Taxable/Deferred/Exempt Balancing

[Alex The Great]

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.

In fact, there is no magic at all about 59-1/2. It is still possible to get funds from retirement accounts penalty free prior to 59-1/2. One options is to retire after 55 and use 55 rule to draw the latest 401K. Principal in Roth IRA is always tax and penalty free.

 

[TickTock]

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.

Underlining in the above quote is mine and this seems to be the key point. Otherwise, the traditional advice holds - fill up deferred and exempt accounts first and then use the remainder (if any) in taxable accounts.

Location for best tax efficiency is a related issue. There's plenty of research and knowledge on that point, though.

 

[imjustawarrior]

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.



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If you are talking about tax efficient fund placement, I agree with you.

I don't think that was the OP's original context and it wasn't mine, but that is okay. We are on the same page now.

 

[SnowballCamper]

It seems to me that comparing the capital gains taxes in a regular brokerage to the deferred income taxes on a 401k can be a bit misleading. Whatever funds are in the regular brokerage presumably came from wages, and were taxed before going in. So the capital gains are an additional tax, and generally a lower rate than earned income taxes.
While the money in the 401k grows without capital gains taxes, it hasn't been subject to regular income tax, until it's withdrawn.
Significant numbers of us end up with large 401k balances and not much in the brokerage and wish we could get capital gains taxing on the funds in the 401k in lieu of regular income taxes, but we're still ahead using the 401k because we skipped the taxes on that money when it was earned (at a higher tax rate when we were making the big bucks).

 

[pjigar]

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.

I think this is really the main point when it comes to placement of funds across 3 buckets. After years of maxing out traditional 401K, eventually I realized (after I created the IRA conversion spreadsheet) that we will have an opposite situation: we will be in a higher marginal tax bracket at RMD age than now. So I stopped contributing to traditional 401k and started contributing to Roth 401k like I mentioned in post #7. My situation is unique since I have access to a deferred comp plan (which allows me to lower current marginal tax rate) and the fact that we have amassed a large traditional 401k balance already and we have a few cashflow rentals. But anyone with a prudent investing and high income can easily be in our situation. So the moral of the story is: it depends. You really have to project your RMD income(s) and marginal bracket to decide where to park your money today.

 

[SJhawkins]

Never been a real high earner, Roths were not thing for many years, just filled up on tax deferred for many years. Today have roughly 40% deferred, 40% taxable and 20% roth. Getting close to slowing down (thinking this year) then being done the follwing year around age 58 or so.

I get the feeling we may be chasing our tails a bit with deferred, not expecting any great tax arbitrage, will let you know how it pans out after the next 10-15 years.

The silver lining is we have a good enough mix I feel to deal with the ACA, that in turn will make for a "easier" and or possible early retirement. From that standpoint the tax diversity may be priceless.

Few things I learned; tax laws change and trying to outguess the changes are fruitless. Splitting between tax deferred, taxable and never taxed (roth) by 3 is sane for most average earners/investors.

A slug of Ibonds is a nice to have too, I'm starting too see more value in those as I'm getting closer to retirement, it's taken many years to build anything meaningful but glad we did it.

 

[Texas Proud]

It is interesting to do some math... and as mentioned some hope to have lower tax rate when retired than when working...

I find it interesting that at least 2 of my siblings have higher income today than when they retired... one has not even started RMDs which will really push her over her ending wages...

A gvmt pension and SS can get your income quite high if you worked for 35 to 40 years...

 

[pjigar]

It is interesting to do some math...

Tell me about it! I had to go through 3 different versions of "RMD Scenarios" spreadsheet and it is still not perfect. I can only do a gross estimate of RMD tax rate even with some assumptions and no tax law changes.

 

[YellowSubmarine]

60% Roth/HSA, and 15% SEP IRA, and 25% in taxable brokerage. The taxable consist mostly of tax-free muni zero coupon bonds; hence 6.6% of all NAV is subject to CG and Dividend tax. I've been able to maintain a 12% tax bracket for most years in retirement. At one point (around 2018) I got nailed with excessive tax as I sold some tax free muni bonds with large gains (not realizing they would be subject to CG tax).

 

[sengsational]

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?

