Taxable/Deferred/Exempt Balancing

[TickTock]

When I started getting serious about saving and investing, the standard advice was to fill up tax deferred and tax exempt accounts first, then put whatever remains in taxable. Now, especially for early retirees, there's more emphasis on having enough taxable $$ to get through to age 59-1/2, balance different types of account balances to avoid higher RMDs, and a recognition of the drawback of tax deferred accounts converting capital gains into ordinary income when withdrawn.

But I haven't seen any research into how to balance the three account types. Plenty on how to most efficiently draw on what you have, yes, but not how to best balance in the first place. Has anyone seen this type of analysis or have insights from their retirement?

 

[Gotadimple]

You are speaking about asset location. This is a strategy to reduce tax burden. You'll find a discussion in Rick Ferri's All About Asset Allocation, 2nd edition published in 2010. You can find this at the library, in print, also on Amazon print/kindle. Asset location is about placing certain assets in tax-free (Roth), tax-deferred (Traditional IRA, 401K etc) and taxable (brokerage accounts, savings accounts).

I have the first edition and his discussion of location is on pages 267-269. He is active on the Bogleheads forum and there is a robust discussion around this strategy there. This book is a go-to resource for personal investing.

You can also find good information and analysis on Morningstar, click on Investing Ideas, then on Christine Benz's Portfolios. She has a full series about managing your investments for retirement.

HTH,
Rita

 

[pb4uski]

Interesting concept. I was a high earner who was in a high tax bracket whie working and expected to be in a lower tax bracket in retirement so I prioritized tax-deferred savings. Savings beyond the 401k and HSA limits went into taxable accounts since I planned to retire at 55 and would have had a 4-1/2 year period before I was eligible for penalty free tax-deferred withdrawals... or I could have used the rule of 55.

Roths and HSAs came about late im my career so I didn't have much in tax free when I retired. When I retired in early 2012 we had 44% taxable, 53% tax-deferred and 3% tax free vs 1% taxable, 61% tax-deferred and 38% tax-free today due to aggressive Roth conversions since retiring and use of taxable for spending gap. It seems that even with the relatively aggressinve Roth conversions that I did thus far it just converted the growth in tax-deferred as the dollar amount of tax-deferred is about the same as when I retired.

All of that said, if I were doing it today I probably would not have done anything differently. My tax-deferred savings generally avoided taxes at 28% federal and 6% state... so 34% combined. My Roth conversions since retiring have averaged 10% federal and 3% state (with a number of years at 0% state since we now live in TX and lived in FL). Even looking forward to SS and RMDs, our RMDs will be taxed at ~18% federal and 0% state.

So were are way ahead in taxes... 34% avoided vs 13-18% paid upon withdrawal... so ahead 16-21%... that's a great result IMO.

 

[TickTock]

pb4uski,

Sounds like we're in similar boats. 57% taxable, 38% deferred, 5% exempt. No Roth conversions for now (managing ACA MAGI).

 

[Dash man]

I don’t recall the percentages, but we were heavily into taxable followed by pretax and a small percentage in Roth accounts. Stock options did well for us, resulting in a heavy percentage of taxable accounts and the top tax bracket. We maxed out our 401k plans and did back door Roth conversions.
We’ve been doing large Roth conversions each year since retirement to reduce our pretax accounts and paying the taxes and living expenses out of our taxable accounts.
We will likely never touch our Roth accounts.

 

[SevenUp]

...how to balance the three account types.

TickTock, the order below will serve most people well. For more details, Investment Order includes other account types and considerations.

1) Deductible traditional up to the point that you expect withdrawals in retirement will start to incur too high of a marginal rate, compared with the marginal tax rate you can save now.
2) As much into Roth as you can contribute after maximizing #1
3) As much into taxable as you can after maximizing #1 + #2.

There is no "best percentage" of each. Rather, the percentages are outcomes based on ordering such as above.

