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Math/tax question
Old 10-11-2008, 08:26 AM   #1
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Math/tax question

My wife is currently putting $15,000.00 per year in her 403b. Assuming an average 6% - 7% per year gain for the next 10 years and assuming taxes will rise significantly (who knows how much) I'm wondering if it still makes sense to be putting money into a tax deferred account. If I'm in a 28% tax bracket now and that goes to 35% by the time I withdraw the money did I really accomplish anything by deferring?
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Old 10-11-2008, 08:41 AM   #2
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You have the same question everyone has in a tax deferred plan. "What will my tax rate be when I withdrawl the money?" The simple answer is no one knows. You have to guess and or hope that your marginal tax rate will be close to the same or lower. That becomes even more problematic with the prospect of paying the tax on SS income that might have been avoided if you were in a Roth version of a 401k or 403b.

Glad I couldn't help.

I am personally putting money into a tax deferred 401k because if I didn't I'd be limited on putting other money into a Roth IRA. My marginal tax rate would also be at the upper end of today's range on my non-deferred contributions. I am gambling that I'll be able to "game the system" somewhat when I no longer have an income to move money at a lower tax rate from my tax deferred to after tax accounts.

If you were in a low marginal tax bracket now, I'd encourage the Roth options. Since you are in a high bracket, I'd suggest you evaluate what I'm doing.

You have to think through the options and make your best guess.

Of course, if the market falls for the next 10 years you will have avoided paying taxes on all the money you lose.
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Old 10-11-2008, 08:41 AM   #3
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The trick is to lower your withdrawals and your tax bracket in retirement.

Pay off your debt. Then you'll need to withdraw quite a bit less. Between lowered withdrawals and the standard deduction, you might not pay anything at all in taxes. I didnt pay anything for the three years I was retired before I got married.
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Old 10-11-2008, 08:46 AM   #4
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Depends also on how long you expect it to be in the tax-deferred account and what you assume to be the alternative investment (all LTCG? and what that tax rate will be compared to today's). In general, if same rate of return inside/outside and same taxation inside/outside, advantage grows for tax deferred the higher the rate of return,
the higher the tax rate, and the longer you are in there. Throw in a higher tax rate
when coming out of the tax-deferred account, and the advantage decreases and could also go negative. Throw in a LTCG rate in alternative investment and the advantage for tax-deferral decreases and could also go negative. A lot depends on the exact assumptions including whether or not you get matching from the employer, how much,etc.
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Old 10-11-2008, 08:52 AM   #5
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Of course, if the market falls for the next 10 years you will have avoided paying taxes on all the money you lose.
That's a very depressing thought I had not considered but a real possibility..
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Old 10-11-2008, 09:33 AM   #6
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My wife is currently putting $15,000.00 per year in her 403b. Assuming an average 6% - 7% per year gain for the next 10 years and assuming taxes will rise significantly (who knows how much) I'm wondering if it still makes sense to be putting money into a tax deferred account. If I'm in a 28% tax bracket now and that goes to 35% by the time I withdraw the money did I really accomplish anything by deferring?
I'll let others talk about whether your numbers are correct, I'll just give you my idea of the math.

If you go the 403b route, you'll take $15,000 of pre-tax money and put it into an account that accumulates at 6% a year for 10 years. You will have $26,863 in the account then. If you withdraw it and pay 35% tax, you'll have $17,461 of spendable cash.

If you go the taxable route, you'll put $10,800 of after-tax money in an account. If the account grosses 6% every year, but you pay 28% annually on the gain, you will be accumulating at 4.32%. After 10 years, you'll have $16,485 of spendable cash.

The 403b is the better strategy with these assumptions.

Note that your tax rate will probably go up sometime during the 10 years. If it's 35% in some of the "later" years, your accumulation in the taxable account for those years is only 3.9%, and the 403b advantage is bigger.

Also, note that the taxable strategy is better if you are holding the money for only a "few" years, but long enough for your marginal tax rate to go up. The cross-over point is somewhere between 5 and 7 years, depending on when the shift to 35% occurs.