That's because "It's tough to make predictions, especially about the future." As mentioned, the conventional thinking when we were mid career making lots of money is that we'd not be "making" any money when retired, so tax rate arbitrage dictated immediate tax avoidance and to cross that other bridge when we came to it. I don't know about the rest of you, but my experience with financial modeling an entire lifetime didn't start mid-career...it only started when I was considering retirement.

 

[pb4uski]

I think this is really the main point when it comes to placement of funds across 3 buckets. After years of maxing out traditional 401K, eventually I realized (after I created the IRA conversion spreadsheet) that we will have an opposite situation: we will be in a higher marginal tax bracket at RMD age than now. So I stopped contributing to traditional 401k and started contributing to Roth 401k like I mentioned in post #7. ...

For those of you whose tax rate in retirement is the same or higher than when working, figure it this way: Unless you were just following the herd, the only reason that one would chose tax-deferred savings is if you expected your tax rate in retirement to be lower than your tax rate while working. If it turns out the opposite, then you have been much more financially successful than you anticipated. Congratulations!

OTOH, the bad news is that you probably worked longer than you needed to!

 

[SJhawkins]

Looked at this with some very rough numbers a few years ago. For a married couple with no pensions, average/decent SS with around $2-3 million in assets having around $1 million in tax differed accounts with the rest in some mix of Roth and brokerage seems sane and manageable.

This may allow for an early retirement if one chooses, depending on spending obviously. Some years to do some conversions before SS while both spouses are alive and hopefully after SS starts albeit smaller conversions probably. If you end up in single filer bracket it's still some what manageable, much better if both spouses live to a ripe old age.

As other have said any guess of the future is just a guess, to me tax planning out 10 years is generally doable. Planing out your tax burden while interesting for 20-30 years is just a WAG, not that one should ignore future projections.

One does not have to look in the past to far for examples, take secure act 2.0, don't hold me to the name. Where they changed the rules for inherited IRAs, if we happen to be an unlucky couple and die early our kids will end up distributing out our IRAs in their prime earning years, will end up paying way more in taxes then we ever saved. This alone has me thinking I'm not so sure I want any more tax differed savings going in my last couple of years working. Also going to make sure we do the best we can with Roth conversions.

Will let you know how it all works out in about 30 years from now......

 

[TheWizard]

When I retired in 2013, 95+% of my $$$ was in tax-deferred 403(b) and less than 5% in Roth IRA.
My taxable account at the time was negligible.

I don't really regret saving so much in tax-deferred, but if I did it over, I'd probably put a portion of my contributions into a Roth 403(b) instead of all into traditional 403(b).

Since retiring, my AGI and taxes have been comparable to what they were in my latter working years, adjusted for inflation, and I'm totally fine with that.

Another interesting metric is how my allocation between different accounts has evolved since 2013. My taxable account has grown from zero to a few hundred K$$$, since that's the only place I can invest excess income anymore.

Within a few years, I expect my taxable account to become equal to my Roth IRA in size.
Around the same time, I expect my taxable + Roth accounts total to become equal to the nominal value of my remaining tax-deferred accounts.

It's all good...

 

[GrayHare]

It seems to me that comparing the capital gains taxes in a regular brokerage to the deferred income taxes on a 401k can be a bit misleading. Whatever funds are in the regular brokerage presumably came from wages, and were taxed before going in. So the capital gains are an additional tax, and generally a lower rate than earned income taxes.
While the money in the 401k grows without capital gains taxes, it hasn't been subject to regular income tax, until it's withdrawn.

The commutattive property of math proves the idea of such an additional tax is a fallacy. Specifically, for a given tax rate, whether you pay that tax in advance of investing or after investing makes no difference in the post-tax value of your net worth. When you pay the tax does not matter, instead only the tax rate is relevant to your after-tax net worth. This is why paying the generally-lower cap gains tax of taxable accounts leaves you with more after-tax money.

 

[SevenUp]

The commutattive property of math proves the idea of such an additional tax is a fallacy. Specifically, for a given tax rate, whether you pay that tax in advance of investing or after investing makes no difference in the post-tax value of your net worth. When you pay the tax does not matter, instead only the tax rate is relevant to your after-tax net worth. This is why paying the generally-lower cap gains tax of taxable accounts leaves you with more after-tax money.

