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Old 03-27-2012, 02:28 PM   #21
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Originally Posted by ERD50 View Post
In the Roth case, the taxes are moving in time, but they are just a move, not 'gone' or 'saved' (though you are hoping for eventual savings).

-ERD50
The problem I see is the potential to never recognize the expense. For someone who is adjusting their budget based entirely on an initial withdrawal amount + inflation, and ignoring portfolio fluctuations for budgeting purposes, then the pre-paid tax expense just disappears from consideration. You might spend less in the future because you owe less taxes, but more likely you'll spend what the 4% + inflation calculation tells you to spend. But if we do that we're really over spending our budget because we're disguising some of our tax expense as negative portfolio return.
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Old 03-27-2012, 03:20 PM   #22
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I do not treat it as an expense. IMO that would make no sense, and in fact so doing might dissuade you from making a intelligent long term move that would improve your balance sheet.

Does a corporation expense stock buybacks that result in cancelled stock?

No, because they are changing the capitalization, not incurring an operating expense or a tax item that needs to be counted against revenues. Similarly, when a taxpayer makes a Roth conversion from a TIRA, he is in effect buying back stock from the governments, since the taxing authorities have an ownership interest in TIRA balances that they do not have in Roth balances. Furthermore, since tax rates can and will change, governments % of the stock in our TIRAs may be on sale right now.

IMO, the only argument against this is that you expect to be relatively poor in retirement.

Ha
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Old 03-27-2012, 03:49 PM   #23
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Originally Posted by haha View Post
Similarly, when a taxpayer makes a Roth conversion from a TIRA, he is in effect buying back stock from the governments, since the taxing authorities have an ownership interest in TIRA balances that they do not have in Roth balances.
So the accounting would be as follows:

Year 1 Earn $100 and contribute it to an IRA
Revenue: . . . $100
Tax Expense: . . ($15)
Net Income . . . $85


Assets: Stock in IRA $100
Liabilities: Taxes Payable $15
Equity (Net Worth): $85

Year 2 Convert to Roth:

Assets ($15) . . . $85
Liabilites ($15) . . . $0
Equity . . . $85

The problem with our accounting is that we generally ignore the tax liability on our balance sheet. Now were suggesting ignoring the expense on our income statement when we extinguish the liability. And yet the taxes are real.
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Old 03-27-2012, 03:52 PM   #24
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Thank you all for your thoughtful replies.

To answer a question that kept coming up - What difference does it make?
The additional tax as a result of the ROTH transfers amounts to over 9% of our annual budget, so it will require us to spend significantly less this year.

One aspect that I should have made clear in my OP is that we use a percentage of portfolio value (as of Jan 1) to determine the year's budget. We do not use the more traditional SWR formula that is automatically adjusted for inflation & is independent of portfolio value. I hadn't thought of this aspect earlier. (Thanks G4G)

I am leaning towards not including the tax in this year's expense, but taking it as a hit against the portfolio value. Given my method of determining annual budgets, my budget for next year will be lower since I am taking the tax hit against the portfolio. However, that decrease is a LOT less than taking the hit in this year's budget. So, the 'expense' is being taken into consideration, but like an amortization rather than a current expense.

I tried valuing at my T-IRA holdings net taxes, but as pb4uski pointed out, I couldn't decide what factor to use, so gave up.

Thanks again to all those who took the time to reply. You guys are the best!
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Old 03-27-2012, 03:59 PM   #25
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I do use the same method as chemist. And the main reason is exactly because of what walkinwood followed up with:

Quote:
To answer a question that kept coming up - What difference does it make?
The additional tax as a result of the ROTH transfers amounts to over 9% of our annual budget, so it will require us to spend significantly less this year.
It makes no sense to me whatsoever that my expenses for the year would have to decrease because of a decision to do a conversion. They may both really be expenses, but they are very different types of expenses. Likewise, I know that $100K in a TIRA isn't worth as much as a ROTH.
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Old 03-27-2012, 04:05 PM   #26
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What difference does it make?
The additional tax as a result of the ROTH transfers amounts to over 9% of our annual budget, so it will require us to spend significantly less this year.
May I ask how you would deal with the purchase of a new car? Would you need to spend ~$20K less on everything else in the year of the purchase or would you spend $18K more than budget and spend $2K less than budget each of the following 9 years you owned the car? It seems that pre-payment of taxes should be treated the same way as you'd treat any other large upfront purchase.

