Comparing net worth with taxable vs tax deferred accounts

[Ready]

As people post their financial profiles it occurs to me that many people have a substantial amount of their investments in tax deferred accounts, such as an IRA or 401K. In evaluating your FI readiness, I'm curious to see how people compare a person with assets mostly in tax deferred accounts versus taxable. In my case, 85% of my investments are in taxable accounts, so aside from any future capital gains or dividends, I've already paid the tax bill on them.

So if you were comparing the FI readiness of two individuals, both with $1M in total net worth, but A has $1M in an IRA and B has $1M in taxable accounts, how much do you take into account the future taxes due on the IRA withdrawals in evaluating FI?

In my case, I would anticipate paying around 20% federal taxes and 8% CA taxes in retirement. I understand the rates will vary among different individuals. In my case, am I 28% better having $1M in taxable than if the entire amount was in an IRA? Or is it more complicated than that?

 

[jebmke]

The future taxes are part of the ongoing expense so that would impact any readiness evaluation. Readiness has to take into account expenses as well as the pile of money created to pay them.

 

[Animorph]

The future taxes are part of the ongoing expense so that would impact any readiness evaluation. Readiness has to take into account expenses as well as the pile of money created to pay them.

+1 for comparisons.

For myself, I track taxable cost basis and calculate taxes for each year in my projections. For a simple net worth calculation I count only 85% of IRA's versus 100% of Roths and taxable.

 

[David1961]

For a simple net worth calculation I count only 85% of IRA's versus 100% of Roths and taxable.

Good thread. A question for Animorph - does this mean that when you calculate your net worth, you only count 85% of the value of your IRA since you expect to pay 15% taxes when you withdrawal? Makes sense, I just want to make sure I understand.

 

[RunningBum]

I discount my IRA by the estimate tax rate I anticipate paying on it. This way I can estimate my personal expenses by more steady amounts rather than worrying about whether I'll be pulling from tax deferred or already taxed sources. The math works out pretty much the same either way, I think it's just a matter of whichever way is easier for you to keep track of. Some will say that taxes are expenses, not reductions in assets, but I don't owe those people an audit on my system for tracking.

In my case, am I 28% better having $1M in taxable than if the entire amount was in an IRA? Or is it more complicated than that?

Mostly right, but your math is a bit off. You're actually 28% worse if the entire amount was in an IRA, or 38.8% better (1.00/.72). It may actually be less, many find they pay less in taxes in retirement.

 

[RunningBum]

BTW, the main reason I do it this way is that at one point in my life, most of my wealth was in unexercised stock options. I knew they would take a huge tax hit as soon as exercised them, so I just discounted them. Once I started doing that it seemed to me an obvious step to also discount my IRA and 401K, by a lesser tax rate. Had I started with just IRA/401Ks, I might have done it differently.

 

[Ready]

I find it interesting that Firecalc never asks what portion of your portfolio is tax deferred. I suppose it just expects you to calculate how much taxes you will owe once you start withdrawing money from your tax deferred accounts, but I rarely see any comments about this subject when people discuss the analysis that Firecalc provides.

For someone who is not intimately familiar with taxes due on tax deferred accounts, I would think that Firecalc might produce results that sound much better than they really are once taxes are factored in.

 

[marko]

All my analyses and calculations --including those in Firecalc--assume taxes.

TaxCaster or TurboTax provide a pretty good reference and I created a nomograph of sorts by varying different withdrawal amounts coupled to other income, dividends, social security and deductions and get a net "take home" amount (total income minus taxes).

From there, I can figure out my expenses and look across and see how much I need to withdraw from my IRA.

 

[Shawn]

As others have mentioned, I believe the best approach is to consider taxes an expense when evaluating readiness. Of course, this can be difficult since taxes may change depending on the source of income (e.g., they may jump when RMD's are required).

Some people argue that tax ramifications also need to be considered when implementing an asset allocation. Suppose a person desires a 50/50 equity/bond split, and has equal room in taxable and IRA accounts. If the person puts all the equities in the taxable account and all the bonds in the IRA, the person is actually over-weighted in equities because the government through its taxes essentially owns a fraction of the bonds in the IRA portfolio.

 

[Ready]

Some people argue that tax ramifications also need to be considered when implementing an asset allocation. Suppose a person desires a 50/50 equity/bond split, and has equal room in taxable and IRA accounts. If the person puts all the equities in the taxable account and all the bonds in the IRA, the person is actually over-weighted in equities because the government through its taxes essentially owns a fraction of the bonds in the IRA portfolio.

A very good point. It's a significant overweighting if you are going to be in a high federal tax bracket, and even worse if you have to throw in a high state tax, such as California, into the mix.

 

[brewer12345]

You may count it any way you like. I count a dollar of assets as a dollar of assets. My tax bill will be close to zero over the next decade, my deferred assets will continue compounding tax deferred, and I should get some FAFSA love when the time comes.

 

[gcgang]

As people post their financial profiles it occurs to me that many people have a substantial amount of their investments in tax deferred accounts, such as an IRA or 401K. In evaluating your FI readiness, I'm curious to see how people compare a person with assets mostly in tax deferred accounts versus taxable. In my case, 85% of my investments are in taxable accounts, so aside from any future capital gains or dividends, I've already paid the tax bill on them.

