Torn About Tax Deferral

[panacea]

I really struggling on an issue that I'm hoping talking it through with you fine folks will help.

DW and I have been very good about maximizing every opportunity to defer taxes using our 401ks, HSAs, etc. This has allowed us to historically stay around the top of the 15% bracket or not far into the 25% bracket... a pretty happy place to be from a tax standpoint. I prepared a tax projection (as I usually do this time of year) and for the first time it looks like we're going to be in the 28% bracket. Don't get me wrong, we're not complaining... these tax "problems" are only because things are going pretty well for us financially.

But getting closer to the real issue...
We never really planned on having this level of income. I sort of thought we'd FIRE before reaching this income level but since it sort of surprised us I think we may have to consider changing our long-term saving approach. I used to think maximizing all tax-deferred vehicles was the way to go because if we could save 25% on taxes now while w*rking and then distribute from our accounts in retirement at 15%... that's a pretty good deal. So now that we're looking at the 28% bracket, in one way it seems even more important to defer taxes as much as possible... on the other hand, it looks like we may not be in the 15% bracket in retirement anymore if most of our money is in tax-deferred vehicles. I ran a retirement projection that shows we will realistically fall in the 25% bracket... all because we're being so diligent about putting money away in our retirement plans... but haven't had much excess to save after tax. If we have to primarily live off these accounts in retirement, as you know, it's all taxed at ordinary income tax rates. We have been funding Roth IRAs but these accounts will be small compared to our 401k balances. 25% is still lower than 28% so maybe the same approach should apply.

When I think it through, it seems like a reasonable consideration from a long-term planning perspective that we should look at reducing our tax-deferred savings now and increase our after-tax savings so we're not socked later by taxes. We could better manage our tax bracket if we had more tax buckets to choose from. Obamacare is a good example of why this would be a good strategy. At this point, I think we'd be over the income limit to get any kind of break on our health insurance premiums... assuming nothing changes with the law. This could be a big deal if we FIRE at 55.

DW and I could both start funding Roth 401ks at work... or just one of us could change. The problem is, this will drive me absolutely crazy now. I won't like seeing our tax bill jump up dramatically because $35,000 that used to be tax deferred is immediately slammed onto page one of our tax return. Ack!

It's possible that our incomes will continue to increase nicely and we could simply continue funding the pre-tax 401ks and put as much away as possible on an after-tax basis... but who knows if our good fortune will continue like this. It looks like we've got a solid 10 years left in the w*rkforce to save but that could certainly change as well. The future is bright but you never know.

Any thoughts on this would be greatly appreciated. When it's your own money / taxes, sometimes I think a person's judgment can be a little clouded. And there's so much uncertainty in tax law and our personal lives that I'm not sure there's a perfect answer.

 

[ShortInSeattle]

This might be an overly simplistic view, but if you retire at 55 you only need 4.5 years worth of expenses in tax deferred, no?

You need a lot of investment returns to equal tax-deferred growth. So I tend to max those out first, realizing that if I am imbalanced at ER I can do a 72(t) if needed.

SIS

 

[H2ODude]

I always blindly maxed 457 and 401, IRA as well. At 62 have about 2/3 in IRA (moved all there at retirement). Had an accountant 20 years ago posit that with what I was doing I could find myself in higher bracket in retirement than when earning. Looks like in fact I won't but will return to "working bracket" once minimum distribution kick in. Since that time I was able to materialize a fairly good db pension as well. All I can do is convert what I can to Roth before 70, but it will make a minor dent in the tIRA holding. We lead a nice lifestyle, actually upped it since retirement, but still won't need what we have (currently about 2.5 WR).

FWIW, current accountant insists you never pay tax before you have to, except to do Roth conversion up to 15% rate is exhausted, which is my plan. It's funny but I never spent much time on investments while working, just set AA and threw as much in as we could, and LBYM. Now, watch the investments but mainly scratch my head trying to figure best way to keep the tax implications as low as possible.

