Quiz - $1 Million Tax Deferred or Not?

[Cut-Throat]

I was thinking about this and thought I would ask the forum for a more diverse answer.

What would you rather have $1 Million Tax Deferred or $1 Million Not.

IOW - The taxes would not be paid on the $1 Million Tax deferred nor on the gains.

or Having the taxes paid on the $1 Million and having to pay the taxes on the gains each year.

Would it ever be better to take the $1 Million tax deferred over the $1 Million Taxes paid?

 

[2B]

You were not totally clear.

I would much rather have $1 MM taxes paid but I assume you assume the taxes would reduce the amount to less than $1 MM.

If it was an even choice as to when to pay the taxes, going tax deferred allows you to time the withdrawls at a lower marginal tax rate. That's the same reason you don't withdrawl the entire amount out of your IRA the day you turn 59 1/2. It's a no-brainer unless you know tax rates are going to rise dramatically.

 

[Cut-Throat]

You were not totally clear.

I would much rather have $1 MM taxes paid but I assume you assume the taxes would reduce the amount to less than $1 MM.

If it was an even choice as to when to pay the taxes, going tax deferred allows you to time the withdrawls at a lower marginal tax rate. That's the same reason you don't withdrawl the entire amount out of your IRA the day you turn 59 1/2. It's a no-brainer unless you know tax rates are going to rise dramatically.

You were not totally clear either.

But let me help you. Yes the taxes are all paid on the $1 Million that is not tax deferred, but the gains on it are not and would have to be paid each year.

On the $1 MIllion tax deferred, the taxes are not paid.

What I am getting at is the benefit of tax deferring has. IOW - How long a time period would it take for the Tax deferred to become the better deal. And at what interest rate?

 

[Texas Proud]

Cut Throat...

Still not clear.. here are some of the options that I see..

1. I have $1 million that no tax is due on it... but I can invest in a tax deferred account and all FUTURE earnings will not be paid in the year it is earned...

2. I have $1 million that no tax is due on it... but I can invest in anything I want and pay taxes on all FUTURE earnings when it is due... but I can invest in stock where I can defer the capital gains if I wish..

3. I 'win' or something $1 million and it will go into a tax deferred account and the taxes that are due because I won it will be deferred AND any future earnings will be deferred

4. I 'win' or something $1 million and I must pay taxes on that winnings today and I can invest the net amount into a tax deferred account and all future earnings will be tax deferred..

5. I 'win' or something $1 million and I must pay taxes on the winnings today and I can invest in anything, but all current earnings will be taxed when it is due (earned), but I can invest in stock where I can defer the capital gains if I wish...

So, what is your questioin again

 

[Cut-Throat]

2 options.

1.) You have $1 Million in a tax deferred account. All earnings are tax deferred.

2.) You have $1 Million in a non-tax deferred account and have to pay taxes each year on the gains realized.

Hope this clears things up.

 

[mickeyd]

Intreging Q there C-T.

What I am getting at is the benefit of tax deferring has

I would take the $1M cash today as I will be spending it as part of my current and future lifestyle.

If I were say age 30, I would probably take it as a tax-deferred  bunch of $ (what is it an IRA from my long-lost uncle Jim?) so it could grow tax deferred for another 40 years (70 1/2 rule).

 

[Texas Proud]

2 options.

1.) You have $1 Million in a tax deferred account. All earnings are tax deferred.

2.) You have $1 Million in a non-tax deferred account and have to pay taxes each year on the gains realized.

Hope this clears things up.

Yes.. it makes sense now... you have $1 million free, no tax due on it, where to invest...

I would invest in a non-deferred account... I would do mostly stock and pay at the capital gains rate.. this is due to NO current tax benefit on the investment and that you will have to pay ordinary income tax on the money when you withdrawl...

 

[LOL!]

Would the tax rates be the same? Or would they be like an IRA (marginal income tax rates) vs capital gains tax rates?

Even in a taxable account, one can work it so that you do not realize any gains, so in essence you get tax deferral.

 

[justin]

2 options.

1.) You have $1 Million in a tax deferred account. All earnings are tax deferred.

2.) You have $1 Million in a non-tax deferred account and have to pay taxes each year on the gains realized.

I'd take option 2. That's the same as having $1 million in a regular taxable account. I'd invest it in tax efficient choices, mostly stocks.

A low cost variable annuity or muni's may make sense for the bond portion, depending on what other income is earned during the year.