Also, regardless of how you account for it, your Net Worth will indeed be smaller by the amount of taxes you pay. So it's really not a matter of adjusting your net worth, that happens as soon as Treasury cashes your check. The question is how, or whether, you adjust your budget.
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Old 03-27-2012, 04:09 PM   #27
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I do not treat it as an expense. IMO that would make no sense, and in fact so doing might dissuade you from making a intelligent long term move that would improve your balance sheet.

Does a corporation expense stock buybacks that result in cancelled stock?

No, because they are changing the capitalization, not incurring an operating expense or a tax item that needs to be counted against revenues. Similarly, when a taxpayer makes a Roth conversion from a TIRA, he is in effect buying back stock from the governments, since the taxing authorities have an ownership interest in TIRA balances that they do not have in Roth balances. Furthermore, since tax rates can and will change, governments % of the stock in our TIRAs may be on sale right now.

IMO, the only argument against this is that you expect to be relatively poor in retirement.

Ha

Most of the time when a corp buys back stock it does not cancell the stock... they put it in treasury stock... so you still have the full paid in capital accounts with a negative treasury stock account... but buying back stock would NEVER go to the income stmt...

If you want to compare to a corp, then the way chemist does it is better... but guess what, the corp has taken that tax as a hit to it's income statement even though it has not paid the tax.... why do you think companies like GE etc. have a big tax expense on their income stmt and then do not pay that much in tax Deferred taxes.....

So, doing it that way, the OP messed up by not taking the tax hit on his budget back when he put the money into the tIRA.....

Just saying.....
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Old 03-27-2012, 04:23 PM   #28
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I have to admit that the topic piqued my curiosity so I did a little exploring. For personal financial statements, the accounting standards would require that one establish a liability for deferred taxes like is done for a corpration. So if a CPA was doing a net worth statement for an individual who had a tIRA, in calculating the person's net worth they would include a liability for income taxes that would be paid when the tIRA is converted to cash that could be spent.

Like many others, while I am cognizant that $100 in my tIRA isn't worth as much as $100 in my ROTH or many of my taxable accounts, I don't actually include an offset in calculation my net worth (in part because I don't have a good feel for the tax rate to use and it could vary widely depending on how I approach my Roth conversions and in part because I have better things to do, like posting here ).
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Old 03-27-2012, 04:33 PM   #29
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Originally Posted by Gone4Good View Post
So the accounting would be as follows:

Assets: Stock in IRA $100
Liabilities: Taxes Payable $15
Equity (Net Worth): $85


Convert Stock to Roth:

Tax Expense: $15**

Assets ($15) . . . $85
Liabilites ($15) . . . $0
Equity . . . $85.

That is exactly how I picture this. And why I can't see why the OP wants to 'adjust' anything based on this transfer.

-ERD50

Quote:
Originally Posted by walkinwood View Post
Thank you all for your thoughtful replies.

To answer a question that kept coming up - What difference does it make?
The additional tax as a result of the ROTH transfers amounts to over 9% of our annual budget, so it will require us to spend significantly less this year.

...

I am leaning towards not including the tax in this year's expense, but taking it as a hit against the portfolio value. .... So, the 'expense' is being taken into consideration, but like an amortization rather than a current expense.
But this tax bill is being paid. Your portfolio will be $1,000 less, whether you 'take it into consideration' or not. Or, how could you not take into consideration? Your portfolio balance is what it is.

I think you are letting the numbers be the tail that wags the dog. The numbers will fall where they fall. Now, that's fine in order to dissect it to understand what is happening, but you have no control over it (other than converting or not, but that is a separate Q, and you asked we don't go there, and that's fine).

-ERD50
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Old 03-27-2012, 05:47 PM   #30
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Originally Posted by Gone4Good View Post
So the accounting would be as follows:

Year 1 Earn $100 and contribute it to an IRA
Revenue: . . . $100
Tax Expense: . . ($15)
Net Income . . . $85


Assets: Stock in IRA $100
Liabilities: Taxes Payable $15
Equity (Net Worth): $85

Year 2 Convert to Roth:

Assets ($15) . . . $85
Liabilites ($15) . . . $0
Equity . . . $85

The problem with our accounting is that we generally ignore the tax liability on our balance sheet. Now were suggesting ignoring the expense on our income statement when we extinguish the liability. And yet the taxes are real.
The taxes are real, but we are committed to that liability the day we make a deductible contribution to a TIRA. It doesn't happen when we decide to by back some of the government's stock. It has been or should have been accrued when the deductible contribution was first made, and updated annually. Of course few would do this in practice but I have always done it to a reasonable approximation.

