tax adjusted portfolio value

[Animorph]

If you don't discount IRA's/401k's by some percent, you can end up looking like your net worth is decreasing everytime you do a Roth conversion. Or your net worth would look better if you contributed to a 401k/IRA instead of a Roth or after-tax account. We should be optimizing after-tax value, however we do it.

 

[smjsl]

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?

Example: before-tax dollars:
401k balance: 1,000,000
taxable account balance: 1,000,000
Roth balance: 1,000,000
desired allocation: 60/40 stocks bonds (in real, after-tax dollars)
I will use conversion factors from my first response (25% for 401(k) and 10% for taxable)

Calculations:
401k after-tax dollar balance: 750,000
taxable account after-tax dollar balance: 900,000
Roth after-tax dollar balance: 1,000,000
Total: 2,650,000 in after-tax dollars

So, we want 2,650,000*0.6=1,590k in stocks and 2,650,000*0.4=1,060k in bonds in after-tax dollars.

Now, the part you were missing, is when you place after-tax money back to 401k for example, you have to convert back to before-tax dollars... In other words, $1 after-tax dollar placed in 401(k) would be 1/0.75=$1.33 before-tax dollars in 401(k). This way, when it gets taxed 25%, you'll get back to $1...

So, if I want to put bonds in 401(k), I will start with trying to fit 1,060,000 / 0.75 = 1,413,333.33 into 401(k). Since I only have 1M (before-tax) space there, I will fill 1M with bonds, which will on after-tax basis be 750k. So, on after-tax basis, I still need to place 1,060k-750k=310k in bonds somewhere. Let's say I place 310k after-tax in bonds into Roth. Due to 1-to-1 conversion in Roth, this is equivalent to 310k before-tax money there.

So, you'd end up with:

Bonds: 1,060k after-tax total split as:
- 401k 1M before tax, or 750k after-tax
- Roth 310k before tax, or 310k after-tax

Stocks: 1,590k after-tax split as:
- taxable 1M before-tax, or 900k after-tax
- Roth 1M-310k = 690k before-tax, or 690k after-tax


P.S. One thing I try to always mentally do when talking about dollars is to have two subscripts next to each number - year and whether it's after-tax or before-tax; for example, $100 is not very meaningful, especially in planning... to me, it would always be something like $1002012,before-tax

So, if you keep this in mind, and place these subscripts after each dollar amount, it may help you follow calculations like these...

 

[jon-nyc]

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 ....

Its not always a question of ignoring the advice. One only has so much tax deferred capacity. If you save significantly more than that, you end up with most of your nest egg in taxable.

 

[RunningBum]

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.

Yes, this is why I model after-tax too. If I had $3M in stock options and was going to be forced to exercise them in a certain time period either due to them expiring or me leaving, I wanted to know what that $3M was going to be worth when I got hit with taxes. Taxes weren't going to be a yearly ongoing expense through retirement that I could budget in. If I was going to get dinged for $1.2M it didn't make any sense to budget $24K ($1.2M/50 years) for taxes the rest of my life, because once I exercised the options, the taxes were paid and the money I used to pay them with was gone, so why include it?

Now I'm retired and have no more options, but I haven't bothered to revamp my calculations to use pre-tax numbers. It still doesn't make sense to me because $300K in a tIRA isn't the same as $300K in a Roth or $300K in a taxable account with an unspecified basis.

To each their own on their method. I think the most important things are to account for taxes one way or the other, and to be understand and be comfortable with your method. There's no right or wrong. For an audited business account I'm sure there are accounting standards, but not for my own account.

As for AA, it was already answered, but the short answer is that I balance based on the post-tax amounts. If I have $1M pre-tax and $900K post-tax and a 50/50 AA, my stock and bond balances are (ideally) $450K post-tax. They may not be 50/50 pre-tax. There is no extra $100K to account for.

It can be slightly more complicated to rebalance since all Vanguard and other institutions deal with is "pre-tax" funds. If I'm at $400K bonds and $500K stocks, I may not be able to just shift $50K over to bonds. I have to figure out what $50K post-tax works out to be. But I don't spend too much time on it, since I'm fine getting it "close enough". And truthfully I probably do just transfer $50K and not worry about it.

 

[packrat44]

I am also in the minority and refer to my net worth in after-tax value. Any 401k/TIRA is discounted 25% since that is the projected tax bracket at time of disposal. Last year I sold a long term stock (holding about 25 years) that had increased in value 173 times purchase price. I discounted the value of that stock 15% prior to the actual selling date due to the pending capital gains tax. Everyone does what makes them feel most comfortable.

 

[W2R]

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

+3

And a concern that I have is that for me (YMMV), calculating the "after-tax" value of my portfolio could bring in the usual risks that come to bear when thought processes and computations are deliberately over-complicated. I like to keep things pretty simple and direct. I know that I have to pay taxes, and about what they will be, and taxes do not change my portfolio size (ask Vanguard! ) They are an expense that I expect to pay.

Taxes also depend on my withdrawal strategies, which could conceivably change. In fact, they did just in the past month! For various reasons I am withdrawing only half as much from my TSP (=401K) as in previous years. In retirement, one has to be able to do such things without another portfolio size confusing the issue.

