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Does the tax efficiency tail sometimes wag the investment return dog?
Old 02-23-2011, 10:37 AM   #1
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Does the tax efficiency tail sometimes wag the investment return dog?

I am trying to think through my philosophy on investments in the various accounts of TIRA, Roth, and taxable. 80% of my investments are taxable. It's mainly the Roth and TIRA that I am not sure I have a good handle on. My Roth philosophy is that I want only high probability bets in an established Roth. I really don't want that money on which I have previously elected to pay tax disappear. So to me, high quality, high probability payers of growing and well covered dividends are about perfect. Likewise, TIPS at good real rates, or even fixed treasuries when they appear to compensate for inflation risk- which IMO they do not at present

OTOH, during the period of allowed recharacterization I think the Roth conversion offers other possibilities. A somewhat less secure investment with a good risk reward ratio might be fine, as one can always re-characterize it if it has lost signigficant money. So in a way, this is the same as losing money in a TIRA or 401k.

TIRA? I don't really know. I sometimes hate to buy stocks in one, knowing that I will eventually cash out the gains at ordinary income rates. But I know that there is at least one very successful investor on this board who lives from the withdrawals from tax-deferred accounts invested entirely in equities. So when returns on fixed income are relatively bad, as they are now, I consider equities which are not obviously overpriced for my tax-deferred account (TIRA).

I would like any comments or ideas that people might have on this general area.

Ha
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Old 02-23-2011, 10:50 AM   #2
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Ha,
I take the opposite view, but taxable account is about 30% of my total with the balance almost evenly distributed among Roth and T-IRA.

So my perspective is that I will draw from taxable and from T-IRA first. This gives the Roth more time to grow. The taxable holds the most tax efficient, the Roth has more equities, while the T-IRA which I will liquidate/convert before the Roth hold more fixed income.

That's not to say there isn't some fixed income (TIPS) in the Roth, but only because I had no cash in the TIRA to complete my asset allocation for fixed income.

-- Rita
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Old 02-23-2011, 11:03 AM   #3
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I would like any comments or ideas that people might have on this general area.
I have no idea but definitely think the ideas you presented are worth considering. Also it might be worth running a few scenarios through TurboTax. My taxes in retirement are so small, that I wonder if taxes really make as much difference as we think. It's easy to resent taxes and maybe this colors our perception of their affect in lowering income.
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Old 02-23-2011, 11:10 AM   #4
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I have no idea but definitely think the ideas you presented are worth considering. Also it might be worth running a few scenarios through TurboTax. My taxes in retirement are so small, that I wonder if taxes really make as much difference as we think. It's easy to resent taxes and maybe this colors our perception of their affect in lowering income.
You are single, as I am. I can't see how I will ever be taxed at less than the marginal rate of 25%, even if rates do not increase. And I consider that my retirement is somewhat marginally financed.

Even with no pension income, once RMDs are started, even modest social security income and some investment income push you well over taxable income of $34,500.

Ha
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Old 02-23-2011, 11:15 AM   #5
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You are single, as I am. I can't see how I will ever be taxed at less than the marginal rate of 25%, even if rates do not increase. And I consider that my retirement is somewhat marginally financed.

Even with no pension income, once RMDs are started, even modest social security income and some investment income push you well over taxable income of $34,500.

Ha
My taxable income was over that amount, but still my federal taxes came to only 11% of my AGI last year and state taxes were 2% despite the fact that I am no tax guru. I see what you mean, though. Those are not the marginal rates.

Edited to add: I am already taking substantial monthly payments from the TSP, to lower my future RMDs and minimize the tax effect of SS+RMDs later on. My taxable income should be about the same (depending on future yield of my taxable investments).
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Old 02-23-2011, 11:16 AM   #6
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You are single, as I am. I can't see how I will ever be taxed at less than the marginal rate of 25%, even if rates do not increase. And I consider that my retirement is somewhat marginally financed.

Even with no pension income, once RMDs are started, even modest social security income and some investment income push you well over taxable income of $34,500.

Ha
That is one of the reasons I wonder about delaying taking SS . At 70 you have to start RMD's and if you have delayed SS that adds even more income . So will the gain in SS be eaten away by taxes ?
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Old 02-23-2011, 11:18 AM   #7
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Ha...I have about the same percentage as you in "taxable". Don't have a Roth yet. I have a tendency to treat all avenues similarly but adjust percentages somewhat... meaning..I want some growth, value, income and stability in all.
I can't predict what the future will be...so..I suppose that is why I do it this way.

Now..in 3 years when I officially retire....I may elect to turn the taxable portion into all tax free type investments..leaving the growth and value...in the IRAs'.
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Old 02-23-2011, 12:01 PM   #8
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A Roth IRA is precious future-tax-free space. Sure you want it to grow as large as possible, but you also do not want to have any losses there because there is no easy way to "top-up" after a loss nor can one easily do tax-loss harvesting (except on recent conversions, one can do a recharacterization).

