Roth vs Traditional IRAs (esp regarding tax rates)

[Cobra9777]

I have this image in my mind of pb4 drooling on his keyboard while reading post #20. Anywho...

For us, with the exception of a couple of (relatively) low late-career income years that we took advantage of, roths made no sense when we were working. (And were not even available to us for most of our work years)

Once we retired, converting aggressively has made sense--so far. (Working was 39.6 marginal, now converting to top of 24)...

Similar story here, though not quite as good. We deferred at 28-33%; now converting at a mix of 12% and 22%, pre SS/RMD. At 52, we were 60/40 tax-deferred/taxable. At 70ish, it should be one giant Roth... plus it's shiny little cousin, the HSA.

I think it's a bit more difficult for early-30-somethings in the 22% and 24% brackets. Historically, those are great rates that cover a ton of territory in the MFJ brackets. And that would favor the Roth. Both my kids are in that scenario. They do tax-deferred only for the match and then all Roth.

Plus if you want a blank stare, tell an early-30-something it depends on their tax rate in retirement. You might as well have said, it depends on whether or not the universe is infinite. It's like an unknowable concept at that age. So they go with what they know and love, and that's the Roth.

 

[pb4uski]

I have this image in my mind of pb4 drooling on his keyboard while reading post #20. ...

It was more rolling my eyes.

 

[sengsational]

It was more rolling my eyes.

That logic has been hashed over so many times, correctly, by you and others. I read the post and was going to chime in, but without the thoroughness and example numbers. But yes, on the ease with which the alternative unequal scenario is accepted...

 

[OldShooter]

It was more rolling my eyes.

The Roth/tIRA scenario is pretty simple and clear once you "get it." Before enlightenment I spent a number of years thinking that in our tIRAsI we were making money by investing the government's money. Not so, of course. So I have some sympathy for those on the path.

I still roll my eyes at all the secondary effects of these decisions, like taxing SS, ACA cliffs, Medicare premium cliffs, etc. I'd bet that it is the minority of FAs/CFPs who really understand it all.

 

[pb4uski]

^^^ Yes, if you have those second order implications the modeling can get real complicated real quick.

 

[RunningBum]

I still roll my eyes at all the secondary effects of these decisions, like taxing SS, ACA cliffs, Medicare premium cliffs, etc. I'd bet that it is the minority of FAs/CFPs who really understand it all.

I can't say how to quantify those secondary effects with certainty, but I understand the meaning of those factors. And for that matter, since I don't know future tax rates or investment returns, I have no certainty with the primary factor. Everything is an educated guess.

I could list out how I'm factoring in all of those secondary effects, but I wouldn't want you to hurt your eyes over-rolling them. Quick summary is that I think I can get my Roth fully converted before I start SS unless I start SS early, and I can do it without going over the ACA cliff. So I'm doing the best I can to avoid the SS tax hump and impacting IRMAA by not having RMDs.

What advice I'd give for anyone else would require knowing their full financial picture, and it'd be a lot of work for me, so I don't really try. I just remind people that those are factors in play.

None of this is a huge game changer, unless a few thousand here and there is really meaningful. I figure, why not take my best guess on getting those right, and if I'm wrong, oh well.

 

[kaneohe]

..............................
For example let's say you put $1,000 into an IRA at age 40 because you are at the 39% bracket. That money triples before you withdraw it 25 years later and you are in the 22% bracket. You are now paying 22% on $3,000 which is more than the 39% at $1,000. The longer that money is left in the IRA the more it grows and the worse this answer gets.

...............................

I believe your focus is on the wrong thing here.......taxes you pay. You should be looking at the return after taxes , not the taxes alone.

e.g. suppose someone offered to make your money increase by 10x instead of the 3x here. Would you turn that offer down because the taxes would be higher?

 

[pb4uski]

I was actually taking with a friend today and that came up... he said that in years where his business did well he would pay big bonuses to employees since it reduced his taxes so much... I told him that he didn't really come out ahead as long as his tax rate was less than 100%... I'm not sure if he got my point.

 

[SevenUp]

For example let's say you put $1,000 into an IRA at age 40 because you are at the 39% bracket. That money triples before you withdraw it 25 years later and you are in the 22% bracket. You are now paying 22% on $3,000 which is more than the 39% at $1,000. The longer that money is left in the IRA the more it grows and the worse this answer gets.