OTOH, if you use the "taxable" strategy, but put the entire $10,800 in non-dividend paying stocks, which earn 6%, you'll have $19,341 in the account at 10 years. If you sell the stocks and pay a 15% LTCG rate on the gain, you end up with $18,060 of spendable cash. This strategy is best for any period that is long enough to qualify for the 15% rate.

[caveat - I made a stupid error on something that wasn't any more complicated than this a couple days ago, so take my comments as a "second opinion" that you can compare to your calculations.]
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Old 10-11-2008, 10:10 AM   #7
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One other tidbit is that the expenses in a 403b are often much higher than what one can get with their own choices in a taxable fund...

And in independents example above I think theres a mixup...there wouldnt be any taxes paid on the gains on the funds in the taxable account until they were sold...unless they're in funds that generate capital gains...but those would be taxed at a much lower rate than 28%.
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Old 10-11-2008, 10:23 AM   #8
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Good grief! No wonder I'm poor..I haven't a clue what I'm doing or why I'm doing it..
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Old 10-11-2008, 11:02 AM   #9
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Assumptions:
- Invest $15,000 per year.
- 7% annual return.
- Tax rate of 28% while accumulating and 35% upon withdrawal.
- Income and capital gains taxes are the same at terminal date.
- Taxes are due immediately at terminal date (including on all capital gains in the taxable account).
- No taxable dividends or gains assumed in the taxable account until the terminal date.
- Expenses are the same for both accounts.


After 10-yrs . . . Taxable account has an $81.10 higher AT balance
After 20-yrs . . . Non-taxable account has $36,317 higher AT balance
After 30-yrs . . . Non-taxable account has $144,477 higher AT balance

So under this (highly unrealistic, but greatly simplified) set of assumptions, investing in a non-taxable account wins for any period longer than 10-yrs. Changing the assumptions may change the result:

Assumption changes favorable to the Non-taxable account:
- Assume lower tax bracket after retirement (not unreasonable even with higher rates overall)
- Assume account is drawn-down slowly and taxes paid out over time instead of all at once (also very reasonable)
- Assume investments throw off taxable distributions (very reasonable for any mutual fund and many individual stocks).
- Assume some rebalancing or adjustments to investments over the life of the account generating taxable gains (pretty reasonable)

Assumption changes favorable to the taxable account:
- Much higher tax rates in the future then today, even after retirement (who knows?)
- Continued favorable tax treatment on investment income (this could really come under attack as a sop to "the rich", but a complete equalization doesn't currently appear to be in the cards - at least for now)
- Lower expenses (probably a good bet depending on your plan)
- Expect to make withdrawals in just a couple of years from today.
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Old 10-11-2008, 11:11 AM   #10
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If you plan to reach FI and retire early, you also have the option of converting. Once you get an employer plan converted to an IRA, you can then convert portions to a tax-free Roth by paying the taxes at your then current tax rate. If rates stay progressive as they are, then if you have some low income years before a pension, SS or RMD kicks in, you may be able to get the tax deferred money into a tax free account paying less tax than you would had you just saved in a taxable account. Too many variables to model this one out, but it seems to work for some people.
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Old 10-11-2008, 11:58 AM   #11
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- Lower expenses (probably a good bet depending on your plan)
Thats the problem. My wifes old 403b's cheapest fund option was an S&P 500 option that cost (in total) about .5% ER. The average fund costs totalled 1.5%+
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Old 10-11-2008, 01:02 PM   #12
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Thats the problem. My wifes old 403b's cheapest fund option was an S&P 500 option that cost (in total) about .5% ER. The average fund costs totalled 1.5%+
Yup, expenses chew you up. Here's the same numbers assuming a higher expense ratio of 30bp and 130bp for the tax deferred account:

30bp higher

After 10-yrs . . . Taxable account has $1,975 higher AT balance
After 20-yrs . . . Non-taxable account has $23,464 higher AT balance
After 30-yrs . . . Non-taxable account has $96,232 higher AT balance