So if you were comparing the FI readiness of two individuals, both with $1M in total net worth, but A has $1M in an IRA and B has $1M in taxable accounts, how much do you take into account the future taxes due on the IRA withdrawals in evaluating FI?

In my case, I would anticipate paying around 20% federal taxes and 8% CA taxes in retirement. I understand the rates will vary among different individuals. In my case, am I 28% better having $1M in taxable than if the entire amount was in an IRA? Or is it more complicated than that?

Net worth is defined as assets minus liabilities.

You make a good point in saying taxes are a liability that will be owed on tax deferred assets, and even on taxable accounts that have unrealized capital gains. With the ever changing IRS, however, an accurate estimation of the tax liability will be just an educated guess, at best.

You are better off having the funds in an after tax account, obviously. 28% better? Sure, why not.

 

[RetireAge50]

Some of the tax deferred money will have zero tax and some at low tax rates. Not likely to be 20% average.

Last year we had $200,000 earned income and only paid 11.4%. I don't expect to pay much taxes in retirement even with mostly tax deferred money.

But yes I do include the estimated taxes as an expense.

 

[travelover]

This is an excellent point. I approached it 15 years ago from the stand point of equitably splitting assets in a divorce. I found CPAs fled at the thought of being involved in a divorce, so I got no help from them. Since I was keeping the house, it was not as easy as splitting everything in two parts.

 

[RunningBum]

You make a good point in saying taxes are a liability that will be owed on tax deferred assets, and even on taxable accounts that have unrealized capital gains. With the ever changing IRS, however, an accurate estimation of the tax liability will be just an educated guess, at best.

Changing tax laws make it just as difficult to estimate future tax expenses if you do it that way. There's the same uncertainty no matter which way you do it.

 

[MichaelB]

I find it interesting that Firecalc never asks what portion of your portfolio is tax deferred. I suppose it just expects you to calculate how much taxes you will owe once you start withdrawing money from your tax deferred accounts, but I rarely see any comments about this subject when people discuss the analysis that Firecalc provides.

For someone who is not intimately familiar with taxes due on tax deferred accounts, I would think that Firecalc might produce results that sound much better than they really are once taxes are factored in.

The problem with trying to incorporate taxes in FIRECalc analysis is not everyone has the same tax rate, and one individual might have a rate that differs from year to year. Each of us should determine how much tax we will pay each year and include it in our budget projections, and that is made pretty clear in most of the FIRECalc discussions.

 

[foxfirev5]

The effective tax rate on a SWR of 3-4% on a 1 million portfolio would be pretty low. In my case I see about a 5-6% difference in the impact on my portfolio. My question is whether or not a 1 million portfolio is enough regardless of taxes.

 

[marko]

When talking about income, people never say: "I make $X after taxes...".

They always talk about their gross; before taxes.

For counting purposes, isn't counting your net worth the same?

As noted above, yes, you need to calculate taxes into your withdrawal schemes but as far as net worth, I'm not sure.

 

[pb4uski]

My spreadsheet projections include a mini tax return that computes taxable income and federal and state taxes so my taxes are in my expenses for planning purposes.

However if I was doing a formal net worth calculation I would do a deferred tax liability for my tax-deferred accounts and for unrealized gains and losses on my taxable accounts.

 

[clifp]

As other have said you need to treat taxes as an expense. Also age and withdrawal rates matter greatly. The taxes of million dollars in IRA for a 40 year planning on with drawing 3.5% will likely be much less than 70 years old withdrawing 5% who also has SS income.

However when I am looking at other people portfolio, "in the can I retire portion of forum", I apply a 20% of the money in an IRA/401K and 25% for portfolio overs $2 million.

 

[H2ODude]

I think this is why I like the FIDO RIP calculator. It folds taxes into the calculations knowing what kind of accounts you're drawing from, what state your in, etc. You can then look at the detailed spreadsheet of costs, assets, taxes, minimum withdrawals and get a feel for the reasonableness of it all.

 

[Huston55]

I think this is why I like the FIDO RIP calculator. It folds taxes into the calculations knowing what kind of accounts you're drawing from, what state your in, etc. You can then look at the detailed spreadsheet of costs, assets, taxes, minimum withdrawals and get a feel for the reasonableness of it all.

+1

You can also read the "methodology" accompanying RIP to understand how it estimates taxes (the tax section is 8 pgs long so, it's very detailed), and adjust accordingly if you choose.

 

[David1961]

I have a question for the folks who treat taxes as a liability instead of an expense. Suppose you own $500k of individual stocks in a regular (not tax advantaged) account that pays a net dividend of 4% (of qualified dividends). For your net worth calculation, do you use the full $500k or do you use 85% of it? I know this account is different than having money in an IRA, but aren't the dividends taxed in a similar way a withdrawal from an IRA would be? And if you sold some of the stocks, wouldn't you pay taxes on the capital gains (although it would not be counted as ordinary income)? I feel like I'm missing something. Thanks.

 

[smjsl]

I normally count Roth @100%, 401k @75%, taxable @90%, stock options @50% (and at a relatively low price, not current one usually). I use these factors for both AA and NW calculations.

 

[REWahoo]

You people need to find a worthwhile hobby...