 

[pjigar]

What a coincidence! I posted the following in another thread just a few minutes ago and then I saw this thread:
I always ask young folks to balance 3 buckets equally if they can: pre-tax (401K/IRA), tax-free (HSA/Roth 401k/Roth IRA) and after-tax (brokerage, rental, business, etc.). It helps you better manage spending, taxes and future tax law changes.

FWIW our pre-tax:tax-free:after-tax ratio stands at 32%:18%:50% today. We are maxing out all tax-free buckets until FIRE. We will start Roth conversions after FIRE.

Response to your original post:
As to the strategy, some are obvious and the others will be in the "it depends" camp. A few strategies that will apply almost universally:
* Max out HSA (since it has best of both worlds, pre-tax contribution and tax-free growth/withdrawal)
* Max out Roth buckets early in your career when your marginal tax bracket is really low <20%.
* Contribute at least to company match on 401k/Roth 401k depending on your marginal tax bracket.

It gets tricky as you approach mid career because you think you are paying high tax which could have been even higher when RMD hits. I created a spreadsheet that helped me estimate tax bracket we may fall into at RMD age. My projections showed that we would be in even higher bracket than current bracket when we hit RMD even with aggressive Roth conversions till RMD, thanks to in part due to cashflow businesses and deferred comp. So I switched to maxing out Roth 401k (and backdoor IRA and mega-backdoor IRA) since a last few years. Here is the link to spreadsheet if anyone wants to try:

RMD Scenarios

docs.google.com

 

[TheWizard]

I didn't retire "early".
But if you retire three years before age 59-1/2, I would think you'd want a lump sum in your taxable account somewhat greater than what you expect to need.
For example, $60k annual expenses for three years, I'd want at least $200k in taxable to fund that...

 

[imjustawarrior]

a recognition of the drawback of tax deferred accounts converting capital gains into ordinary income when withdrawn.

I don't think this is correct or I'm not following you.

There is no avoiding the ordinary income tax rate except for an HSA. Capital gains are never converted into ordinary income.

Scenario 1: Earn $1000 that goes into 401k. Doubles in 10 years. Withdrawn in retirement. You get $2000*(1-tax_rate)

Scenario 2: Earn $1000 that goes into taxable as $1000*(1-tax_rate). It doubles in 10 years and you have $2000*(1-tax_rate).

If the tax_rate is the same in each scenario, then you have the same amount. Normally, people are expecting their tax_rate to be lower in retirement, so scenario 1 is better. Also, scenario 2 really doesn't end up with $2000*(1-tax_rate) because there are taxes on dividends along the way and then the capital gains taxes when sold. Scenario 1 is far better.

 

[SnowballCamper]

I think the best balance is determined by the fact that our wages generally increase over time, but not so much to ignore matching funds, so:
First, get the matching funds in the tax deferred 401k because it's free money.
Second, (in addition to first) use the Roth IRA early in career because we likely aren't above the cutoff salary and some flexibility exists with the ability to withdraw contributions, and other permitted uses before age 59.5
Third, maximize deductible contributions in peak earning years.
Fourth, save in a regular brokerage.
For much of my higher earning years I did 2, 3, & 4 because the Roth was still available (matching funds were never available). Doing all of the above is prudent and the contribution limits prevent any serious mistakes if you're using all the options in the best order.

 

[TickTock]

Capital gains are never converted into ordinary income.

All withdrawals from a tax-deferred account are taxed as ordinary income, converting any capital gains inside the account.

Looking at capital gains tax rates vs. ordinary income for 2025 MFJ, capital rates are lower. 0% CG goes roughly to the top of the 12% bracket; 15% (going to 18.3% when the NIIT kicks in at $250k) goes to nearly half of the 35% bracket.

So saving in a taxable account: less $ to contribute due to taxes, interest/dividends/distributions are taxed as they occur (could be taxed as ordinary income or at CG rates), unrealized capital gains compound untaxed, capital gains when realized are taxed at a favorable rate, and the original principle is not taxed when withdrawn.

