Qualified vs Unqualified strategy?

[Lisa99]

I've searched and not found a similar thread so hope this isn't a question asked often.

If you were to do over the percentage of investements you put into a qualified plan (i.e., 401k or other) vs unqualified would you change your decision based on what you know in retirement today?

Reason for my question:
DH and I max out our 401k every year and put money into Vanguard index funds. Our split right now between qualified and unqualified is about 50/50.

I learned today that capital gains and dividends are taxed at 0 up to the 15% bracket. With that information, is it better to fund 401k to the matching and then put everything else in unqualified? We have no debt other than mortgage (which we don't want to pay down yet) and we have a 6-month cash cushion so any money deferred from 401k would go to Vanguard.

Our effective tax rate is 28% today and we can 'afford' the extra taxes we'd have to pay today by not having the bigger 401k deduction.

 

[pb4uski]

Since I ERd I have become more appreciative of having diversity across taxable/tax-deferred and tax-free accounts in addition to asset diversification.

I think it largely depends on 1) your tax rate now vs your tax rate in retirement and sources of funds between when you ER and 2) when you can begin tapping tax-deferred monies without penalty.

The former was the overriding factor for me as my tax rate while working was much higher than my tax rate in retirement, so tax-deferred was my best bet. Also, my 401k allowed penalty free withdrawals if you exited after age 55 so the latter wasn't a factor for me.

It sounds to me from what you wrote that your tax rate now is probably higher than what it will be in retirement and if that is the case I think what you are doing is preferable.

 

[Animorph]

If tax rates are simply equal in and out of the 401k, the growth in a 401k is essentially untaxed. The growth in your taxable accounts may not be taxed if you don't have any distributions while you are in the 28% bracket and you actually stay within the 15% bracket during retirement. Also, those cap gains will count against the the tax bracket, so if you try to fill it with IRA withdrawals that will shrink your ability to fill it with cap gains. I think there is less risk if you max out the 401k.

 

[nun]

FYI be careful with your use of "qualified" and "unqualified" here. By unqualified I assume you mean regular taxable investments. There is a class of tax deferred retirement accounts that are "non-qualified" that include 457s and it's important not to get confused.

 

[MichaelB]

I've searched and not found a similar thread so hope this isn't a question asked often.

If you were to do over the percentage of investements you put into a qualified plan (i.e., 401k or other) vs unqualified would you change your decision based on what you know in retirement today?

Reason for my question:
DH and I max out our 401k every year and put money into Vanguard index funds. Our split right now between qualified and unqualified is about 50/50.

I learned today that capital gains and dividends are taxed at 0 up to the 15% bracket. With that information, is it better to fund 401k to the matching and then put everything else in unqualified? We have no debt other than mortgage (which we don't want to pay down yet) and we have a 6-month cash cushion so any money deferred from 401k would go to Vanguard.

Our effective tax rate is 28% today and we can 'afford' the extra taxes we'd have to pay today by not having the bigger 401k deduction.

By qualified and unqualified do you mean tax deferred and after tax?

 

[bUU]

I'm trying to figure out what breakdown we should be aiming for. I guess the objective is probably to aim to fund the pre-tax side of things so that in retirement we're pulling no more than $70k out of the pre-tax side. (Does that sound right?) Is there a tool out there that we can plug in what we project we'll have and it'll tell us what the RMDs would be? Seems to me that to get to a $70k RMD from 401(k)s you'd have to have two people with pretty large 401(k) balances, on?

 

[pb4uski]

The RMD factor at age 70 is 27.4 so to have a 70k RMD at age 70 your balance would need to be ~$1.9 million.

 

[Lisa99]

By qualified and unqualified do you mean tax deferred and after tax?

Yes, tax deferred and after tax.

Our tax rate is considerably higher than I expect it to be after retirement since I have a small pension and will be living mostly off of our investments.

 

[LOL!]

Our assets are split about 50:50. I really like this because while early retired, we can live off of taxable investments and do Roth conversions up until about age 70 when we start SS benefits.

The taxable investments will not be taxed because return of capital is not taxed (it's tax-free) and any long-term cap gains will be offset by previous carryover losses. One can then convert between $50K to $75K a year to from 401(k) to Roth IRA, so over 20 years of early retirement, one can get more than a million dollars converted to a Roth IRA without paying any taxes. That is, that 401(k) money was tax-free going in and it is tax-free coming out.

So no worries about RMD because almost all the qualifed assets will be converted Roth IRAs before RMDs are necessary.

A calculator like www.i-orp.com is very beneficial in this regard, but it underestimates the amounts one can convert, so it has to be used in conjunction with TurboTax which really helps with one's personal tax situation.

Some folks will want to convert up to the top of their 15% marginal income tax bracket, but I don't think we need to get out of the 0% bracket. Of course, things could change.