Focusing on the amount of tax paid may not be best. Consider focusing instead on the amount remaining after tax is paid. Looking at the tax amount is the second of two Common misconceptions in this area.

I realize this ignores the impact of the money you could have invested by not paying the taxes in the year of ROTH contribution but many people would have spent that money anyways and not saved it.

Well, yes, contributing more money now is likely to provide more money later.
To make it strictly a fair "traditional vs. Roth" question, one needs to start with the same pre-tax amount for both options.

 

[2177V]

I do not think there is a clear answer since everyone's situation is different.

I have a traditional IRA because I was earning a lot of money as an engineering manager....and taxes at that time were killing me. I elected a traditional IRA to reduce my taxes on my high earnings. Now that I am retired, I have to be careful how to withdraw in order to avoid my withdrawal income from pushing my retirement income into a higher tax bracket. This is manageable and my tax avoidance during my contribution years allow my next egg to grow more using the tax avoidance money that I would have paid Uncle Sam and the State of California.

On the other hand, my young wife opened a business and her net reportable income is relatively low because of her business deductions. In her relatively lower income situation, we decided on a Roth IRA since the tax avoidance money during her earning years is relatively small for a traditional IRA. I also expect her retirement income will be higher than her current income after she cash out her business, sell some of our properties and she inherit my traditional IRA after I kick the bucket.

Having both taxible income and non-taxible income during retirement have some advantages to my wife since she can withdraw taxible income until she reach a certain tax threshhold then then withdraw non-taxible income from her Roth IRA to maintain her standard of living.

Hence, a traditional IRA made sense to me since I was a high earner while a Roth IRA made sense to my wife since her current income was relatively low but her retirement income is expected to be high.

 

[2177V]

I do not think there is a clear answer since everyone's situation is different.

This is manageable and my tax avoidance during my contribution years allow my next egg to grow more using the tax avoidance money that I would have paid Uncle Sam and the State of California.

Hence, a traditional IRA made sense to me since I was a high earner while a Roth IRA made sense to my wife since her current income was relatively low but her retirement income is expected to be high.

To clarify using tax avoidance money to grow my nest egg...my nest egg included a traditional IRA, taxible mutual funds, rental property income and government pensions. Tax avoidance money generally went into my taxible mutual funds because there is a yearly cap on contributions to a traditional IRA.

 

[mckittri2000]

We currently have a mix of both Roth and traditional IRAs. I can control my taxable income this way and if we need a little more for big purchases during the year then we just pull from the Roth.

 

[2177V]

We currently have a mix of both Roth and traditional IRAs. I can control my taxable income this way and if we need a little more for big purchases during the year then we just pull from the Roth.

That works.

Here are the federal taxable income brackets for a married couple.

https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets

Note that a married couple tax rate is 12% up to $80,250 and then it jumps to 22% which is a HUGE 10% difference. The next bracket is $171,051 but the difference is only 2%. Having both a traditional IRA and a Roth IRA, you can play this game to your advantage.

IRA withdrawals are taxed as "income" while cashing out taxable mutual funds are usually taxed as "long term capital gains" which is 0% if a married couple income is less than $80,000 and 15% $80,000 to $496K. This is illustrated in the following link:

https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates

For 2019-2020, the $80,000 should be the maximum retirement income that you can have to minimize your retirement taxes for a married couple. However, be aware that these tables may change in the future depending on the new administration. If there are some talk about raising the capital gain tax, I suspect the stock market may decline in December because people may cash out to take advantage of the current low capital gain taxes in the above link.

 

[aaronc879]

That works.

Here are the federal taxable income brackets for a married couple.

https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets

Note that a married couple tax rate is 12% up to $80,250 and then it jumps to 22% which is a HUGE 10% difference. The next bracket is $171,051 but the difference is only 2%. Having both a traditional IRA and a Roth IRA, you can play this game to your advantage.

IRA withdrawals are taxed as "income" while cashing out taxable mutual funds are usually taxed as "long term capital gains" which is 0% if a married couple income is less than $80,000 and 15% $80,000 to $496K. This is illustrated in the following link:

https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates

For 2019-2020, the $80,000 should be the maximum retirement income that you can have to minimize your retirement taxes for a married couple. However, be aware that these tables may change in the future depending on the new administration. If there are some talk about raising the capital gain tax, I suspect the stock market may decline in December because people may cash out to take advantage of the current low capital gain taxes in the above link.