 

[pb4uski]

....Capital gains are never converted into ordinary income....

I think what is being referred to is holding domestic equities in a taxable account compared to a tax-deferred account.

Qualified dividends and LTCG on domestic equities in a taxable account get preferential tax rates... generally 0% or 15% for most people.

However if you hold those same domestic equities in a tax-deferred account like a tIRA, and withdraw dividends and LTCG then those withdrawals are taxed as ordinary income at higher rates.

So holding domestic equities in a tax-deferred account is suboptimal because doing so effectively converts capital gains into ordinary income.

 

[Koolau]

Too many issues go into the mix to set "best practices" when it comes to taxable/deferred/exempt. All I know is that I have regretted putting "too much" into deferred but I don't know what the right mix is - not even for me in my situation. Too many things change in taxes and living circumstances to know for certain what to do. A simple "thirds" approach would likely w*rk as well as any other for most people - but that's a guess. YMMV

 

[Texas Proud]

This is still a bit simplistic in how to look at things....

I was using my taxable account to live off of for many years... until I ran out of low capital gain assets.. almost all of my current holdings in my taxable account has a minimum 50% gain and a lot at 70% ish...

So if I sell I have a cap gain that affects my ACA credits (DW and DD are still on it)... so even if I did not have to pay cap gain taxes it is a taxable event...

So location is not the only thing you need to think about...

 

[imjustawarrior]

So holding domestic equities in a tax-deferred account is suboptimal because doing so effectively converts capital gains into ordinary income.

Please give me an example of this where holding equities is better in a taxable account than a 401k. Assume the ordinary tax rate is a constant. I gave my example above. What is wrong with my explanation? I do not believe it is suboptimal. If it is suboptimal, then why are so many people using 401ks?

 

[COcheesehead]

I was told by an advisor to do a third in each, but in reality that was almost impossible to do when you earn high income. I contributed to a Roth when I could, which was rare. Loaded up my 401k,/IRA, bought a deferred annuity to stash more tax deferred and let the rest spill over into taxable.
When I retired I was almost 50/50 deferred vs taxable and just a tiny bit in a Roth. Having as much in taxable as we did is what allowed us to retire early with lots of flexibility. 5 years in at age 62, we still live exclusively off our taxable and likely could the rest of our lives, but RMDs will come at age 75. I now look at the deffered annuity as our LTC bucket. There are no RMD requirements from that so I am letting it ride. I don’t need it, so it will be there when we get old or it will go to our scholarship funds we created.

 

[pjigar]

Please give me an example of this where holding equities is better in a taxable account than a 401k. Assume the ordinary tax rate is a constant. I gave my example above. What is wrong with my explanation? I do not believe it is suboptimal. If it is suboptimal, then why are so many people using 401ks?

I created a couple examples. I got surprising results. Do you see any computational errors in my examples?

We have to plug-in the tax_rate first. Let's try a couple of people: Jack falls into 12% marginal rate and Jill falls into 24% marginal rate. We also have to breakdown the "earn" part in your examples. Let's assume (for simplicity), both Jack and Jill invested in BRKB which has almost no dividends.

Jack's Scenario 1: Earn $1000 that goes into 401k. Doubles in 10 years. Withdrawn in retirement. You get $2000*(1-0.12)=$1760
Jack's Scenario 2: Earn $1000 that goes into taxable as $1000*(1-0.12)=$880. It doubles in 10 years and you have $880 (principal) + $880*(1-LTCG of 0%) = $1760.

Jill's Scenario 1: Earn $1000 that goes into 401k. Doubles in 10 years. Withdrawn in retirement. You get $2000*(1-0.24)=$1520
Jill's Scenario 2: Earn $1000 that goes into taxable as $1000*(1-0.24)=$760. It doubles in 10 years and you have $760 (principal) + $760*(1-LTCG of 15%) = $1460.