 

[MichaelB]

Our effective tax rate is 28% today and we can 'afford' the extra taxes we'd have to pay today by not having the bigger 401k deduction.

Not sure what "effective" rate means. What matters is your marginal rate, because that is what you would pay in additional tax if you chose to shift 401(k) funds to after tax. Entering retirement with a mix of tax deferred and taxable savings gives you additional flexibility, and many here have expressed regret at having too much tax deferred on retirement.

 

[Animorph]

As far as my calculations were concerned, I've always found that I should max out any tax-favored accounts, with traditional/Roth selection decided by tax rates. Anything left over goes into a taxable account. Roth conversions during early retirement are just something you have to do because of 401k/IRA/Roth limits, not something that you short 401k contributions for so that you have taxable funds available for Roth conversions. Of course external things like building an emergency fund and saving for a house downpayment may modify this a bit, since a 401k is pretty inflexible. Otherwise, if you find yourself with everything in a 401k/IRA that's probably quite good.

 

[PatrickA5]

Our assets are split about 50:50. I really like this because while early retired, we can live off of taxable investments and do Roth conversions up until about age 70 when we start SS benefits.

The taxable investments will not be taxed because return of capital is not taxed (it's tax-free) and any long-term cap gains will be offset by previous carryover losses. One can then convert between $50K to $75K a year to from 401(k) to Roth IRA, so over 20 years of early retirement, one can get more than a million dollars converted to a Roth IRA without paying any taxes. That is, that 401(k) money was tax-free going in and it is tax-free coming out.

So no worries about RMD because almost all the qualifed assets will be converted Roth IRAs before RMDs are necessary.

A calculator like www.i-orp.com is very beneficial in this regard, but it underestimates the amounts one can convert, so it has to be used in conjunction with TurboTax which really helps with one's personal tax situation.

Some folks will want to convert up to the top of their 15% marginal income tax bracket, but I don't think we need to get out of the 0% bracket. Of course, things could change.

Can you explain how someone can convert $50K to $75K a year without paying taxes? Thanks.

 

[Original Wally]

Ours WAS 100% Qualified (401k) and "Eligible" (457) as we kind of NEEDED the deduction in order to afford the deferrals. SINCE ER (@ 55 years, 7 mos), I have been TRYING to shift some to an after tax account. Withdraw only up until any more would put me in a higher bracket. So far that taxes on the conversion have been tolerable. That way,we are slowly building an after tax portfolio that will allow access to cash WITHOUT incurring a tax burden - like automobile purchase or cruise to Tahiti or whatever.

 

[LOL!]

Can you explain how someone can convert $50K to $75K a year without paying taxes? Thanks.

Married, filing jointly, 2 kids (1 in college, education credits), pay property taxes, give away to charity (over the standard deduction), pay health insurance premiums, $3K capital loss, foreign tax credit.

Have you ever done your own taxes with TurboTax? Have you ever thought, what if I did this? And checked it out in TurboTax?

 

[Htown Harry]

Can you explain how someone can convert $50K to $75K a year without paying taxes? Thanks.

Here's the thread that showed me the light, Patrick. Follow LOL!'s link to an article that explains it very thoroughly.
http://www.early-retirement.org/forums/f27/2012-taxes-im-stupified-64369-2.html#post1265516

 

[Original Wally]

Have you ever done your own taxes with TurboTax? Have you ever thought, what if I did this? And checked it out in TurboTax?

I use H&R Block (cheaper than Turbo - which I used for YEARS) and one of the final things I do each year is a Pro Forma for NEXT year. (Understood that MAJOR assumption is that there will be no major changes in tax law...). Run scenarios... what if we withdraw this amount or that. What happens if withholdings to this or that. What does my Schedule A look like... do I want to make changes to Church contribs. Stuff like that. Since I get my return DONE by early Feb, it is still early enough in the year to kind of get a game plan. Sorry, I may be RETIRED, but I am still a spreadsheet geek... once a bean-counter, always a bean-counter.

 

[audreyh1]

When I first retired (1999) I thought that I was at a disadvantage for having mostly taxable accounts, and not much in tax-deferred accounts. And maybe I was.

For many of my working years I was severely limited by how much I was allowed to save in tax-deferred accounts. I also got "lucky" with my taxable investments.

But since retiring, tax policy has swung so strongly towards rewarding capital gains and qualified dividends and lowering taxes considerably on amounts within the 15% tax bracket, that it seems having mostly taxable investments is not so bad after all.

I suspect an evenly split taxable and tax-deferred retirement portfolio, hopefully with being able to convert a good chunk of the tax-deferred in Roth, gives one the most flexibility tax-wise. One can carefully choose which type of asset to hold in each account and optimize taxes during accumulation. And after retirement one can carefully choose where to draw the income to minimize taxes.

