tax adjusted portfolio value

[karluk]

The recent poll that showed wide (and nearly random) variations in the percentage of assets of forum members being held in taxable accounts got me thinking. Even though conventional wisdom encourages people to put retirement savings in tax deferred accounts, the people who ignore this advice and invest mostly in taxable accounts during their accumulation years do have a significant tax advantage in retirement. At the cost of what was most likely a higher tax bill during the accumulation phase, they have also probably reduced their future tax liability after retirement. So an apples-to-apples comparision of two different retirement portfolios should include an adjustment for future tax liability.

For my family, this means an adjustment for the funds in our tax deferred 457 plans. I have about $575,000 deferred and DW has $175,000. Our combined earned income this year puts us close to the top of the 15% tax bracket, but in future years we should be able to make about $50,000 per year in withdrawals and/or Roth conversions while remaining in the 15% bracket. So I expect our entire 457 balances to be taxed at 15%, for a total tax liability of .15*(575000+175000) = $112,500. That's federal taxes only. There would be a similar calculation for state taxes, unless we decide to move to a state with no income tax.

This $112,500 is something I would not expect to pay if we currently had the entire $750,000 invested in taxable accounts with no unrealized capital gains.

Is this a reasonable adjustment to make of portfolio balances at the beginning of retirement? I don't know the inner workings of Firecalc, so I don't know if it allows such an adjustment. It seems to me that the amount is large enough that it should be included in one's retirement planning.

 

[NW-Bound]

It looks reasonable to me, although you could fine tune it a bit more by taking into account exemptions and the deduction, at least the standard one.

 

[ERhoosier]

Good point. I know a number of very smart wealthy folks who STOPPED contributing to non-matching retirement accts a few yrs ago on theory that top marginal tax rates would rise. Somewhat dated specifics, but they felt paying 28% now was better than paying much higher rates just a few yrs later. In some cases they were right. The benefit of tax deferral was less than the increase in marginal tax (inc. Medicare & state income taxes)

 

[pb4uski]

I don't think many people adjust portfolio balances at the beginning of retirement as you suggest.

What you are suggesting is what accountants refer to as deferred income taxes. In your case, you have a deferred income tax liability of $112,500 and it would reduce your net worth. So if you were to hire a CPA to prepare personal financial statements for you (for say, a bank loan or something like that) your net worth would be reduced by the $112,500.

But in my experience in informal groups like ours, deferred taxes are not typically included. In my case, I hope to be able to manage my income so I pay very little taxes on my tax-deferred funds.

 

[smjsl]

Yes, when I compute my net worth, I compute it on after-tax basis. I make adjustments as follows:
Roth - no adjustments
401k/tIRA - 0.75 * balance (conservatively assuming 25% rate on these)
taxable - 0.9 * balance (you have to pay taxes for appreciation here too - you can estimate this one better if know or can estimate your basis... and of course if you tax-loss-harvested, you will have to pay more taxes as well)

Then, total these up for net worth.
I also use these after-tax adjustments for asset allocation purposes (e.g. for computing stocks vs bonds percentages, etc.).

 

[bo_knows]

Yes, when I compute my net worth, I compute it on after-tax basis. I make adjustments as follows:
Roth - no adjustments
401k/tIRA - 0.75 * balance (conservatively assuming 25% rate on these)
taxable - 0.9 * balance (you have to pay taxes for appreciation here too - you can estimate this one better if know or can estimate your basis... and of course if you tax-loss-harvested, you will have to pay more taxes as well)

Then, total these up for net worth.
I also use these after-tax adjustments for asset allocation purposes (e.g. for computing stocks vs bonds percentages, etc.).

Not to nitpick, but if you're withdrawing say $90k/yr as a couple, in 2013 your effective tax would be 15.9% (because of the difference between marginal and effective tax rates). Don't sell yourself TOO short

 

[smjsl]

Not to nitpick, but if you're withdrawing say $90k/yr as a couple, in 2013 your effective tax would be 15.9% (because of the difference between marginal and effective tax rates). Don't sell yourself TOO short

Well...

