When are post-tax savings better than pre-tax?

[RockMiner]

For those of us still in the accumulation phase...I have seen occasional caveats about having "too many pre-tax assets". So far the arguments presented have not impressed me. Most seem to be directed at those who may have large retirement incomes. For those of us shooting for ER incomes in the 50K range, it seems hard to justify giving up the deferral of "higher bracket" present day income taxes on 401k contributions.

It seems unlikely that my post ER tax bracket will ever be higher than it is today. Perhaps some of the board experts could enlighten me on this topic?

 

[brewer12345]

As far as taxes go, it depends on what you think taxes will look like far into the future. Will tax rates have to shoot up to pay for military misadventures, unrealistic SS and Medicare promises, god knows what else? Will they stay at current levels? Will they convert to a national income tax? I don't know. I bet that the tax code will change a number of times in my lifetime, though.

There are other reasons why you might choose to have a sizable nut outside tax deferred accounts. Probably the biggest reason is flexibility. Any time I like and for any reason, I can tap my after-tax assets. I also can invest in literally just about anything I like. These are not features of IRAs, etc. and sometimes it is a big drawback. I also tink that there is a reasonable case to be made that taxes should not be the primary motivator of anyone who invests in relatively tax-efficient strategies. Finally, I view different types of savings as diversification WRT the tax code. It is probably not a bad idea to have some pre-tax, some after-tax and some Roth savings, so that no matter what Congress does you are liely to have some form of assets that would benefit from changes.

Having said that, most of us who are trying to save enough to FIRE generally end up needing to stash more than can be put away in tax-advantaged savings, so most of us end up with tax-advantaged and after-tax assets.

 

[retire@40]

It's best to have a blend of pre-tax and post-tax accounts than only to have one or the other. The allocation of that blend depends on each person's particular situation, so it cannot be easily defined here.

It would be ideal to be able to have just enough income to be in the zero tax bracket, or no higher than 10%. You can only base your tax decisions on our current knowledge of tax laws. It makes no sense to try to predict what the tax laws will be in the future.

 

[wzd]

It makes no sense to try to predict what the tax laws will be in the future.

I agree but am not sure it is so clear cut. You have to ask the question - will my taxes be higher now or later, and I believe that our tax rates are at a low, and can only go up. With the deficit, rates have to go up, or government spending has to go down, or deep **** has to get deeper. My "cynic" meter pegs when talking about government spending going down, so I think taxes will go up (and the deep **** will get deeper).

So, if tax rates will be higher, then what? It is usually still good to defer taxes, but you do have to look at income levels. If you are in a higher income tax bracket now than you will be in retirement (true for most), then deferal can make a lot of sense, but because I believe taxes are currently lower than average, I would be careful and add some fudge factors in the analysis. In any case, I would prefer Roth IRA's, which do not defer taxes, but do waive taxes on earnings.

There is some intangible benefits to IRA's/401k's you also have to consider. Most people consider the money untouchable, and it is more likely that after tax funds will be spent for something than IRA/401k funds. Unless you are sure you and your spouses can clearly delimit spending and retirement savings, this may be a factor to consider.

My advice (and what I did), 3% of salary to IRA, 12% to 401k, and >10% to after tax savings. As retire@40 says, a blend, and reasons for the blend are unique to each person.

Even the wonderful Roth IRA's have their risks. The killer for those of us with Roth funds will be lower income taxes, and a consumption tax (or VAT). Nothing is a sure bet! So make your predictions on tax law - and the best bet is probably close to no/minimal change - then work thru the numbers to see what makes sense for you, but do the same thing you do with your investments - Diversify

If you want to look at tax planning, http://i-orp.com has some tools to look at that. I would recommend it as one of the tools that should be in your arsenal of planning tools.

 

[wzd]

One personal experience: With the low interest rates, the SEPP withdrawals would be below our spending plans. With deferred pension, SS at 62+, a cheaper, smaller house in 10 years (after kids are gone), the early draw rate from savings requires an after tax component. If I didn't have that, we would be in trouble (working, HELOC, selling income real estate).

 

[RockMiner]

Thanks to all for the input! Certainly, future tax rates are unknown and pre/post tax diversification makes sense. We do have both, but mainly because of the limits on pre-tax contributions.

In the past I have seen some "advisors" raving about what a good idea it is to convert a lot of IRA assets into Roth assets...I still don't understand how it can be a good thing to pay those taxes sooner, and at a higher rate than would likely be experienced from more gradual ER withdrawls. Maybe I'm missing something?

 

[John Galt]

Hey Rock! I don't think you are "missing something".
I never understood that advice either.

JG

 

[BigMoneyJim]

Those same advisors seem to be awfully worried about the required minimum distributions kicking in at age 70 1/2 causing undue tax burden. For most on this board I think the kicking would be because if RMD made us withdraw more than we wanted then it means we could've retired ealier. (Being 34 I guess my tense is "will have could have retired" or "will have could retired"...)