 

[thefinancebuff]

When I think it through, it seems like a reasonable consideration from a long-term planning perspective that we should look at reducing our tax-deferred savings now and increase our after-tax savings so we're not socked later by taxes.

This almost never pays off if you really do the calculation, Obamacare subsidy cliff notwithstanding. Additional after-tax savings yes, but not at the cost of tax-deferred savings.

 

[RunningBum]

Is everything in 401Ks, or is some in a tIRA? If the latter, one option would be to continue to defer to your 401K, but at the same time convert up to an equal amount of your tIRA to a Roth. Money in the Roth is never taxed again, and you have flexibility in taking some of it out before 59.5, especially if you have 10 years before you might need it. I would definitely do this over just skipping the 401K, so the real question becomes whether to convert some of your tIRA or not (again, if you have a tIRA).

Other than that, I agree, it's a guess whether having more income after retirement will hurt you. I'd be inclined to defer enough to keep income in the 25% bracket, try to save enough after tax so you can control your income from 55-65, and resign yourself to 85% (or more if things change) of SS taxed.

I know others have lamented about deferring too much income and paying a higher rate in retirement. When it's the difference between 15% and 25% it's a big deal. 25 to 28% is only 3%. I'm still trying to figure the impact on SS taxation, and even if I get it right it could easily change by the time I start collecting. The uncertainty about taxes and subsidies for than a few years away is really tough to do and you probably have to take your best guess with the info available (including asking for advice here like you did) and not agonizing over it.

 

[Alan]

This almost never pays off if you really do the calculation, Obamacare subsidy cliff notwithstanding. Additional after-tax savings yes, but not at the cost of tax-deferred savings.

That makes sense to me particularly now that the OP is in the 28% bracket he is deferring some 28% taxable money to be paying later at 25% when he retires. (Assuming tax rates stay where they are, but that is a big assumption).

 

[samclem]

I understand your situation, and it's good you are looking ahead. Do the math for a "single taxpayer" rather than MFJ (if one of you passes away early) and you'll probably be even more shocked by the resulting tax bite in retirement.

Remember that if you'll have some time between retirement and MRDs, that gives you the opportunity to move some of that tIRA money into Roth accounts at potentially lower rates than you'll experience today.

Despite the possible tax bite later, I think it's a good idea to defer them in almost all cases. If I pay the money now, it is gone forever and not in my accounts where it might do us a lot of good if we have a big downturn or we have unexpectedly high costs. In such cases my effective tax rate in the future might be lower than my present projections, so I'll be ahead. And if I do end up paying higher rates many many years down the road, after I've "won the game" and the end is getting closer, I just don't think it will bother me as much as paying them now with many miles of uncertainty still left to travel using this nest egg.

 

[Animorph]

Keep maxing out the tax deferred accounts while you are in the higher tax brackets. Even if the tax rate is the same in and out, you effectively get tax free growth in retirement accounts.

I don't think I could show that forgoing a tax deferred contribution in order to invest in a taxable account would be beneficial. Even if you were doing Roth conversions at 15% for a few years. But you might still take a look at it. Those of us who have done that have paid plenty of taxes on income and capital gains for the privilege.

Now if you need to build up some taxable savings to fund the years between retirement and 59.5, that's a different story.

 

[jerome len]

taxes have only one way to go.......up! I would fully fund Roth 401k opportunities if you can afford to, then you'll have more after tax income. Don't forget about the possibilities of so much income you'll have to pay taxes on SS and/or alternative minimum taxes......I get hit on both......never thought I would......and LOVE my Roth IRA

 

[panacea]

This might be an overly simplistic view, but if you retire at 55 you only need 4.5 years worth of expenses in tax deferred, no?

You need a lot of investment returns to equal tax-deferred growth. So I tend to max those out first, realizing that if I am imbalanced at ER I can do a 72(t) if needed.

SIS

Thanks, SIS.

