Questions on taxable retirement investing

[cxw267]

These forums are great! Hoping that all of you can provide a bit of advice.

At 27, my wife and I have been heavily saving into non-taxable retirement accounts since college graduation. At this point, we're maxing out my 401k, fully funding two Roths, and contributing to her 403b plan at a reasonable level. We've also got our emergency 6-months of expenses set aside in a MMA. With those outflows being comfortable now, we're ready to save additional money into taxable accounts that would bridge us into retirement should we decide to retire early.

Any advice for someone that to this point hasn't had to worry much about the tax ramifications of investment decisions? Investment vehicles that I should consider or avoid? Most of my current choices follow standard Modern Portfolio Theory - a variety of low cost index funds targeting different portion of the stock and bond market with porportions based on their market values. Reasonable to continue with that in taxable accounts, or is something else more appropriate?

 

[charlie]

cxw267,

A young investor in the accumulation phase should
consider low cost, low turn-over index funds like
Total Stock Market and Total International for
the equity investment and I-bonds for the bond
allocation in an after tax account. You should
select an allocation to suit your risk tolerance
and rebalance by adding new money on a
regular basis. You will owe a little income tax
at the low dividend income rate but very little
cap gains taxes. Tax on the I-bonds will be
deferred until you sell. Taxes on your equity
investment will be at the low cap gains rate
when you eventually start the distribution phase.

Some will dispute this advise but I would suggest
that you look carefully at maximizing your ROTH first
and your after tax second as apposed to contributing to a 401k beyond the employer match. IMHO, future distributions from your 401k, which are taxed at ordinary income rates, may expose up to 85% of your SS income to ordinary income tax rates. And, I think
it is more likely than not that some administration will raise the tax rates in the future.

All of this is Investment 101 .... trite but true.

Cheers,

Charlie

 

[Hyperborea]

A young investor in the accumulation phase should
consider low cost, low turn-over index funds like
Total Stock Market and Total International for
the equity investment and I-bonds for the bond
allocation in an after tax account.

I would tweak this a little and suggest that you be careful of the "total international" type funds in a taxable account.  Many of these kind of funds, such as the one from Vanguard, are a fund of funds.  That means that the total international fund holds other funds for the various world regions - a European fund, an Asian fund, an Emerging Market fund, etc.  This will mean that you won't be able to claim the foreign tax credit on your tax returns.  It may not make a lot of difference now but as your holdings build up it will.

Consider something like Vanguard's Tax Managed International instead.  This will let you get the foreign tax credit.  It does have a small downside in that there are redemption fees for the first five years.  That's not a big concern since you are early in the accumulation stage but it does limit the potential for tax loss harvesting (if any occurs). If you're investing enough in the taxable account to get over the limits reasonably soon then you might want to hold the regions separately - a European Fund, a Pacific fund, etc.

A really important point is that you look at all your accounts as one portfolio.  You don't want an allocation for your IRA and one for your 401k and one for your taxable account, etc.  You want one allocation for the whole thing and you want to rebalance over the whole thing.  You will keep different asset classes in each account as some are more or less tax efficient than the others.

 

[retire@40]

I would tweak this a little and suggest that you be careful of the "total international" type funds in a taxable account.  Many of these kind of funds, such as the one from Vanguard, are a fund of funds.  That means that the total international fund holds other funds for the various world regions - a European fund, an Asian fund, an Emerging Market fund, etc.  This will mean that you won't be able to claim the foreign tax credit on your tax returns.

I thought the foreign tax paid by any mutual fund trickles down to the shareholder for purposes of claiming a foreign tax credit whether its a fund of funds or not.

 

[Hyperborea]

I thought the foreign tax paid by any mutual fund trickles down to the shareholder for purposes of claiming a foreign tax credit whether its a fund of funds or not.

Ok, I'm not a tax expert but as I understand this is part of the rules on passive foreign investment companies. It's been discussed on a number of different index fund boards.

 

[saluki9]

I thought the foreign tax paid by any mutual fund trickles down to the shareholder for purposes of claiming a foreign tax credit whether its a fund of funds or not.