- I rather be more conservative than less

- I will be withdrawing in a very long time, so tax rates are very unclear this far in advance

- 25% includes federal, state, local, any other applicable taxes

- It's not clear to me if 401(k) funds will be the only taxable ones upon distribution. For example, if social security is still there and is taxables to a degree, then effective rate on 401(k) will be higher than assuming it's at the "bottom" of the tax rates.

 

[pb4uski]

Not to nitpick, but if you're withdrawing say $90k/yr as a couple, in 2013 your effective tax would be 15.9% (because of the difference between marginal and effective tax rates). Don't sell yourself TOO short

+1 my view would be that you should use the tax rates that you expect to apply to income generated by the asset as you redeem it considering likely tax strategies. typically it would be based only on enacted tax law applicable to the expected taxable amounts (in other words, changes in tax laws or rates would not be anticipated).

The relevant tax rates to be applied is usually the most judgmental part.

 

[bo_knows]

Well...

- I rather be more conservative than less

- I will be withdrawing in a very long time, so tax rates are very unclear this far in advance

- 25% includes federal, state, local, any other applicable taxes

- It's not clear to me if 401(k) funds will be the only taxable ones upon distribution. For example, if social security is still there and is taxables to a degree, then effective rate on 401(k) will be higher than assuming it's at the "bottom" of the tax rates.

Cushions are allowed, for sure. You just didn't even mention how much you'd be withdrawing, so 25% effective rate seemed pretty high (as most people are in a lower bracket in retirement anyways).

Personally, I invest in various investments that carry various tax implications, so that I don't have to worry about trying to min/max in my accumulation phase. I'll just try to use those particular investments to my advantage when the time comes.

 

[MichaelB]

Is this a reasonable adjustment to make of portfolio balances at the beginning of retirement? I don't know the inner workings of Firecalc, so I don't know if it allows such an adjustment. It seems to me that the amount is large enough that it should be included in one's retirement planning.

Seems to me you would want to know this for two reasons. One is to compare with others. The other is to make sure you have enough money to fund your retirement. The way most here deal with the second is to include taxes on withdrawals as part of their spending. This is what FIRECalc assumes. When comparing with purely after-tax portfolios, calculating the deferred tax works. So does comparing withdrawal rate %, if they include income tax on the amount withdrawn.

 

[pb4uski]

Good point, if you are using tax adjusted portfolio amounts then you should probably reduce spending to only reflect taxes on current income in taxable accounts and exclude taxes on tax-deferred distributions so you don't double count.

 

[smjsl]

25% effective rate seemed pretty high (as most people are in a lower bracket in retirement anyways).

+1 my view would be that you should use the tax rates that you expect to apply to income generated by the asset as you redeem it considering likely tax strategies. typically it would be based only on enacted tax law applicable to the expected taxable amounts (in other words, changes in tax laws or rates would not be anticipated).

To give an example from today's tax laws... Take a person receiving Social Security. Due to the way it is taxed today, after first ~19k of taxable income, the rest of the withdrawal will be taxed at 22.5% rate (because every additional dollar will bring in $0.5 in taxable social security). And after ~28k, marginal tax rate will be 27.75% (increase of each $1 will bring in $0.85 into taxable territory).

This does not even account for state (or any other) taxes...

And yes, effective tax rate will be lower in above example of course but just saying the numbers are not totally out of wack... (unfortunately)

 

[RunningBum]

Who says we ignored the advice to use tax deferred accounts? I put in enough to get the company match in early years, and in my later working years I maxed out my 401K, and was ineligible for a Roth. It just happened that I made enough primarily through employee stock options, and secondarily through ESPP and other investments that most of my nest egg is in taxable accounts.

Like smjsl, I also figure my net worth for SWR rate purposes based on an after tax calculation taking out 15% federal and 5.75% state for IRA distributions/conversions and LTCGs. It may be a bit high, especially for LTCGs, but I'll take the cushion.

 

[LOL!]

If one is in the 15% marginal income tax bracket, their effective tax rate has got to be less than 5%. That's because lots of their income is not taxed and only a little bit is taxed at 15%. Plus cap gains and qualified dividends are taxed at 0% for these folks.