If I understand your comment, I'm not worried about getting access to retirement funds. I'll be able to access my 401k after 55 without penalty. I was trying to figure out if I should have more taxable accounts to work with during those years, as well as future years to draw from so not all my income is taxable at ordinary income tax rates. I could essentially pull some from "savings" that wouldn't be taxed (at least not at the same high rate).

 

[panacea]

I always blindly maxed 457 and 401, IRA as well. At 62 have about 2/3 in IRA (moved all there at retirement). Had an accountant 20 years ago posit that with what I was doing I could find myself in higher bracket in retirement than when earning. Looks like in fact I won't but will return to "working bracket" once minimum distribution kick in. Since that time I was able to materialize a fairly good db pension as well. All I can do is convert what I can to Roth before 70, but it will make a minor dent in the tIRA holding. We lead a nice lifestyle, actually upped it since retirement, but still won't need what we have (currently about 2.5 WR).

FWIW, current accountant insists you never pay tax before you have to, except to do Roth conversion up to 15% rate is exhausted, which is my plan. It's funny but I never spent much time on investments while working, just set AA and threw as much in as we could, and LBYM. Now, watch the investments but mainly scratch my head trying to figure best way to keep the tax implications as low as possible.

Yes, this is precisely the issue. It sounds like you've got an ideal strategy, filling up the 15% bracket. However, I don't think I'll be able to use your Roth conversion strategy anymore unless I use it to fill up the 28% bracket. And that certainly won't be a good approach for me because I'm surely not going to be in that high a tax bracket (or higher) in retirement.

 

[walkinwood]

Looks like you have 13 years to ER (based on your 2026 ER date in your profile)

If you are maxing out your tax deferred contributions now, you should be able to direct any additional increases in salary into taxable savings between now & ER. Assuming your career continues to do well, you can sock away a lot in taxable accounts after maxing out your tax-deferred accounts. Your peak working years are ahead of you.

13 years is also a long time to have gains accumulate tax free. Work out a spreadsheet for both options for both working and ER years to make sure, but I think you'll come out ahead by maxing your Tax deferred accounts before taking Obamacare into account.

Great position to be in. Congratulations & all the best.

 

[panacea]

This almost never pays off if you really do the calculation, Obamacare subsidy cliff notwithstanding. Additional after-tax savings yes, but not at the cost of tax-deferred savings.

That makes sense to me particularly now that the OP is in the 28% bracket he is deferring some 28% taxable money to be paying later at 25% when he retires. (Assuming tax rates stay where they are, but that is a big assumption).

Yes, I think you are both correct. I think the best approach at this point is to continue maxing my pre-tax contributions and just get serious about my after-tax savings.

 

[growing_older]

Because of the way marginal tax brackets work, you may still be ahead if you are in a higher tax bracket in retirement. When you are contributing, it is usually the case that every dollar contributed would have been taxed at your top marginal bracket for that year. The dollars taxed at lower brackets you spent. When you take distributions, you get to take dollars out at each of the lower brackets (and spend them) until you get to the higher brackets. So even if some dollars come out at a higher bracket, you may have been able to get a lot more put in at brackets higher than they came out at.

 

[panacea]

taxes have only one way to go.......up! I would fully fund Roth 401k opportunities if you can afford to, then you'll have more after tax income. Don't forget about the possibilities of so much income you'll have to pay taxes on SS and/or alternative minimum taxes......I get hit on both......never thought I would......and LOVE my Roth IRA

While this is certainly an important consideration, I tend to disagree with the premise. I think that tax rates may go up for the highest earning individuals, but not so much for the masses. Congress has increased taxes to very high rates in the past and it didn't work out so well. Here's a link for the Laffer curve, which I think explains better than I could the trade off between increased tax rates and lower overall revenues.

http://www.laffercenter.com/the-laffer-center-2/the-laffer-curve/

I suppose I could find myself in your position (I didn't expect to be where I am now I suppose), but don't plan to have so much money that I'm going to find myself in the highest brackets in retirement at least... if that's the case, I w*rked too long!