The favorable long term cap gains tax rates won't take much of a bite in this case, since basis will be equal to market value (today) and future sales won't cause many CGs to be realized.

There might be some limited situations where the tax deferred choice (CT's choice #1) might make more sense.

 

[sgeeeee]

This isn't adressing the question directly, but I had the data and spreadsheet available and it does examine the tax deferred advantage in a different way.

An illustration of the advantage of tax deferred retirement investing.  The example assumes a $2000 per year investment for 30 years (pre-retirement) followed by a $2000 per year withdrawal for 30 years (post-retirement).  For the taxable account, earnings during pre-retirement are taxed at 28%, earnings during post-retirement are taxed at 18%, and withdrawals are untaxed.  For the tax-deferred account, earnings are not taxed during pre-retirement, but both earnings and withdrawals are taxed at 18% during post-retirement. All investments are assumed to earn 7% pre-tax return per year.


year....taxable....tax 
...........account...deferred account
==========================
1 $2,101 $2,140
2 $4,207 $4,290
3 $6,419 $6,590
4 $8,742 $9,051
5 $11,183 $11,685
6 $13,746 $14,503
7 $16,439 $17,518
8 $19,268 $20,744
9 $22,239 $24,197
10 $25,360 $27,890
11 $28,638 $31,843
12 $32,081 $36,072
13 $35,698 $40,597
14 $39,497 $45,438
15 $43,488 $50,619
16 $47,680 $56,162
17 $52,083 $62,094
18 $56,708 $68,440
19 $61,566 $75,231
20 $66,669 $82,497
21 $72,029 $90,272
22 $77,659 $98,591
23 $83,573 $107,493
24 $89,785 $117,017
25 $96,310 $127,208
26 $103,164 $138,113
27 $110,364 $149,781
28 $117,926 $162,265
29 $125,870 $175,624
30 $134,214 $189,918
31 $139,917 $200,852
32 $147,712 $212,551
33 $156,051 $225,070
34 $164,975 $238,465
35 $174,523 $252,797
36 $184,740 $268,133
37 $195,672 $284,543
38 $207,369 $302,101
39 $219,885 $320,888
40 $233,276 $340,990
41 $247,606 $362,499
42 $262,938 $385,514
43 $279,344 $410,140
44 $296,898 $436,490
45 $315,681 $464,684
46 $335,779 $494,852
47 $357,283 $527,132
48 $380,293 $561,671
49 $404,913 $598,628
50 $431,257 $638,172
51 $459,445 $680,484
52 $489,606 $725,758
53 $521,879 $774,201
54 $556,410 $826,035
55 $593,359 $881,497
56 $632,894 $940,842
57 $675,197 $1,004,341
58 $720,461 $1,072,285
59 $768,893 $1,144,985
60 $820,715 $1,222,774

 

[Delawaredave]

each year on the gains realized.[/b]

If you are talking about the same tax treatment on earnings for both options, then you would be better off deferring earnings - and let that deferred tax compound for you.

However, maybe you're trying to compare taxable account (where capital gains get 15% treatment) versus 401K - where all the gains are taxed as regular income - correct ?

I did a rough analysis a couple years ago - I'll see if I can find it.   I think if you did not need the money for 7 years or more - you were better off in deferred account - even if you could not take advantage of capital gains on distribution.

 

[Delawaredave]

An illustration of the advantage of tax deferred retirement investing.  The example assumes a $2000 per year investment for 30 years (pre-retirement) followed by a $2000 per year withdrawal for 30 years (post-retirement).  For the taxable account, earnings during pre-retirement are taxed at 28%, earnings during post-retirement are taxed at 18%, and withdrawals are untaxed.  For the tax-deferred account, earnings are not taxed during pre-retirement, but both earnings and withdrawals are taxed at 18% during post-retirement.  All investments are assumed to earn 7% pre-tax return per year.

Great analysis - thanks !

On the taxable account, a portion of the 7% annual gain is going to be capital gain (5% of the 7% ?) - this portion would only be taxed at 15% - whereas all of the gain is going to be taxed at 28% for the deferred scenario.

Would you be able to rerun with capital gains portion on taxable account gain ?

Thanks !!!

 

[free4now]

Just to recap: the question is: You have $1 million free and clear, taxes paid. Do you invest it in a tax deferred or taxable account.

The answer obviously depends on a number of factors that have not been supplied:

- How long will you be taking withdrawls (tax deferred better for longer term, taxable better for shorter term).