You add the standard deduction of $24,800 onto that don't you?

 

[pb4uski]

Yes, so if a couple had $24,800 of Roth conversions and $80,000 of preferenced income their total tax bill would be zero.

 

[2017ish]

...

For 2019-2020, the $80,000 should be the maximum retirement income that you can have to minimize your retirement taxes for a married couple. ...

It all depends upon your burn rate and the relative amount you have in traditional retirement/ira accounts.... For us, it would be absolutely foolish to target $80,000 taxable income 2020-2025. We maximize the 24% bracket, which appears to be prudent for minimization of lifetime taxes.

As always, YMMV.

 

[2177V]

You add the standard deduction of $24,800 onto that don't you?

Yes...I believe your statement is correct. My big point is you can plan on a minimal income withdrawal to avoid taxes in 2020 tax year but tax laws may change in the future and will likely go up...rather than down.

Having said that...a good strategy is to maximize your withdrawal now for tax year 2020 while taxes are relatively low....in order to avoid a future tax liability. This is why I suspect that at the end of Dec 2020, some investors may withdraw money. This may lead to a market correction but a recovery in Jan 2021 when investors jump back in using the money they withdrew....after resetting their capital gain basis to a higher one. This does not apply to IRA but it does apply to taxible mutual funds and stock.

You can't escape taxes but you can game the system. This is especially true to large investors who have large tax liabilities and are looking for ways to reduce their tax liabilities.

 

[Time2]

Something I missed or it has not been mentioned, the value of money in a non tax deferred account. The Tax rate is 0% when LTCG is less than $80,000, so with a $24,400 standard deduction, you could generate $104,400 of income tax free.
Also, if your gains are 50%, you could withdraw $160,000, $80,000 of which are your money and $80,000 are LTCGs. Redeposit the $80,000 resetting your LTCGs to zero on that $80,000.

 

[pb4uski]

Yes, that is called gains trading and is a no-brainer if you have headroom in the 0% LTCG tax bracket. And no need to wait 31 days or whatever because the wash sale rules don't apply to gains.

 

[Time2]

Yes, that is called gains trading and is a no-brainer if you have headroom in the 0% LTCG tax bracket. And no need to wait 31 days or whatever because the wash sale rules don't apply to gains.

My point was, 0% tax is better than 12% tax. So, have a mix.

 

[2177V]

Yes, so if a couple had $24,800 of Roth conversions and $80,000 of preferenced income their total tax bill would be zero.

What is preferenced income?

If you have $80,000 of taxible income, you still have to pay taxes based on "$1,975 plus 12% of the amount over $19,750" for a married couple based on the following link:

https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets

However, any capital gain is considered "non-taxible income" according to the following link:

https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates

As pointed out earlier, standard deduction is considered non-taxible income. Also note in the second link above, LTCG mentioned "taxible income" as the determining factor. Taxible income generally does not include (1) standard deductions, (2) Roth withdrawals and (3) LTCG (but only if your taxible income is less than $80K).

My main points are (1) withdrawal from a traditional IRA is subject to income taxes according to the first link above. (2) LTCG can be 0% if you limit your income by gaming the system according to the second link above.

 

[pb4uski]

I sometimes use preferenced income as a term of convenience to cover off qualified dividends and LTCG that get preferential rates of 0% or 15% (or more at higher income levels).

So in my prior post, the $24,800 of Roth conversions would be offset by the $24,800 of standard deduction, result in $0 ordinary income and $0 tax.... then the $80,000 of preferenced income (qualified dividends and/or LTCG) would be taxed at 0% since the taxable income would only be $80,000.

You can prove it by going to the dinkytown 2020 tax calculator and inputting MFJ, $24,800 of Roth conversions and $80,000 of qualified dividends/LTCG and the resulting tax will be $0.

You would get the same result if you had $0 of Roth conversions (ordinary income) and $104,800 of preferenced income.

I just happen to think that it is preferable to use the standard deduction to offset discretionary ordinary income assuming that the tax rate on RMDs is likely to exceed the 15% preferenced tax rate (assuming that preferenced rates are still around).

https://www.dinkytown.net/java/1040-tax-calculator.html

In doing this tax planning it is optimal to think of ordinary income and preferenced income separately.