No, when it's wrapped into another fund you lose the tax credit. This has happened in many wrap programs where investors end up being taxed on municipals because they were wrapped up into another fund.

I would say that you would be wise to stick with domestic stock index funds in your taxable accounts and rebalance your total portfolio to leave all of your fixed income in the deferred accounts.

 

[cute fuzzy bunny]

Make sure you know what the tax credit is worth to you before making it a part of your decision criteria.

My tax benefit for my foreign holdings (~5% total port in europe, 5% in pacific) was $36 in tax I didnt have to pay. Not a factor in choosing a fund unless all other things were equal. The auto-balancing in a 'fund of funds' like total international could easily be worth a lot more than $36.

Of course, your mileage may vary...if you have a $5M port and have 30-40% allocated to international, your foreign tax benefits might be a little more significant.

 

[Dude]

Some will dispute this advise but I would suggest
that you look carefully at maximizing your ROTH first
and your after tax second  as apposed to contributing to a 401k beyond the employer match.  IMHO, future distributions from your 401k, which are taxed at ordinary income rates, may expose up to 85% of your SS income to ordinary income tax rates.  And, I think
it is more likely than not that some administration will raise the tax rates in the future.  

"future distributions from your 401k, which are taxed at ordinary income rates, may expose up to 85% of your SS income to ordinary income tax rates"

OK, this has got me worried since I'm 35 and plowing money into my 401k and Roth IRA but not into regular taxable accounts.....could someone please explain how 401k distributions affect taxing of SS benefits?  Thanks.

 

[Martha]

"future distributions from your 401k, which are taxed at ordinary income rates, may expose up to 85% of your SS income to ordinary income tax rates"

OK, this has got me worried since I'm 35 and plowing money into my 401k and Roth IRA but not into regular taxable accounts.....could someone please explain how 401k distributions affect taxing of SS benefits? Thanks.

Taxation of social security benefits is currently dependent on how much income you have outside of social security. Distributions from a 401k are all treated as income to you and therefore are counted when determining whether your social security might be taxed. ROTH distributions are not treated as income so any money coming out of a ROTH will not be counted in determining whether your social security is taxed.


From the www.ssa.gov website:

Some people who get Social Security benefits have to pay income taxes on them. This will apply to you only if you have other substantial income in addition to your benefits (for example, wages, self-employment, interest, dividends and other taxable income that you have to report on your tax return). No one pays taxes on more than 85 percent of his or her Social Security benefits and some pay on a smaller amount, based on these IRS rules:

* If you file a federal tax return as an "individual" and your combined income* is between $25,000 and $34,000, you may have to pay income tax on 50 percent of your Social Security benefits. If your combined income is above $34,000, up to 85 percent of your Social Security benefits is subject to income tax.
* If you file a joint return, you may have to pay taxes on 50 percent of your benefits if you and your spouse have a combined income* that is between $32,000 and $44,000. If your combined income is more than $44,000, up to 85 percent of your Social Security benefits is subject to income tax.
* If you are married and file a separate tax return, you probably will pay taxes on your benefits.

*On your 1040 tax return, your "combined income" is the sum of your adjusted gross income, plus nontaxable interest, plus one-half of your Social Security benefits.

Every January you will receive a Social Security Benefit Statement (Form SSA-1099) showing the amount of benefits you received in the previous year. You can use this statement when you complete your federal income tax return to find out if your benefits are subject to tax. Although you're not required to have federal taxes withheld from your Social Security benefits, you may find it easier than paying quarterly estimated tax payments. See here for information on how to have taxes withheld.

For more information about your taxes, see Internal Revenue Service (IRS) Publication 554, Tax Information for Older Americans, and Publication 915, Social Security Benefits and Equivalent Railroad Retirement Benefits. Both publications have worksheets to help you figure out whether your benefits would be taxable.

 

[TromboneAl]

that would bridge us into retirement should we decide to retire early.

Pssst. I've got a secret for you that you'll love. Come closer...

[whispering] You don't have to wait until age 59.5 to withdraw from IRA accounts without penalties.