The commutative property of multiplication is indeed applicable for simple cases of traditional vs. Roth accounts.

Comparing either traditional or Roth vs. taxable is a bit more complicated, due to the annual tax drag and extra (beyond the ordinary income tax that applies at some point to all three account types) capital gain tax for the taxable account.

 

[TheWizard]

The commutattive property of math proves the idea of such an additional tax is a fallacy. Specifically, for a given tax rate, whether you pay that tax in advance of investing or after investing makes no difference in the post-tax value of your net worth. When you pay the tax does not matter, instead only the tax rate is relevant to your after-tax net worth. This is why paying the generally-lower cap gains tax of taxable accounts leaves you with more after-tax money.

I'm familiar with the commutative law but am a bit confused on what you are saying.

Assume $100k in tax-deferred stock fund, a 24% tax bracket, and a ten year timeframe.
Withdraw the $100k now, pay $24k tax, and invest remaining $76k in same stock fund in taxable account.
Over next decade, Qual Divs taxed at 15% then sell entire balance at 10-year mark to buy a yacht, paying 15% tax on the LTCG.

VS leave entire $100k in tax-deferred for ten years and pay 24% tax on entire appreciated lump when withdrawn.

Which scheme gets you the bigger yacht ?

 

[surprising]

I've only been retired for a few months now at 51 but I can see that my taxes will be far far lower in retirement, at least for now. Not sure if this will hold throughout retirement, but feels like having 35% of my 401k in roth might not be worth it, since I was in a high tax bracket for decades. The bigger issue for us early retirees though is how to cover the years before 401k. I spent a lot of time figuring out what to do during these first years before 401k, and I decided on using dividends to fund basic living expenses. I also have rentals, and so dividends plus rentals cover all my basic expenses. I spent the 5 years or so before retiring building up a portfolio of dividend paying stocks/funds. Once those dividends plus rentals covered basic living expenses, I felt I could retire (along with all the positive projections from the calculators). My average yield on cost is 10%. If I had done a bond ladder instead, I would have required at least twice the capital, which would have delayed my retirement for years.

 

[CRLLS]

Planning an ironclad retirement plan when you are in your 20's is virtually impossible. Nobody knows then what the tax laws, tax rates/brackets, inflation etc will be 30+ years out. We started out doing what we were told to do with the 3-legged stool plan of personal savings, SS and pension. Then came the introduction of IRA's, followed by 401K's with and without employer contributions. Then pensions were frozen and then eliminated, Roth IRA's became a thing. HSA's came along as did Roth 401Ks. Tax brackets and deductions seemed to change every 4-8 years. Not to mention other major things that never existed when I was starting out that can affect a budget like the taxation of SS benefits, ACA and its subsidies, IRMAA or Covid stimulus. How can anyone's original plan be solid throughout their lifetime. The best that we can all do is to roll with the changes as they occur. Looking back and thinking I should have done this, or I should have planned for that, is not going to accomplish anything. Looking forward is great for planning purposes so long as that plan is reviewed as things change. as Mike Tyson said, "Everyone has a plan until they get punched in the face". In this case, when you see a right hook coming at you, duck right and plan your next move.

 

[SnowballCamper]

The commutattive property of math proves the idea of such an additional tax is a fallacy. Specifically, for a given tax rate, whether you pay that tax in advance of investing or after investing makes no difference in the post-tax value of your net worth. When you pay the tax does not matter, instead only the tax rate is relevant to your after-tax net worth. This is why paying the generally-lower cap gains tax of taxable accounts leaves you with more after-tax money.

Consider the regular brokerage:
$10,000 is earned and then gets income taxed at 20% leaving
$8000 to put in the brokerage which then grows by $1,000 (12.5%) but capital gains tax is 15% leaving
$8,850

In the 401k:
$10,000 is earned but not taxed before it goes in the 401k leaving
$10,000 to grow and have a capital gain of $1,250 (12.5%) that is not taxed as a capital gain yielding
$11,250 pre tax, which get regular income tax of 20% when withdrawn leaving
$9,000

I end up with more money by using the 401k, because I avoid the additional capital gains tax.