I worked out our tax rate for spending $100,000 from our retirement portfolio. Basically, the overall rate was essentially 0%. Thus, there was no need to tax-adjust anything. (Aren't Roth conversions at a 0% tax rate nice?)

But this discussion occurs every so often. It seems to me that folks with pensions are the ones that will be paying taxes. For folks without pensions, are they not surprised that their taxes essentially disappear?

 

[NW-Bound]

But this discussion occurs every so often. It seems to me that folks with pensions are the ones that will be paying taxes. For folks without pensions, are they not surprised that their taxes essentially disappear?

As I just stopped working and barely got started in figuring out the tax situation for a non-pensioner retiree, I found this was way, way, too good to believe.

 

[karluk]

If one is in the 15% marginal income tax bracket, their effective tax rate has got to be less than 5%. That's because lots of their income is not taxed and only a little bit is taxed at 15%. Plus cap gains and qualified dividends are taxed at 0% for these folks.

I worked out our tax rate for spending $100,000 from our retirement portfolio. Basically, the overall rate was essentially 0%. Thus, there was no need to tax-adjust anything. (Aren't Roth conversions at a 0% tax rate nice?)

But this discussion occurs every so often. It seems to me that folks with pensions are the ones that will be paying taxes. For folks without pensions, are they not surprised that their taxes essentially disappear?

I'm glad your taxes are so low. For others, such as my family, tax considerations form an essential part of retirement planning. Our pension income and DW's earned income will put us well into the 15% tax bracket for the foreseeable future. That means that every dollar I withdraw from my 457 plan will be taxed at 15% federal. State taxes will put the total tax burden on withdrawals over 20%. So the key for us is to limit the damage by staying in the 15% bracket. I have a plan which should allow us to do so, but it doesn't change the fact that I have an expected future tax burden in the low six figures, which should really be subtracted from the value of our portfolio in order to give an accurate picture of our financial situation.

 

[karluk]

I also use these after-tax adjustments for asset allocation purposes (e.g. for computing stocks vs bonds percentages, etc.).

Would you mind explaining your after-tax asset allocation in more depth? It sounds to me as if you are doing something like the following hypothetical calculation:

pre-tax portfolio size = $1,000,000
after-tax value = $900,000

Asset allocaton targets:
50% stocks
50% bonds

If this were your situation, would you invest 50% of $900,000 = $450,000 in stocks and bonds because $900,000 is a more accurate measure of your portfolio's value than $1,000,000? If so, what do you do with the extra $100,000?

 

[audreyh1]

If one is in the 15% marginal income tax bracket, their effective tax rate has got to be less than 5%. That's because lots of their income is not taxed and only a little bit is taxed at 15%. Plus cap gains and qualified dividends are taxed at 0% for these folks.

I worked out our tax rate for spending $100,000 from our retirement portfolio. Basically, the overall rate was essentially 0%. Thus, there was no need to tax-adjust anything. (Aren't Roth conversions at a 0% tax rate nice?)

But this discussion occurs every so often. It seems to me that folks with pensions are the ones that will be paying taxes. For folks without pensions, are they not surprised that their taxes essentially disappear?

I suppose the reason folks with pensions pay taxes is because the funding for those pensions was pre-tax?

Yep - save pre-tax (tax deferred) and pay taxes during retirement when you draw on those savings. Save post-tax, pay taxes while working and while investments are growing, and tax burden is lower in retirement. Makes sense - you pay sooner, or you pay later.

 

[audreyh1]

I'm glad your taxes are so low. For others, such as my family, tax considerations form an essential part of retirement planning. Our pension income and DW's earned income will put us well into the 15% tax bracket for the foreseeable future. That means that every dollar I withdraw from my 457 plan will be taxed at 15% federal. State taxes will put the total tax burden on withdrawals over 20%. So the key for us is to limit the damage by staying in the 15% bracket. I have a plan which should allow us to do so, but it doesn't change the fact that I have an expected future tax burden in the low six figures, which should really be subtracted from the value of our portfolio in order to give an accurate picture of our financial situation.