I tried a partial IRA-Roth conversion in 2000 when I was out of work most of the year and made the conversion at a 15% marginal tax rate. (Although I had to recharactarize (undo) in April because I didn't have enough cash to pay the tax.) Unless you have a low income year I don't see why roth makes more sense, at least in my situation.

 

[John Galt]

Both of my parents have traditional IRAs and of course
they are way past 70.5. Anyway, every year they go down to the bank and the bankers tell them how much to take out. I asked Dad what he did with the money.
It goes into his checking account, which just builds and builds. I wouldn't be surprised if he had more
money in non-interest checking than invested earning interest.
In fact, I'm sure he does. And of course, he only deals with one bank, and he takes whatever they want to pay him on CDs, etc. Banks must love these old people.
Makes me nuts to watch it though.

JG

 

[wzd]

RE BMJ's comment -

I think that partial IRA/Roth conversions make a lot of sense for those at younger ages if they happen to have a low income year for any reason (like out of work, took a year sabatical, etc). It's just a chance to pay tax at a low 10% rate, and I just don't think you will get many of those.

 

[ESRBob]

Sure,
There is something very nice about knowing you've taken your medicine and will never have to pay tax on a 401k.

Also, if you pay tax later, you pay it on an amount that (hopefully!) has grown enormously over the years. So no matter what percentage, you're still paying a bigger dollar amount real or otherwise.

Don't convert until/unless you are in ER or have a low taxable income year. You want to be getting these funds out of the taxable world paying just 10% or 15% tax rates.

Also FWIW, don't forget, you need some taxable funds in ER because you need to be able to withdraw your 4% to live on! If its all tax-deferred, you cant get at it until your're not really early retirement anymore (59 1/2)

 

[gneeby]

RE BMJ's comment -

I think that partial IRA/Roth conversions make a lot of sense for those at younger ages if they happen to have a low income year for any reason (like out of work, took a year sabatical, etc). It's just a chance to pay tax at a low 10% rate, and I just don't think you will get many of those.

A low adjusted gross income is the perfect time to do a partial rollover of an IRA into a Roth IRA because the personal income tax rate will be low on the IRA withdrawal, maximizing the capital that goes into the Roth IRA. In many retirements this opportunity will occur twice: 1)early on when the after-tax account is being drawn down and 2) after the sale of the retiree's house providing significant non taxable capital to live off of.

This has been modeled by the retirement calculator i-orp cited earlier. It is worth studying orp's distribution schedule for how this works in an individual's particular case.

 

[LOL!]

Why drag this 5-year old thread up? Could you not find a more recent thread on the same issue or start a new one? Moderator! Moderator! Help!!

 

[jIMOh]

There is a time component I use to help me with my decisions.

I am about 17 years from FIRE.

Roths for wife and I are maxed
HSA is maxed as well
401ks are not.
We save close to 30% of gross, with 25% earmarked for retirement. We gross in 25% tax bracket and file taxes in 15% tax bracket after mortgage, HSA and other deductions.

Right now we have room to increase 401k and do so about once a year, 1% per year in one or the other 401k. We have more than 15k in 401k contribtions to go before maxing the accounts is even a factor (I think I put in 8k and wife puts in 3.5k).

The time factor is this-

Any investments I make with more than 15 years from withdraw will be tax deferred. HSA or 401k right now.

If I am in 25% bracket or higher the 401k will be used, regardless of 15 year guideline I gave myself.
If I am in 15% bracket it is probably I will add to my PRPFX (taxable) position, increase cash position, pay down mortgage or open a muni bond position if time horizon is less than 15 years. Because the investments I would choose are the less aggressive types, I might get one double in 15 years... meaning growth is not my concern, something else is (kids college, paid off house, larger emergency fund).

If all of the above were met (kids had enough for college, mortgage paid off, 24 month emergency fund existed) and FIRE was in less than 15 years, I would opt for taxable accounts with equities. The probability that money would grow to point where I had a tax problem in 10-15 years is minimal. Famous last words maybe... but I look at the taxable vs tax favored account question with "how many years will I get tax savings" as part of the equation.

 

[Rich_by_the_Bay]

Another thing: I'm maxed out on my tax sheltered options and am stashing away as much after-tax cash as I can. The reason is that I hope to semi-retire with a decent earned income (though no where near my full-time gig).

If I want to supplement it each month, the tax-free cash can be used without kicking us up a bracket. My part-time earnings alone will define my tax bracket so I get to keep more than I would withdrawing from my IRA.

I'd rather shelter it all, but since I can't I realize that post-tax cash will have some advantages.

 

[HornedToad10]

I've actually been thinking about Roth 401k vs. Trad 401k lately...

I think I'm going to stick with the Traditional 401k. Mainly because right now I live in California with around 9-10% state income taxes. Correct me if I'm wrong, but with the Roth 401k I pay the Federal AND State income taxes, and with Trad 401k I pay neither. However, in retirement, if I end up leaving California for a state with no Income tax, then I am only paying the Federal tax and am thus saving ~9%. Is this correct?