 

[Alan]

taxes have only one way to go.......up! I would fully fund Roth 401k opportunities if you can afford to, then you'll have more after tax income. Don't forget about the possibilities of so much income you'll have to pay taxes on SS and/or alternative minimum taxes......I get hit on both......never thought I would......and LOVE my Roth IRA

Not always true that a person's marginal tax rate will go up, even if tax rates go up in all brackets. A high earner may be in a high tax bracket now and in future the tax rates in all brackets may go up but for an early retiree, like myself at 55, he may well drop a couple of tax brackets so that his marginal tax rate is much lower than when he was working. He then has a number of years in a lower tax bracket before SS and RMD's come into effect, possibly pushing him into a higher bracket at that point.

 

[panacea]

Looks like you have 13 years to ER (based on your 2026 ER date in your profile)
Great position to be in. Congratulations & all the best.

Thanks, walkinwood. I need to change my profile- my date has moved up to 2023!

Because of the way marginal tax brackets work, you may still be ahead if you are in a higher tax bracket in retirement. When you are contributing, it is usually the case that every dollar contributed would have been taxed at your top marginal bracket for that year. The dollars taxed at lower brackets you spent. When you take distributions, you get to take dollars out at each of the lower brackets (and spend them) until you get to the higher brackets. So even if some dollars come out at a higher bracket, you may have been able to get a lot more put in at brackets higher than they came out at.

Not sure I understand this. Let's say I make $100,000 today and after deductions and pre-tax contributions I'm at the top of the 15% marginal tax bracket. Every additional dollar I earn is then taxed at 25%. If I'm retired and draw $100,000 from a Traditional IRA or 401k, the same rules apply. Isn't it the same thing?

 

[RunningBum]

I think what growing_older is saying is that say you all of the 401K deferred money ($34K) would have all been taxed at 25%. In retirement, perhaps you won't be right at the 15/25% edge when you pull the money out, so perhaps half of it will be taxed at 15% and half at 25%.

 

[panacea]

Is everything in 401Ks, or is some in a tIRA? The uncertainty about taxes and subsidies for than a few years away is really tough to do and you probably have to take your best guess with the info available (including asking for advice here like you did) and not agonizing over it.

We currently have about 80% in 401ks, 15% in Roth IRAs and 5% in taxable accounts... or thereabouts. We just pushed all rollover IRAs into our 401ks so we can continue to fund Roth IRAs every year using the backdoor Roth strategy. This should help a little bit in that we'll have $11,000 per year (plus increases) being added to our non-taxable bucket.

You're right about not getting nutty about something I can't control... I'm really a planner though and I don't like missing anything that I can control. But this is definitely an uncertainty.

 

[RunningBum]

I hear ya...I plan and plan and plan, and then something changes, or I find an error in a formula or find out I got hit with AMT and have to recharacterize part of my Roth conversion. I used to get upset when those things happen, but now I just learn and adjust, and if things change and make my decision wrong I just write it off to be like reallocating my AA just before a market swing the wrong way.

Even the seemingly obvious prediction that future taxes will be at least the same if not higher may not hold true if a VAT is enacted, but I'm not going to plan for a VAT and reduced income taxes.

 

[panacea]

I think what growing_older is saying is that say you all of the 401K deferred money ($34K) would have all been taxed at 25%. In retirement, perhaps you won't be right at the 15/25% edge when you pull the money out, so perhaps half of it will be taxed at 15% and half at 25%.

Okay, that makes sense. Thanks.

I hear ya...I plan and plan and plan, and then something changes, or I find an error in a formula or find out I got hit with AMT and have to recharacterize part of my Roth conversion. I used to get upset when those things happen, but now I just learn and adjust, and if things change and make my decision wrong I just write it off to be like reallocating my AA just before a market swing the wrong way.

Even the seemingly obvious prediction that future taxes will be at least the same if not higher may not hold true if a VAT is enacted, but I'm not going to plan for a VAT and reduced income taxes.

Agreed. We could also wonder if congress will someday decide to tax part of Roth IRAs (like they did with Social Security), but we can't plan around that either!