Whatever happens I would maximize the company match for the 401K. Then I would probably still attempt to maximize the tax-deferred savings. But I would also save aggressively in taxable accounts as well. Hopefully just as much each year. The tax-deferred options usually aren't enough to save for retirement anyway, unless one is able to use a SEP-IRA.

 

[NW-Bound]

Can you explain how someone can convert $50K to $75K a year without paying taxes? Thanks.

Here's the thread that showed me the light, Patrick. Follow LOL!'s link to an article that explains it very thoroughly.
http://www.early-retirement.org/forums/f27/2012-taxes-im-stupified-64369-2.html#post1265516

I may be still confused, but when one withdraws from a traditional IRA to put into Roth, he still has to report that withdrawal as income, and there might be tax liability on that income, is it not?

The additional tax incurred by this conversion is more palatable for an early retiree with low income than for someone at a higher tax bracket, but it is not really tax-free, is it? Of course if an early retiree has zero income, then his conversion will be tax-free, but up to his personal exemptions and deductions only.

Am I missing anything?

 

[Animorph]

If you have enough deductions you can have a significant income tax free. I had about $27k itemized deductions last year. Add in exemptions for three and a tuition tax credit and I could have income greater than $40k without owing any tax. Plus you have 0% capital gains tax in the bottom tax brackets. One of the fun things you can do when RE'd.

 

[haha]

I may be still confused, but when one withdraws from a traditional IRA to put into Roth, he still has to report that withdrawal as income, and there might be tax liability on that income, is it not?

Yes, it is ordinary income. All these ideas depend on having a very low income, and pretty much complete control over the form of that income. For example if you have any taxable interest or nonqualified dividends, or pension, or annuity payments, or royalties, that will all be taxable.

It is much easier to report no income, if your investments never throw off any cash, other than in a sale.

Ha

 

[ShortInSeattle]

Correct me if I am wrong, but couldn't you roll your 401(k) into an IRA upon retirement and take out substantially equal periodic payments, even before the age of 59.5.

If so, a taxable nest egg could be less important.

SIS

 

[Original Wally]

Correct me if I am wrong, but couldn't you roll your 401(k) into an IRA upon retirement and take out substantially equal periodic payments, even before the age of 59.5.

If so, a taxable nest egg could be less important.

SIS

An after tax portfolio is good for those times you need a chunk of cash. You can get a cash out of an after tax portfolio with less of a tax burden.

 

[audreyh1]

Correct me if I am wrong, but couldn't you roll your 401(k) into an IRA upon retirement and take out substantially equal periodic payments, even before the age of 59.5.

If so, a taxable nest egg could be less important.

SIS

IMO, for most people, you are simply not allowed to put enough money into a tax deferred account each year to save enough if you restrict yourself to only saving tax-deferred. The limits are a bit more generous now. They were very restricted back in the 80s and 90s. If you are self-employed and have access to a SEP-IRA, then you are allowed to defer quite a bit. But not self-employed folks, especially those with higher salaries, run into a lot of limits for how much can be tax deferred. 401k plans often restrict how much the higher income folks can put away, and these same folks often don't qualify for traditional IRA or Roth IRA due to salary limits. So, unless you have a decent pension, you had better save a lot in after tax accounts, otherwise your nest egg will not be large enough to retire early comfortably.

 

[audreyh1]

I remember that for me in the 90s, I wanted to put 10% away in my 401K, but I was usually restricted to 6% or 7% due to the salary restrictions of the plan. At least I was able to put in enough to catch the 3% company match. I did not qualify for a tax-deferred IRA due to salary level, but at least I was able to put in $2K after tax each year in an IRA to grow tax-deferred. But $2K a year is piddling. I did not qualify for a Roth IRA either, due to salary, so no option there.

So I saved and invested as much as I could in taxable accounts to make up for these restrictions.

 

[PatrickA5]

Married, filing jointly, 2 kids (1 in college, education credits), pay property taxes, give away to charity (over the standard deduction), pay health insurance premiums, $3K capital loss, foreign tax credit.

Have you ever done your own taxes with TurboTax? Have you ever thought, what if I did this? And checked it out in TurboTax?

Actually, I prepare taxes for a living (CPA).

I thought someone had found a way to do huge conversions tax-free. True, if you have little other taxable income, several exemptions, adjustments to income, lots of itemized deductions and credits, you can lower the tax liability of a conversion. But, most people that have large deductions and credits also make a lot of taxable income of which the conversion is added on top. Also, I doubt there are many who could do 50K-70K in conversions with offsetting deductions/credits over a period of 20 years.

Having said that, you're doing a great job of lowering your tax bill. I've got kids in college, itemize, HSA, etc, but we make too much to even consider a Roth conversion. Once we retire and the income comes down, we'll probably start doing conversions as my goal is to be 50% tax deffered and 50% after-tax.