Thus, you sometimes want to be conservative in your Roth so you don't have losses. That means bonds and other fixed income. At other times, you may want to be aggressive and have those emerging markets small cap funds.

If you can't decide whether to be conservative or aggressive, you have to have both fixed income and equities in your Roth.

You can market time where you have your risky assets. In bull markets, put those equities in the Roth and bond funds in the traditional. Reverse in bear markets. Split in uncertain markets.
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Old 02-23-2011, 08:34 PM   #9
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That is one of the reasons I wonder about delaying taking SS . At 70 you have to start RMD's and if you have delayed SS that adds even more income . So will the gain in SS be eaten away by taxes ?
This is a real issue and all the "sales jobs", er I mean articles, touting 70 as the right age to take SS, avoid this issue like the plague.
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Old 02-23-2011, 08:41 PM   #10
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This is a real issue and all the "sales jobs", er I mean articles, touting 70 as the right age to take SS, avoid this issue like the plague.
I don't think that's a reason not to take SS at 70 (though it can be). I think that's a reason to look at the timing at which you take taxable income, and do some tax planning.
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Old 02-23-2011, 09:04 PM   #11
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That is one of the reasons I wonder about delaying taking SS . At 70 you have to start RMD's and if you have delayed SS that adds even more income . So will the gain in SS be eaten away by taxes ?
so you need to spend down your TIRA and 401K (or do roth conversions) in the years leading up to age 70
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Old 02-23-2011, 09:31 PM   #12
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This is a real issue and all the "sales jobs", er I mean articles, touting 70 as the right age to take SS, avoid this issue like the plague.
The "sales jobs" I think, are directed more towards the non-saver community...the right advice for those folks will not necessarily be the right advice for the kind of folks who frequent this forum.

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so you need to spend down your TIRA and 401K (or do roth conversions) in the years leading up to age 70
Especially if there is also going to be means testing. Use it while you can or the grasshoppers will come eat it for you, courtesy of the gummint.

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Old 02-23-2011, 11:07 PM   #13
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That is one of the reasons I wonder about delaying taking SS . At 70 you have to start RMD's and if you have delayed SS that adds even more income . So will the gain in SS be eaten away by taxes ?
But recall that the worst case for federal is 39% if you go back to clinton rates, at 376k per year. If you are at that point and have lived a lbym lifestyle, then you are more than set. (States could add another 6 -7 % after the federal deduction), and of course if you are retired you can pick a tax efficient state.
So worst case its about 50% to taxes, but thats at a high income level.
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Old 02-24-2011, 12:59 AM   #14
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IMO, a big factor that determines the proper answer to your general question is the individual's age. Ceteris paribus, one should take less risk in an IRA as one gets older given the fact that a terminal date does in fact exist in the future with the Taxman. Since a large component of Investment Risk is volatility of returns it should be clear that the pragmatic decision is to reduce volatility as one approaches the known taxable event. I believe that the OP is at or very near the RMD age in his TIRA so his reluctance to take more risk seems perfectly natural. However, for comparative purposes, if the OP were in his 40's it should be just as clear that he should feel compelled to take more risk than the older version of himself.

As for the Roth, I would make the argument that since the tax liability is behind him that a good case can be made to actually take more risk - as determined by the individual's aggregate risk appetite - in that portfolio than in either the TIRA or his taxable portfolios. As a specific example, the Roth has
no capital gains or loss concerns to manage so the argument would be to favor more active trading or invest in more volatile investments in that portfolio relative to the other two portfolios.
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Old 02-24-2011, 01:42 AM   #15
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Since a large component of Investment Risk is volatility of returns it should be clear that the pragmatic decision is to reduce volatility as one approaches the known taxable event.
Thanks for your analysis Gus. Also, I really like the recharacterization of le mort into "the known taxable event". Nothing to worry about there!

Ha
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Old 02-24-2011, 09:49 AM   #16
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IMO, a big factor that determines the proper answer to your general question is the individual's age. Ceteris paribus, one should take less risk in an IRA as one gets older given the fact that a terminal date does in fact exist in the future with the Taxman. Since a large component of Investment Risk is volatility of returns it should be clear that the pragmatic decision is to reduce volatility as one approaches the known taxable event. I believe that the OP is at or very near the RMD age in his TIRA so his reluctance to take more risk seems perfectly natural. However, for comparative purposes, if the OP were in his 40's it should be just as clear that he should feel compelled to take more risk than the older version of himself.