Accounting is never perfect, and always at some remove form economic reality, but the I don't think that the buyout of an ownership interest is ever an income statment item, though is does belong on the Flow of Funds statement. Of course "ever" is a big word, and there may be something, but from my ordinarily practical POV it would not matter.

Ha
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Taxes is spending
Old 03-27-2012, 06:16 PM   #31
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Taxes is spending

Quote:
Originally Posted by ERD50 View Post
In the Roth case, the taxes are moving in time, but they are just a move, not 'gone' or 'saved' (though you are hoping for eventual savings).

-ERD50
+1
To us it's spending and it should stay within reason and SWR. Meaning - we don't convert if we can't afford the taxes this year.
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portfolio balance
Old 03-27-2012, 07:00 PM   #32
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portfolio balance

Quote:
Originally Posted by ERD50
Your portfolio will be $1,000 less, whether you 'take it into consideration' or not. Or, how could you not take into consideration? Your portfolio balance is what it is.

-ERD50
It depends on how you separate portfolio from spending account. We have a 'virtual savings' account that we spend from for large one time expenses and vacations. It is subtracted from total portfolio value in our spreadsheet. That's what makes it 'virtual' and the monthly spending doesn't effect the portfolio performance. Whatever works - some people keep separate checking/savings accounts that they fill each year to fund their expenses.

When I make a Roth conversion, I also estimate taxes and adjust quarterly tax payments to IRS & State. That makes them happy, but I am
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Old 03-27-2012, 09:05 PM   #33
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May I ask how you would deal with the purchase of a new car? Would you need to spend ~$20K less on everything else in the year of the purchase or would you spend $18K more than budget and spend $2K less than budget each of the following 9 years you owned the car? It seems that pre-payment of taxes should be treated the same way as you'd treat any other large upfront purchase.
I'll pay for it over a couple of years. The hit is once every 8-10 years, unlike the ROTH transfers which will be an annual hit as long as I feel it is in my interest to do them. I also have an emergency fund (that I do not count as part of my portfolio value in order to calculate my annual budget) in case there is an unexpected large expense.

Quote:
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Also, regardless of how you account for it, your Net Worth will indeed be smaller by the amount of taxes you pay. So it's really not a matter of adjusting your net worth, that happens as soon as Treasury cashes your check. The question is how, or whether, you adjust your budget.
You're right. (and ERD50 as well) It will go immediately against my net worth. I was trying to articulate the two options I was dealing with.
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Old 03-27-2012, 09:11 PM   #34
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The taxes are real, but we are committed to that liability the day we make a deductible contribution to a TIRA. It doesn't happen when we decide to by back some of the government's stock. It has been or should have been accrued when the deductible contribution was first made, and updated annually. Of course few would do this in practice but I have always done it to a reasonable approximation.

Accounting is never perfect, and always at some remove form economic reality, but the I don't think that the buyout of an ownership interest is ever an income statment item, though is does belong on the Flow of Funds statement. Of course "ever" is a big word, and there may be something, but from my ordinarily practical POV it would not matter.

Ha
I agree completely with the first paragraph. The tax liability arises, and is recorded (or should be), the moment we earn taxable income. Sticking that taxable income in an IRA doesn't abolish the liability, it merely defers it. If we record the expense when incurred, we don't record it again when the liability is actually paid. But this is accrual accounting. Most of what we individuals do is cash accounting. And in cash accounting we don't normally recognize an expense until it is actually paid. Neither way (cash or accrual) is necessarily right or wrong as long as we're consistent. If we haven't recognized the tax expense when it is earned, then we really need to recognize it when its paid. My assumption is that the OP doesn't include a deferred tax liability in his net worth calculations, but I could be wrong.

