it and review the output, it appears to attempt to keep you in a tax bracket as long as possible by maxing out the tax bracket. In my case, it mixes after tax funds, Roth funds, and traditional IRA funds to keep me at the top of my tax bracket and not into the next tax bracket for the next 30 years.

I think it comes down to a bet on what tax rates will do. These models simply assume no change, other than possible inflation of brackets, and there is not really any better guess.


Wayne