 

[RunningBum]

+3

And a concern that I have is that for me (YMMV), calculating the "after-tax" value of my portfolio could bring in the usual risks that come to bear when thought processes and computations are deliberately over-complicated. I like to keep things pretty simple and direct. I know that I have to pay taxes, and about what they will be, and taxes do not change my portfolio size (ask Vanguard! ) They are an expense that I expect to pay.

Taxes also depend on my withdrawal strategies, which could conceivably change. In fact, they did just in the past month! For various reasons I am withdrawing only half as much from my TSP (=401K) as in previous years. In retirement, one has to be able to do such things without another portfolio size confusing the issue.

Like I said, to each his/her own. I don't find doing after-tax calcs to be risky or over-complicated at all. In fact I feel it's even easier to account for the tax changes due to where you withdraw money from because I've already factored it in.

 

[scrabbler1]

I'm with Audreyh1. My income tax bill is a pretty small part of my budget so I do not discount the IRA portion of my portfolio. I am in the 15% bracket (federal) with some room to spare because only 62% of my current income is taxable at the federal level.

Also, unlike with othr expenses, if my income taxes rise it is because my income also rose, guaranteeing me the means to pay the higher bill. This happened back in 2010 when I had a spike in my income due to an unexpected short-term cap gains distribution in one of my bond funds. I was reinvesting cap gain distributions so I to carefully manage my budget to avoid a cash flow crunch.

I will say, however, that when I was planning to cash out my company stock held in my tax-deferred account back in 2008 I figured out in advance what it was worth after paying the large income tax bill (state and federal). But that was a one-time, lump-sum distribution as opposed to a more gradual distribution through annual RMDs.

 

[karluk]

Thank you, smjsl and the others who use tax-adjusted portfolio management, for your clear explanations. I'm expecting too large of a future tax bill to simply ignore, so I'll have to think things over and decide how to incorporate some of your techniques into my own investing strategy.

 

[Independent]

When I retired we had money in pre-tax and post-tax accounts (e.g. traditional IRAs vs. CDs).

I certainly recognized that a dollar of pre-tax balance was going to fund less spending than a dollar of post-tax balance, and planned withdrawals and spending accordingly.

If I had calculated a ratio between the two, I would have had to make some assumption on how to handle taxes. But, I did't see why calculating that ratio is a worthwhile exercise for my own planning. So I didn't.

 

[smjsl]

Thank you, smjsl and the others who use tax-adjusted portfolio management, for your clear explanations. I'm expecting too large of a future tax bill to simply ignore, so I'll have to think things over and decide how to incorporate some of your techniques into my own investing strategy.

You are most welcome, karluk. I do want to point out that some other folks here do not suggest to ignore future taxes but prefer to account for them as part of their expenses. If done correctly, both approaches are equivalent and should produce the same result.

What you don't want to do is account for taxes 0 times by ignoring them or two times by double counting them... just account for them once - either think of what you have on after-tax basis (thereby decreasing your nominal balance), or approximate your tax bill in future (thereby increasing your projected expenses). Whatever you feel more comfortable doing...

 

[karluk]

You are most welcome, karluk. I do want to point out that some other folks here do not suggest to ignore future taxes but prefer to account for them as part of their expenses. If done correctly, both approaches are equivalent and should produce the same result.

That's true and I apologize if I came across as being dismissive of the methods of people who account for taxes as an expense, rather than by downwardly adjusting their portfolio value. The only people who appeared to ignore taxes completely were the ones who expected to pay little or no taxes on 401k withdrawals, and clearly a $0 expense is an expense that's justifiable in ignoring.

 

[cinman2000]

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.

I am currently doing the same, but am concerned that my assumptions are too conservative. I'm using an effective tax rate that is the same as I have today while working (18%) and assuming that all my spending after age 70 will be taxed at this rate. Prior to age 70, I am planning to keep my IRA deductions low enough to stay within the 15% bracket so that my Capital Gains are taxed at 0. I need to do some more work to determine what my real taxes will look like on the Social Security dollars. Certainly not 18% of the total. Back to my spreadsheet

 

[pb4uski]

I am currently doing the same, but am concerned that my assumptions are too conservative. I'm using an effective tax rate that is the same as I have today while working (18%) and assuming that all my spending after age 70 will be taxed at this rate. Prior to age 70, I am planning to keep my IRA deductions low enough to stay within the 15% bracket so that my Capital Gains are taxed at 0. I need to do some more work to determine what my real taxes will look like on the Social Security dollars. Certainly not 18% of the total. Back to my spreadsheet

What I did was to just take my then current year return and adjust income and deductions for changes in retirement (mostly taking out my earnings from my job and adding private pay health insurance premiums to deductions) and looked at the result. For us most other things stayed the same, but our effective tax rate is dramatically lower (17% federal and 9% state while working to 0% federal and 2% state) due to lack of wages.

 

[cinman2000]

our effective tax rate is dramatically lower (17% federal and 9% state while working to 0% federal and 2% state) due to lack of wages.

I like the approach...17%? What was it while working?

 

[cinman2000]

For us most other things stayed the same, but our effective tax rate is dramatically lower (17% federal and 9% state while working to 0% federal and 2% state) due to lack of wages.

Wait i misread..0% Federal? You don't have any income from IRA, 401K or SEPP?