- Will there be "lumps" in your withdrawls (lumpy years mean bigger tax on the withdrawls, which favors the taxable account)

- What are the tax rates on the two accounts? Today deferred accounts are typically charged at ordinary income, which is more than the capital gains rates you pay in taxable accounts.

At any rate, the general answer is that if withdrawals are just for a few years I'll take the taxable account. If it's for a conventional 30 year retirement I'll take the tax deferred. If the timeline is somewhere in between then you need to work the numbers.

 

[sgeeeee]

Great analysis - thanks !

On the taxable account, a portion of the 7% annual gain is going to be capital gain (5% of the 7% ?) - this portion would only be taxed at 15% - whereas all of the gain is going to be taxed at 28% for the deferred scenario.

Would you be able to rerun with capital gains portion on taxable account gain ?

Thanks !!!

Okay, if for the taxable account you tax 5/7 of the earnings at 15% and 2/7 at the full tax rate, you change things a little bit. Note that after year 30, the analysis assumes a drop in full tax rate from 28% to 18% in both cases. Here are the results:

year ....taxable....tax
............account....deferred account
=========================
1 $2,114 $2,140
2 $4,234 $4,290
3 $6,475 $6,590
4 $8,843 $9,051
5 $11,347 $11,685
6 $13,992 $14,503
7 $16,788 $17,518
8 $19,744 $20,744
9 $22,867 $24,197
10 $26,168 $27,890
11 $29,657 $31,843
12 $33,345 $36,072
13 $37,242 $40,597
14 $41,361 $45,438
15 $45,714 $50,619
16 $50,316 $56,162
17 $55,179 $62,094
18 $60,318 $68,440
19 $65,750 $75,231
20 $71,492 $82,497
21 $77,559 $90,272
22 $83,973 $98,591
23 $90,751 $107,493
24 $97,914 $117,017
25 $105,486 $127,208
26 $113,488 $138,113
27 $121,945 $149,781
28 $130,884 $162,265
29 $140,331 $175,624
30 $150,316 $189,918
31 $161,170 $200,852
32 $172,663 $212,551
33 $184,832 $225,070
34 $197,719 $238,465
35 $211,365 $252,797
36 $225,814 $268,133
37 $241,115 $284,543
38 $257,316 $302,101
39 $274,472 $320,888
40 $292,638 $340,990
41 $311,875 $362,499
42 $332,244 $385,514
43 $353,814 $410,140
44 $376,653 $436,490
45 $400,838 $464,684
46 $426,447 $494,852
47 $453,565 $527,132
48 $482,280 $561,671
49 $512,686 $598,628
50 $544,884 $638,172
51 $578,977 $680,484
52 $615,079 $725,758
53 $653,307 $774,201
54 $693,787 $826,035
55 $736,651 $881,497
56 $782,040 $940,842
57 $830,102 $1,004,341
58 $880,995 $1,072,285
59 $934,885 $1,144,985
60 $991,950 $1,222,774

 

[Texas Proud]

For the taxable account, earnings during pre-retirement are taxed at 28%, earnings during post-retirement are taxed at 18%, and withdrawals are untaxed. For the tax-deferred account, earnings are not taxed during pre-retirement, but both earnings and withdrawals are taxed at 18% during post-retirement. All investments are assumed to earn 7% pre-tax return per year.

IMHO.. bad assumptions... You are assuming that all income will be taxable in the year earned.. no LTCG... If you change your assumptions to only 10% of the income is taxed at 28%, let's say 25% is capital gains and the rest deferred until withdrawl, which would then get capital gain... I bet the other is the higher number... but I have not done the math...

 

[sgeeeee]

Everyone's tax situation is different. A good assumption for someone who pays high State taxes and has minimal shelters and deductions is a bad assumption for someone in a no income tax State with a multitude of deductions. The spreadsheet I used allows you to change the following assumptions:
1) average annual return on investments,
2) average pre-retirement tax rate,
3) average post-retirement tax rate,
4) annual investment and withdrawal amounts.

If you change any of those values or the length of the accumulation or withdrawal periods, you will change the numbers. Rather than condemn the assumptions without data, why don't you give me different assumptions and I'll run the analysis -- or PM me and I'll send you the spreadsheet. I think you might be surprised at the results.

 

[Cut-Throat]

IMHO.. bad assumptions... You are assuming that all income will be taxable in the year earned.. no LTCG...