 

[COcheesehead]

Consider the regular brokerage:
$10,000 is earned and then gets income taxed at 20% leaving
$8000 to put in the brokerage which then grows by $1,000 (12.5%) but capital gains tax is 15% leaving
$8,850

In the 401k:
$10,000 is earned but not taxed before it goes in the 401k leaving
$10,000 to grow and have a capital gain of $1,250 (12.5%) that is not taxed as a capital gain yielding
$11,250 pre tax, which get regular income tax of 20% when withdrawn leaving
$9,000

I end up with more money by using the 401k, because I avoid the additional capital gains tax.

In a regular brokerage, you may or may not incur capital gains. It all depends on your income level, whether you sell or not, what kind of investment you have and whether you have tax harvest loss carry overs.

 

[SnowballCamper]

In a regular brokerage, you may or may not incur capital gains. It all depends on your income level, whether you sell or not, what kind of investment you have and whether you have tax harvest loss carry overs.

Right, but if the capital gains tax applies, it isn't a fallacy to consider it. It has a real impact that doesn't exist in the 401k.

 

[COcheesehead]

Right, but if the capital gains tax applies, it isn't a fallacy to consider it. It has a real impact that doesn't exist in the 401k.

Agreed, but it’s not a given as shown in your example.

 

[SnowballCamper]

Agreed, but it’s not a given as shown in your example.

It might not be a given in your situation, but it certainly is for others. And in general it applies unless you have an exception to the tax. Yes I chose a simplistic $10,000, which could just as easily been $200,000.

 

[Dtail]

Many folks just look at the tax arbitrage of deferred vs Roth based on RMD's predicted tax bracket vs Roth enhanced RMD tax bracket.
I for one didn't have a Roth available for the majority of my working years or earned too much.
So by using the pre tax contributions plus the matching of some contributions, I view my working tax bracket savings vs my eventual RMD induced tax bracket as another analytic and will by default always be ahead even with no Roth conversions.
That said, we have done some minor conversions in retirement (also had much competition from managing ACA income).
So Roth percentage only at 11% and logically not get to anywhere around 50%, but still feel we won the tax arbitrage game.

 

[Taco]

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.

The saying that it turns capital gains into ordinary income is very unfortunate.

Warrior, The saying that capital gains in a traditional IRA (or 401K) are turned into ordinary income seems accurate to me. I'll give you an example, but not one where the tax rate is constant because that is not how it works. Ponder the following examples and see whether or not you agree...

First, here are the 2024 tax brackets for married filing jointly.

Brackets for Long Term Capital Gains:
0% - up to $94,050
15% - $94,051 to $583,650
20% - over $583,650

Brackets for Ordinary Income:
10% - up to $22,000
12% - $22,001 to $89,450
22% - $89,451 to 190,750
etc.

Assume a married couple has one income source, a pension that pays $69,200. After deducting the standard deduction of $29,200, their adjust income would be $40,000. So the portion of their income above $22,001 is taxed at 12%.

Now assume they hold stock in Apple, in a taxable account. Purchased for $60,000, now worth $100,000, and the $40,000 gain is a long term gain. If they were to sell their shares in Apple, that would immediately create an event that must be reported on their tax return.
The $40,000 long term gain would increase their income to $109,200, or $80,000 after the standard deduction. Since the tax bracket for long term capital gains is 0% up to $94,050, they would owe no tax on their $40,000 capital gain.

Now assume a different scenario - they hold stock in Apple, in a traditional IRA account. Again, it was purchased for $60,000, now worth $100,000, and the $40,000 gain is a long term gain. If they were to sell their shares in Apple, that would NOT create any type of taxable event, like it did above. It would just shuffle their holdings around within their traditional IRA. They no longer own Apple, and have more cash, but no impact to their taxes. To have a taxable event from their traditional IRA, they have to make a withdraw.
So, let's say they make a $40,000 withdraw from their IRA. Withdraws are taxed as ordinary income.
The $40,000 withdraw would increase their income to $109,200, or $80,000 after the standard deduction. Unlike the example above, the entire $80,000 is subject to the ordinary income tax bracket. So they would pay $40,000 & 12% ($4800) on their IRA withdraw.

In both cases, their income was $80,000. But in one case their taxes were lower. That is the basis behind the statement that capital gains, realized in a traditional IRA, will get taxed as (i.e turned into) ordinary income (when those gains are withdrawn).