The second paragraph I don't really see this as the same as buying back shares, but the more I think about it the less I think the distinction is important. The crux seems to be the difference between accrual and cash accounting. You're using accrual and most of the rest of us use cash.
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Old 03-27-2012, 09:50 PM   #35
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I'll pay for it over a couple of years. The hit is once every 8-10 years, unlike the ROTH transfers which will be an annual hit as long as I feel it is in my interest to do them. I also have an emergency fund (that I do not count as part of my portfolio value in order to calculate my annual budget) in case there is an unexpected large expense.
It seems as if you have two choices. You can estimate the total amount of deferred tax you have accumulated, reduce your portfolio by that amount, and base your withdrawals off of the after tax portfolio and ignore taxes as an annual expense (call this the Ha approach).

Or, you can base your withdrawals off of your larger pre-tax portfolio, keep track of how much tax your Roth conversions are pulling forward, and amortize those tax payments over some number of years through an annual reduction in the size of the withdrawals you'd ordinarily make.

What I wouldn't do is base my allowable withdrawals on my pre-tax portfolio and then pretend the taxes aren't being withdrawn from my portfolio. Either everything should be figured on pre-tax basis or after tax basis.
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Old 03-27-2012, 10:25 PM   #36
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.... My assumption is that the OP doesn't include a deferred tax liability in his net worth calculations, but I could be wrong.
...
Your assumption is correct.
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Old 03-28-2012, 07:07 AM   #37
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I think the argument. "I don't account for taxes because I am not sure what the rate will be" is spurious. It won't be 0% so make a best guess and go with it.

PS lest anyone think I am brilliant, I got this idea from a fee paid CFP. He presented my balance sheet with contingent taxes presented as a liability. It made sense to me. Then I read all the stuff by grabiner on Bogleheads on tax adjusted AA which took a while to sink in but finally made sense. Then I got frustrated when making a smart move financially like a Roth conversion or exercising some employee options made things look worse (by both hitting my net worth and adding an expense to my income statement charged against current year's SWR). Finally I hit upon the idea of using "net net worth" (including contingent taxes), basing SWR on that net worth, and not counting taxes as an expense item for SWR purposes (since ALL assets are already burdened with taxes).

For some it may sound needlessly complex but for my particular case where I have Roth assets which are 100% mine and NSO's which will be hit this year with high Fed + State + Local + FICA, there is a big difference in my case.
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Old 03-28-2012, 07:46 AM   #38
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Finally I hit upon the idea of using "net net worth" (including contingent taxes), basing SWR on that net worth, and not counting taxes as an expense item for SWR purposes (since ALL assets are already burdened with taxes).
Are you including taxes on income, dividends and capital gains as an expense in your annual withdrawal? If not, are you estimating the present value of these taxes in your deferred tax liability as well?

I guess when we talk about "taxes" in this context, we need to be kind of specific. Taxes owed on IRA balances are contingent liabilities that under normal accounting rules we would accrue liabilities for. Taxes owed on unrealized capital gains, however, are contingent but not generally accrued. Taxes on future dividends and interest are only accrued when earned.

We should only "ignore" the taxes we've provisioned for. If we've reduced our portfolio estimate by the taxes owed on our IRA balance we can ignore taxes triggered by Roth conversions but not taxes on capital gains or investment income.

This complexity is why most folks find it easier to just deal with taxes as an ordinary expense and adjust their budget accordingly.
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Old 03-28-2012, 08:11 AM   #39
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....Taxes owed on IRA balances are contingent liabilities that under normal accounting rules we would accrue liabilities for. Taxes owed on unrealized capital gains, however, are contingent but not generally accrued. Taxes on future dividends and interest are only accrued when earned. ...
If one accounts for deferred taxes, there would be deferred taxes on tIRA balances and on unrealized gains in taxable accounts (assuming that the investments in taxable accounts are at fair value rather than cost).

Another way to think about the deferred taxes is if you converted the related investment to unrestricted cash, how much tax would that conversion create.

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This complexity is why most folks find it easier to just deal with taxes as an ordinary expense and adjust their budget accordingly.
Totally agree.
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Old 03-28-2012, 10:09 AM   #40
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If one accounts for deferred taxes, there would be deferred taxes on tIRA balances and on unrealized gains in taxable accounts (assuming that the investments in taxable accounts are at fair value rather than cost).
Accounting is a derivative exercise. You can do it any way you want, as long as you understand the principles behind whatever you are doing, and the insights from your accounting help you manage your retirement better.

Ha
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