Ah, yes, as long as someone is in the household earning a (large enough) salary, funds drawn (pensions, IRA withdrawal, etc.) on top of that are taxed at the marginal rate.

Personally, I just know my taxes come out of my annual withdrawal as an expense, and that was budgeted for since day 1. I have no need to calculate the "after-tax" value of my portfolio.

 

[REWahoo]

Personally, I just know my taxes come out of my annual withdrawal as an expense, and that was budgeted for since day 1. I have no need to calculate the "after-tax" value of my portfolio.

+1

I budget for two categories of taxes each year: property tax and income tax. Works for me.

 

[mpeirce]

Back when I was planning my [-]escape[/-] retirement, I definitely factored in taxes.

My situation was that I had substantial company stock options and other company stock from an ESPP. The options were going to be taxed at the highest marginal rate the year I cashed them in (this is the main reason I left the company in January - so I could cash in some of it in one year, then push the remaining chunk of the option income into the following year, one where I would not be not earning much in the way of regular income).

If I hadn't figured all that after-tax, I would have been way off in figuring if/when I could FIRE.

With that behind me, I still count my residual company stock in my spreadsheet model after-tax. Mainly because that's the way I built the model, but also because it seems like a more conservative way to view it.

I'm not currently factoring in taxes for other assets in the taxable accounts. I have been considering adding in factoring in the taxes for those assets into my model, but haven't yet mainly because most of those assets currently have a very high basis. That will change over the next decades (I hope!).

It's also fairly complicated and uncertain because it's not knowable what the tax rate will be 10 or 20 years out. But still, it seems worth it to take a stab at this by making conservative estimate of future rates.

 

[Brett_Cameron]

...

Personally, I just know my taxes come out of my annual withdrawal as an expense, and that was budgeted for since day 1. I have no need to calculate the "after-tax" value of my portfolio.

+2

 

[NW-Bound]

If it weren't for different tax brackets, deductions, and exemptions that created non-linearities in the tax system, there would not be any difference between saving money in before or after-tax accounts.

Suppose a worker has a chance to save $10K in an IRA that will grow 5X by the time he retires, at which time he will pay a 10% tax before he can spend it. Then, what he has at the end is $10K X 5 X 0.90 = $45K.

His brother decides to pay the tax up-front and invests what he has left. At the end, he gets to spend the whole thing tax-free. What his brother has at the end is $10K x 0.90 x 5 = $45K.

So, tax at the end or at the beginning should give the same result!

Well, we all know it does not work out that way. The brother after-tax account will not get to grow 5X, because the cap gain and dividend to be reinvested keep getting a hair cut every year by the yearly income tax, while our man's IRA or pension is allowed to grow unmolested until harvest time.

So, in that view, it is really only fair that the dividend and cap gain of taxable accounts should not be taxed again. Well, tax system is never fair, but the 0% tax rate of investment gains for the 15% tax bracket makes it a bit less unfair.

That said, LOL! described how the Roth conversion allows one to transfer from IRA to a Roth to not pay tax at the start, nor at the end, once one takes into advantage exemptions or deductions, or something like that. I looked for it but have not been able to find his post.

 

[REWahoo]

If it weren't for different tax brackets, deductions, and exemptions that created non-linearities in the tax system, there would not be any difference between saving money in before or after-tax accounts.

Yep. And if it wasn't for gravity we'd all weigh the same, too.

 

[NW-Bound]

We would all be weightless in space, but being lean and mean, I would still have a smaller mass, and can accelerate faster than the next guy when both are wearing the same jet pack.

But back on the topic of this thread, I do not discount my tax-deferred accounts for the tax liabilities. Same as earlier posters, I hope to be able to do OK on whatever is left of the WR after tax, and from what I have seen with the market variations, the tax of 10-15% is really down in the noise. Congress may just change the laws in a few years before I even get my paws on the money anyway.

I am going to spend more time to [-]time the market[/-] rebalance the portfolio, and study this Roth conversion thinggy.