PS: We can make these examples as complicated as we want if we assume that the marginal tax rate will be different in the future, accounting for dividends, etc. But my gut feeling is that pre-tax bucket will continue to win until your future tax rate is pushed really high (due to RMD) compared to today.

 

[Exchme]

For years, I only contributed enough to tax deferred to get the company match and Roths weren't a thing. When Roths first started, they weren't offered in the 401k at work, so we made some contributions for my wife, but then our income went up and that opportunity went away. At higher income, we pushed up the tax deferred savings to the max. Now that I'm part time, we're doing Roth Conversions.

I counsel the kids to use Roth for now while they are still in their lower earning years.

I've done many dumb things with investments, but given what was available at the time, I think we made the right choices as to which account to use for our circumstances.

 

[Exchme]

Please give me an example of this where holding equities is better in a taxable account than a 401k. Assume the ordinary tax rate is a constant. I gave my example above. What is wrong with my explanation? I do not believe it is suboptimal. If it is suboptimal, then why are so many people using 401ks?

pb4uski is correct and it is very standard advice. For instance, from the Bogleheads.org wiki:

Fill your tax-advantaged accounts with your least efficient funds. Exhaust these accounts before putting these funds into your taxable account; if you run out of room, consider more tax-efficient alternatives, such as a stock index fund rather than an active fund or a muni bond fund rather than a total-market bond fund. An example portfolio with three asset classes (a total market US stock market index fund; a total market international stock market index fund, and an intermediate taxable bond fund,) is shown below. Note that in this scenario, we assume bond interest rates have a higher tax cost than stock investments.

The idea also helps as putting bonds in tax deferred slows the growth of that account. It also helps your spouse or other heirs as there is a step-up in basis when each spouse passes away. It reduces current income so may increase ACA credits, reduce taxation of SS benefits and it reduces the need for Roth Conversions.

 

[imjustawarrior]

I created a couple examples. I got surprising results. Do you see any computational errors in my examples?

We have to plug-in the tax_rate first. Let's try a couple of people: Jack falls into 12% marginal rate and Jill falls into 24% marginal rate. We also have to breakdown the "earn" part in your examples. Let's assume (for simplicity), both Jack and Jill invested in BRKB which has almost no dividends.

Jack's Scenario 1: Earn $1000 that goes into 401k. Doubles in 10 years. Withdrawn in retirement. You get $2000*(1-0.12)=$1760
Jack's Scenario 2: Earn $1000 that goes into taxable as $1000*(1-0.12)=$880. It doubles in 10 years and you have $880 (principal) + $880*(1-LTCG of 0%) = $1760.

Jill's Scenario 1: Earn $1000 that goes into 401k. Doubles in 10 years. Withdrawn in retirement. You get $2000*(1-0.24)=$1520
Jill's Scenario 2: Earn $1000 that goes into taxable as $1000*(1-0.24)=$760. It doubles in 10 years and you have $760 (principal) + $760*(1-LTCG of 15%) = $1460.

PS: We can make these examples as complicated as we want if we assume that the marginal tax rate will be different in the future, accounting for dividends, etc. But my gut feeling is that pre-tax bucket will continue to win until your future tax rate is pushed really high (due to RMD) compared to today.

I agree with your analysis. I don't know why people think a taxable account is going to have higher returns as compared to a 401k (or some other retirement account). The saying that it turns capital gains into ordinary income is very unfortunate.

 

[imjustawarrior]

pb4uski is correct and it is very standard advice. For instance, from the Bogleheads.org wiki:

Fill your tax-advantaged accounts with your least efficient funds. Exhaust these accounts before putting these funds into your taxable account; if you run out of room, consider more tax-efficient alternatives, such as a stock index fund rather than an active fund or a muni bond fund rather than a total-market bond fund. An example portfolio with three asset classes (a total market US stock market index fund; a total market international stock market index fund, and an intermediate taxable bond fund,) is shown below. Note that in this scenario, we assume bond interest rates have a higher tax cost than stock investments.