130bp higher
After 10-yrs . . . Taxable account has $8,075 higher AT balance
After 20-yrs . . . Taxable account has $16,083 higher AT balance
After 30-yrs . . . Taxable account has $45,208 higher AT balance

Watch those expenses
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Old 10-11-2008, 01:46 PM   #13
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Quote:
Originally Posted by lawman View Post
My wife is currently putting $15,000.00 per year in her 403b. Assuming an average 6% - 7% per year gain for the next 10 years and assuming taxes will rise significantly (who knows how much) I'm wondering if it still makes sense to be putting money into a tax deferred account. If I'm in a 28% tax bracket now and that goes to 35% by the time I withdraw the money did I really accomplish anything by deferring?
A lot depends on how much match you are getting from the employer. Let me know that and I might be able to advise........
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Old 10-11-2008, 02:05 PM   #14
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Good grief! No wonder I'm poor..I haven't a clue what I'm doing or why I'm doing it..
Well, if it makes you feel any better - it's not you.

It's the stupidly complex, convoluted, cross-purposed, counter-acting, counter-productive, inter-twined, non-intuitive, piece-mealed, "left-hand-doesn't-know-what-the-right-is-doing-vote-for-me-and-I'll-set-you-free" legislation that Congress passes that makes tax planning impossible.

There - feel better now? (we need an emoticon for "I don't know if I should laugh or cry")

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Thats the problem. My wifes old 403b's cheapest fund option was an S&P 500 option that cost (in total) about .5% ER. The average fund costs totaled 1.5%+
Maybe I should track down the person who recently implemented the 403b program at the school DW is at, and give them a hug (or shake their hand, as appropriate)? We had a choice of places to work with, Fidelity was one (but not Vanguard, good enough for me). We can choose any fund (I think, I don't recall restrictions when we picked some wimpy bond fund that wouldn't lose too much money - hmmm, maybe DW should make ALL the investment decisions?), and Fidelity just charges a small annual fee ($15 or something, I'd have to look it up). I was expecting worse.

-ERD50
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Old 10-11-2008, 02:16 PM   #15
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Oh, this was even worse. The high cost choices were inside a variable annuity wrapper.

And all the employees were wondering why they got a free jar of vaseline on their first day on the job.
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Old 10-11-2008, 02:39 PM   #16
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I plan on moving out of a high tax state to a lesser one at retirement. Another thing to consider.
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Old 10-11-2008, 02:40 PM   #17
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My problem with that is that so far I havent seen a state with taxes that would be lower for an early retiree (income tax doesnt matter, low sales/property/investment) that wouldnt suck to live in.
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Old 10-11-2008, 02:51 PM   #18
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I plan on moving out of a high tax state to a lesser one at retirement. Another thing to consider.
What CFB said. Don't they just get you one way or the other? Either that, or you don't get what you need, or there is a State out there that is efficient with the taxpayer's money?

Give us a list!

I suppose there is the possibility that some State is just not spending money on things that are not important to you - that could reduce costs. I'm just having trouble imagining that a State would stand out in that regard. If there is one, it's probably one of those high humidity, termite infested places that I can't stand!


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Old 10-11-2008, 02:52 PM   #19
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My problem with that is that so far I havent seen a state with taxes that would be lower for an early retiree (income tax doesnt matter, low sales/property/investment) that wouldnt suck to live in.
Spoken like a true Californian.

Almost anywhere would be cheaper tax-wise than California except for possibly New York, New Jersey and New England.

You also neglect to include having a "residence of convenience" which is readily available to anyone without having an income tied to a specific location (like an employer). My plan is to rent a bedroom from one of my children and pay them a little rent (inter-generational transfer) which would preserve my no state income tax status while DW and I enjoy our "vacation home" somewhere else. We'd show up every so often to get our drivers licenses renewed, visit some of the grandkids, etc.
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Old 10-11-2008, 02:54 PM   #20
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And all the employees were wondering why they got a free jar of vaseline on their first day on the job.
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