Right now I'm 25% Fed, 9% state, so for Roth 401k to be better, I'd need to be withdrawing from a 401k at higher than a 34% marginal rate of Fed+State? If I'm in California 30 years from now it's possible, but if I'm not in California then it doesn't seem terribly likely...

Plus, I already contribute max to Roth IRA each year.

 

[jIMOh]

I've actually been thinking about Roth 401k vs. Trad 401k lately...

I think I'm going to stick with the Traditional 401k. Mainly because right now I live in California with around 9-10% state income taxes. Correct me if I'm wrong, but with the Roth 401k I pay the Federal AND State income taxes, and with Trad 401k I pay neither. However, in retirement, if I end up leaving California for a state with no Income tax, then I am only paying the Federal tax and am thus saving ~9%. Is this correct?

Right now I'm 25% Fed, 9% state, so for Roth 401k to be better, I'd need to be withdrawing from a 401k at higher than a 34% marginal rate of Fed+State? If I'm in California 30 years from now it's possible, but if I'm not in California then it doesn't seem terribly likely...

Plus, I already contribute max to Roth IRA each year.

correct- one more reason to defer taxes is to consider state income tax into the calculation.

 

[jIMOh]

Another thing: I'm maxed out on my tax sheltered options and am stashing away as much after-tax cash as I can. The reason is that I hope to semi-retire with a decent earned income (though no where near my full-time gig).

If I want to supplement it each month, the tax-free cash can be used without kicking us up a bracket. My part-time earnings alone will define my tax bracket so I get to keep more than I would withdrawing from my IRA.

I'd rather shelter it all, but since I can't I realize that post-tax cash will have some advantages.

Rich- I neglected to add this in my post before yours- that withdrawing cash from a bank does not increase a person's tax bracket, but does increase their purchasing/spending power.

Good point.

 

[BunsGettingFirm]

No one mentioned 72t?

 

[jIMOh]

No one mentioned 72t?

you still pay taxes on the 72t, and it's possible that if Roth conversions are desired that having cash (which is not taxed) is better than deferring taxes while working only to pay as much or more in taxes when retired.

 

[headingout]

Ditto the other comments on Roth IRA's: I look at them every year or so when I read another article extolling the virtues, and find they just don't make sense for us, even if we could fund one (most years we can't). The basic assumption supporting a Roth, that your tax rate will be higher in retirement, seems ludicrous for most of us LBYM'ers. I aim to be in the lowest possible bracket when I retire, if possible. I find much of the Roth IRA advice to be self-serving money-churning from the financial services crowd.

 

[harley]

Ditto the other comments on Roth IRA's: I look at them every year or so when I read another article extolling the virtues, and find they just don't make sense for us, even if we could fund one (most years we can't). The basic assumption supporting a Roth, that your tax rate will be higher in retirement, seems ludicrous for most of us LBYM'ers. I aim to be in the lowest possible bracket when I retire, if possible. I find much of the Roth IRA advice to be self-serving money-churning from the financial services crowd.

My only issue with this statement is that you might very well be in the lowest possible tax bracket, and still be in a higher bracket than you are right now. Somebody's got to pay for all this bailing wire and spit!

I personally have a fair amount of money in traditional IRAs, since Roths weren't available most of my investing life. I'm working on converting them now while I am in a lower (retired) bracket, to hedge my bets on the future of taxation in the good ole' USofA. If I was still w*rking and eligible I'd be accomplishing the same thing by funding a Roth until I was ~even, then splitting between the two types.

 

[Grep]

Will they convert to a national income tax?

This would be the unkindest cut of all for heavy post-tax savers like myself (that and a tax on net worth rather than income). People who use Roth IRA's could be penalized twice as well. Hedging against this is why I'm desperate to pump money into pre-tax accounts as fast as possible (at least 42k per year at present), and why I'm not interested in Roth accounts (along with my high current tax bracket). If it comes to pass, I suppose one could at least hope that there is some sort of substantial credit or deduction to help out.

 

[old woman]

I converted some to ROTH and have about 1/3 each ROTH,401K and Taxable now. I am maxing my 401K until retirement but am 60 now. When I retire I like having different pools of money with different tax implications. I will draw enough from my 401K to get me enough taxable income to get to the bottom of the 15% bracket. The ROTH will be for if I ever need a huge amount at once since it cost me nothing more for taxes. I will use it up before I die. The taxable account I can play with and hopefully have long term gains. I will keep much of this for last if I don't use it all I will leave it to heirs with a stepped up basis.

 

[haha]

Another thing to consider is stealth taxes. As one example of many, once you are on Medicare your premium level is tied to your "adjusted AGI". You add back any tax free income such as municipal bond interest to your AGI. For 2008 tax year if you manage to stay under $85,000 (single) you will pay the base Medicare premium in 2010. Over $85,000 there are step-ups that at the top much more than double your base premium. There is also talk, as yet not enacted, of similarly indexing Pt. D to income defined this way.

This year I am paying a double Part B premium, based on my income in 2007. In 2008, I paid a lesser increase, based on my income from 2006.

Ha