That's right. A lot of people don't realize that. Google 72t.

Pass it on.

 

[Cb]

I wouldn't agonize over engineering my contributions to various accounts on the basis of avoiding today's arcane SSI taxation triggers. I'm pretty confident that in the future ALL SSI income will be subject to taxation.

401K deductions are pretty convenient, and tend to reliably occur in 12 out of 12 months. If me and Momma had been diverting our monthy excesses to taxable accounts over the past 25 years instead of 401K auto-deducts there's a decent chance we'd have skipped a few months and gone with the new draperies instead.

Cb

 

[Nords]

OK, this has got me worried since I'm 35 and plowing money into my 401k and Roth IRA but not into regular taxable accounts.....could someone please explain how 401k distributions affect taxing of SS benefits?  Thanks.

Keep plowing, Dude.  Dig deep & wide. The compounding & tax-deferral of the 401(k) will far outstrip anything you'll pay back in SS taxes.

There are other options, too. When you ER, hopefully before you take SS distributions, you'll have a few years of very low income where you're living off your investments.  During that time you can use Al's 72(t) recommendation or roll your 401(k) into an IRA and then convert that IRA to a Roth.  Once your primary source of income is the Roth, you'll escape SS taxation.

 

[roadkill]

cxw267,
Some will dispute this advise but I would suggest
that you look carefully at maximizing your ROTH first
and your after tax second  as apposed to contributing to a 401k beyond the employer match.  IMHO, future distributions from your 401k, which are taxed at ordinary income rates, may expose up to 85% of your SS income to ordinary income tax rates.  And, I think
it is more likely than not that some administration will raise the tax rates in the future.

 

I agree. In addition, as a part of your analysis relative to a ROTH, you may want to simply consider the trade off between taxes saved by contributing to a pre tax 401k today given your respective tax bracket versuus what the future tax impact may be when the 401k is withdrawn.  I agree that younger folks,at a minimum,  should contribute to the 401k up to the company match, but the additional tax savings on contributions above this amount may not make sense long term to the extent the current incremental tax savings is minimal.

 

[azanon]

Pssst. I've got a secret for you that you'll love. Come closer...

[whispering] You don't have to wait until age 59.5 to withdraw from IRA accounts without penalties.

That's right. A lot of people don't realize that. Google 72t.

Pass it on.

Also not well know, perhaps because traditional IRAs have been around so long, is that you can withdraw the entirity of your Roth IRA contributions penalty free and tax free at any time, any age, and for any reason. Why? Because the IRS already got its share, and because, well, its allowed.

 

[MJ]

First time I qualified for Roth-IRA was last year when I got laid off. I still was unable to get the maximum allowed. I guess, not qualifying was a blessing in disguise.

 

[Dude]

Thanks everyone for your responses.  We fund our Roth IRAs to the $8k max (me and wife) and contribute $8k to my 401(k) (includes employer match).

Roth IRAs are our #1 priority, no question.

I'm just trying to decide whether it makes more sense to contribute more to my 401(k) or to start building a taxable account as Charlie suggested above.

I don't know exactly why, but I have a bad feeling about getting screwed with super-high income tax rates when I go to withdraw from my 401(k).....seems like a perfect storm is brewing with massive baby-boomer retirements, smaller workforce to support their social security "entitlements", skyrocketing health care costs, huge budget deficit, etc.....I worry that I'm going to plow all of this money into my 401(k) and then feel like a sucker when the gov't taxes my withdrawals at 50%!

 

[deserat]

Yup - 50% on that deferred may happen, especially if you have other pension income, too. That's why in addition to fully funding the 403bs and Roths, we have a significant after-tax savings plan - plus we hope to have that cover the gap between his retirement date with the pension to the day one of my pensions becomes available. Basically, we're just trying to cover all bases - if you're supposed to diversify your protfolio, why not diversify those income streams in retirement, too. Additionally, we track what we spend and manage our personal inflation rate.

You are actually doing very well - way ahead of most folks your age - as Nords said, keep plowing - the opportunity to pull the rip cord may come a lot sooner. Always nice to have options in life.

Deserat