The idea also helps as putting bonds in tax deferred slows the growth of that account. It also helps your spouse or other heirs as there is a step-up in basis when each spouse passes away. It reduces current income so may increase ACA credits, reduce taxation of SS benefits and it reduces the need for Roth Conversions.

I agree with tax efficient fund placement, but I don't think that is the context of the discussion. Go back and take a look.

 

[pb4uski]

... All I know is that I have regretted putting "too much" into deferred ...

I have two questions for all those who "regret" putting so much in deferred. 1) What was your combined federal and state income tax marginal rate when you deferred that income? 2) What is your combined federal and state income tax marginal rate when you withdraw those tax deferre savings?

For this purpose you can also include any forfeited ACA premium tax credits or Medicare Part B and Part D IRMAA premiums if you wish.

In our case, we saved ~34% when the income was deferred (28% federal and 6% state) and now pay about 10% on Roth conversions and a projected 18% combined once we have SS and RMDs... so we are way ahead. I never expected that I would pay no tax on withdrawals, but only that I would pay less tax on withdrawals than I avoided on deferrals. Saving 6% on state income taxes was an unanticipated bonus.

 

[pb4uski]

... Jack's Scenario 1: Earn $1000 that goes into 401k. Doubles in 10 years. Withdrawn in retirement. You get $2000*(1-0.12)=$1760
Jack's Scenario 2: Earn $1000 that goes into taxable as $1000*(1-0.12)=$880. It doubles in 10 years and you have $880 (principal) + $880*(1-LTCG of 0%) = $1760.

Jill's Scenario 1: Earn $1000 that goes into 401k. Doubles in 10 years. Withdrawn in retirement. You get $2000*(1-0.24)=$1520
Jill's Scenario 2: Earn $1000 that goes into taxable as $1000*(1-0.24)=$760. It doubles in 10 years and you have $760 (principal) + $760*(1-LTCG of 15%) = $1460.

I think your $1,460 should really be $1,406... ($760*2 or $1,520) - LTCG tax of ($760*15% or $114) = $1,406.

 

[Cobra9777]

When I first retired, we were roughly 50/50 taxable / tax-deferred, with only a very small HSA in the tax-free bucket (no Roth). The taxable account grew very quickly late in my career due to stock options and RSUs. Otherwise, 100% of our retirement savings went into tax-deferred during our working years. We were in the 28% and 33% brackets most years. We are now converting deep into the 22% bracket, with an average rate of 18-19%.

Today, after large Roth conversions and steady HSA contributions, we are up to almost 40% tax-free. The taxable account is much smaller, as it has been used for living expenses (in excess of our 2 small pensions), plus tax on conversions. Tax-deferred is down due to conversions, but market growth has kept it fairly high.

Ultimate goal is 60% tax-free, 30% tax-deferred, and 10% taxable. This should keep us well within the 22% bracket, below the IRMAA thresholds, with lots of flexibility to fund spending.

 

[pb4uski]

Please give me an example of this where holding equities is better in a taxable account than a 401k. Assume the ordinary tax rate is a constant. I gave my example above. What is wrong with my explanation? I do not believe it is suboptimal. If it is suboptimal, then why are so many people using 401ks?

I'll answer the second question first. So many people are using 401ks because they believe that their tax rate in retirement will be lower than while working and so there is tax rate arbitrage to take advantage of. See post #22 above.

For the example, let's say that you have $10,000 in cash in a taxable account and $10,000 in cash in a 401k. You are in the 12% tax bracket and expect to remain in the 12% bracket.

Option A is to buy stocks in the taxable account that pay 2% qualified dividends that are reinvested in the taxable account and that appreciate at 8% annually. The dividends are taxed at 0% as are the LTCG at the end of 10 years. And buy bonds that yield 4% in the tax-deferred account. Option B is vice versa. After 10 years you withdraw all from both accounts. pay the tax and spend the rest. Option A comes out $2,005 or 5% better which is about 12% of the growth in the equities over the 10 years.