Yeah, but that is exactly what I said for this example. That all earnings would be taxed in the year earned.

 

[Texas Proud]

Yeah, but that is exactly what I said for this example. That all earnings would be taxed in the year earned.

And what percentage of people do you think ONLY invest in products that are taxed 100% of all gains every year (add on top of that that will earn 7%)...

so again, bad example.

 

[Cut-Throat]

And what percentage of people do you think ONLY invest in products that are taxed 100% of all gains every year (add on top of that that will earn 7%)...

so again, bad example.

OK - move along!

 

[JohnP]

Bravo C-T    This is a most diabolical, thought provoking question... and one I've been considering myself when mulling over my finances.

We have about a 60/40 taxed/taxdeferred investment ratio... and like you, I'm retired with a still-working wife, and we are still packing away the savings (into both taxed and tax-deferred accounts). 

I've come to the conclusion that once a person is fully retired and living only on their investment accounts, that it makes little financial difference whether they are drawing from a $1M taxable account or from a $1M tax deferred account.  (I think that this is a direct answer to your Quiz question)

I think that the answer would change if there are different amounts - for instance, I'd choose a $10M taxable account over a $10M taxdeferred account due to the taxes - but I haven't been given that choice, lately.

Back to reality... I believe for most FIRED people here, there is little difference, come withdrawal-of-retirement-assets day, between whether it comes from taxed or tax-deferred accounts.

JohnP

 

[Mach1]

2 options.

1.) You have $1 Million in a tax deferred account. All earnings are tax deferred.

2.) You have $1 Million in a non-tax deferred account and have to pay taxes each year on the gains realized.

Hope this clears things up.

It depends on wheather you need to draw from this $1M or not. If money is not needed right now then I'd say option 1. Option 2 have to yield income before taxes is due so either way you'll come ahead.

 

[bongo2]

I recently looked at this in some detail. In my tax situation the deferred account and taxable account were nearly equal, with small changes in assumptions causing one or the other to win. However, I will not be withdrawing the money for many years, and expect to be in a much lower tax bracket when I do. In the situation you outlined (where all cap gains are realized), and if you are currently withdrawing the money, I think the taxable account would almost always win.

 

[scrinch]

Let's say your hypothetical $1.3 million is in a hypothetical IRA and will hypothetically sit there for 23 years until you have to start making withdrawals. At 8% return, the $1.3 million will turn into $7.6 million. From that your minimum annual withdrawal starts at $280K and goes up from there. Ouch...who knows what tax bracket that puts you in? I had better start making withdrawals when I'm 59-1/2...or substantially equal sooner!

 

[modhatter]

I have also ponderered the same question. Look at this example:

You are 65 years old, with no pension and a $1,500 a mo. Soc Sec check. You never worked for a company with a 401K plan, and you never opened an Ira.

If you have one million in cash, say after selling off real estate rentals you owned (and paid uncle sam his due) but none of it is deferred. So you will have to pay taxes on the whole gain of $1,000,000 each year from the start of your retirement. Anywhere from 15% to 32% depending on where you plumk your money.

You actually don't need more than another $20,000 to supplement your social security, but because none of it is deferred, you wind up paying a much bigger tax bill each year, and a healthy portion of your annual gain for the year goes to taxes instead of growing tax deferred. If it were in a tax deferred account, you would only have to pay taxes on the $20,000 that you took out plus on your social security, and the rest could be left in to grow.

So take that scenerio, and put it on a spread sheet, and I wonder where you would be 30 years from now at the end of your retirement.

 

[MasterBlaster]

The more interesting question is...

If I have some extra money (whatever that is) should I invest it pretax in a 401k/IRA type investment or should I invest it after-tax. As others have pointed out gains from after-tax accounts are taxed as (lower) capital gains. Whereas gains from qualified tax-deferred accounts are taxed at higher income tax rates.

It should be obvious that a dollar of gain from an after-tax account is always taxed lower than a dollar gain from the deferred tax account. Also capital gains are only paid once. So if you pay some capital gains cause' your mutual fund makes some trades then you basis is raised and the tax will not be levied (on those gains) at a later date.

One can make a case for putting money in a deferred account when you are working and are theoretically in a higher tax bracket than when you are retired. In that case, if your retired income is less then you'll come out ahead. However if you are like me, and will likely have a higher income in retirement then that will not be the case.

If you can choose your gains, then capital gains are the way to go for most cases. Subject of course to the rules changing by legislation.