As for the Roth, I would make the argument that since the tax liability is behind him that a good case can be made to actually take more risk - as determined by the individual's aggregate risk appetite - in that portfolio than in either the TIRA or his taxable portfolios. As a specific example, the Roth has
no capital gains or loss concerns to manage so the argument would be to favor more active trading or invest in more volatile investments in that portfolio relative to the other two portfolios.

+1 on the Roth thinking.... I want my ROTH to have the biggest gains since I will not have to pay any tax on any of the gain.... so I take bigger risks here..

I am looking to reduce my risk in my 401(k) as I still have a big chunk of mega... I do not have any T IRAs left...


But in the big scheme of things... I want to make as much money as I can... I would rather make more and pay more taxes than make less and pay less taxes...
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Old 02-24-2011, 10:06 AM   #17
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The "sales jobs" I think, are directed more towards the non-saver community...the right advice for those folks will not necessarily be the right advice for the kind of folks who frequent this forum.
R
I guess that is the part that I keep forgetting, and you are right, the articles seem to all assume the retiree has an IRA that is not likely to cause $100,000 RMDs at 70. Folks on this board most likely took full advantage in contributing to their 401ks and IRAs and some will likely have significant RMDs to deal with.

As someone above suggested, "just draw down the IRA by converting to ROTH..", and I can barely stop laughing. HOW? In Nov., I ROTH converted $30k out of my $1.6mil IRA, and guess what, the IRA is now $1.8mil. Darn market.

Tax efficiency in retirement seems like a near impossible task. If I take something like $50k of cap gains or dividends from my taxable account, the effective tax rate (I'll use single for this calc) is 3.09% per the Bankrate tax calculator. On the other hand, if I take that same amount except this time from my IRA, the tax rate is 14.51%.

5, count it, FIVE, times the tax rate.
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Old 02-24-2011, 10:27 AM   #18
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I guess that is the part that I keep forgetting, and you are right, the articles seem to all assume the retiree has an IRA that is not likely to cause $100,000 RMDs at 70. Folks on this board most likely took full advantage in contributing to their 401ks and IRAs and some will likely have significant RMDs to deal with.

As someone above suggested, "just draw down the IRA by converting to ROTH..", and I can barely stop laughing. HOW? In Nov., I ROTH converted $30k out of my $1.6mil IRA, and guess what, the IRA is now $1.8mil. Darn market.

Tax efficiency in retirement seems like a near impossible task. If I take something like $50k of cap gains or dividends from my taxable account, the effective tax rate (I'll use single for this calc) is 3.09% per the Bankrate tax calculator. On the other hand, if I take that same amount except this time from my IRA, the tax rate is 14.51%.

5, count it, FIVE, times the tax rate.
You have larger balances than I, but a similar problem. Until this thread, it seems to be a board assumption that once retirement comes along, taxes are almost non-existent. I couldn't see how that could be looking ahead, and of course now that I am here, taxes are a tricky aspect, and one that I expect to get trickier yet.

Ha
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Old 02-24-2011, 10:46 AM   #19
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You have larger balances than I, but a similar problem. Until this thread, it seems to be a board assumption that once retirement comes along, taxes are almost non-existent. I couldn't see how that could be looking ahead, and of course now that I am here, taxes are a tricky aspect, and one that I expect to get trickier yet.

Ha
Ha, I'm really hoping some brilliant soul comes onto this thread and suggests a method of tax efficient withdrawal for a retiree with significant IRA assets. I cannot for the life of me see how to do it. I feel like I did not do due diligence back in my contribution phase.

At 70, I will be required to take 3.65% of my IRA. So assuming I was 70 today, that would be $65k. AND, if I had waited till 70 for SS, I'd be getting $35k. So that is $100k forced on me when in reality I can live comfortably on $60k, easily. AND, taxes (per Bankrate) would be 20%. On the other hand, if I were free to take cap gains and dividends from a taxable account, I'd only need $25k + $35k to get the $60K that I want. So I'd pay 10% tax. So I'd be paying $20k in the forced scenario, versus, $6k in my preferred.

BTW, I intend to put my ROTH conversions into fairly risky stocks and let that be my hormones account. As I build it the amount is small enough to just roll with volatility, and if I lose, I lose not much.
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Old 02-24-2011, 11:34 AM   #20
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The money in 401K & T-IRAs are going to be taxed, so trying for the lowest tax bracket is probably the best strategy.

I go around in circles when it comes to what to put in a ROTH IRA. Right now, I've put my REITs there. I figure they have a good chance of capital gains & dividends. Some days I think I should put my Emerging Market fund there. My ROTH account is very small, so for me, it isn't a huge issue, but I can understand the OP's dilemma.

As long as I have capital losses to offset my cap gains, I think keeping equities in my taxable account & bonds in my T-IRA is the right strategy. If I'm mistaken, I'd like to hear it.

This is just too complicated for a person who ER'd to have time to do more enjoyable things!
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