Taxable vs Tax Advantaged Retirement Savings

[Regulator]

Good Morning,

I'm 38 and DW is 42. We're getting to the point where we have "just enough" in our Tax Advantaged retirement accounts (401k, Roth IRA, etc.) according to most formulas. We currently save 15% for retirement.

I want to keep saving in our Tax Advantaged accounts for a buffer, but maybe divert some of it to a taxable account at Vanguard. Either way, I'm hesitant to pull the trigger.

Has anybody else faced this decision? If so, what did you do?

Thanks,
Reg

 

[DrRoy]

If you want to RE before 55, you will need something outside the tax advantaged accounts. If retired, you can tap your 401K at 55 and the IRA's of course at 59 1/2. Save only what you need in a taxable account, get your 401k match, and put the rest in the Roth.

 

[bingybear]

I'm not sure what "just enough" really implies at 40 years old. 25x spending?, 50x spending?
But that is not your question. I did not really face your decision as it seems to be save in one place or the other. However, we did save after tax too. 401k's were rather new and and had smaller contribution limits. Roths did not come in until much later. Since we had rolled 401ks to TIRAs, the backdoor roth was not attractive. So, we just saved after tax.
Now RE, the after tax $ really are quite useful. Too young to pull $ out penalty free. We invest in taxable accounts with mostly equity. The distributions kick out mostly Q-divys and some CGs from ETFs. We don't use MF in taxable because they can kick out rather big distributions and tax effects. We can do roth conversions at somewhat low tax rates and pay the tax with after tax $.
Also, for RE we primarily live on after tax $ or distributions. I think the tax diversification of our assets make our RE much more possible (affordable). One could do a similar thing with roths. But I think roths have other advantages that one may want to use... instead of pulling $ out to live in RE.

 

[RunningBum]

Max out anything you can get matched in tax deferred.


Max out a Roth IRA contribution.


After that it depends on your current and predicted retirement tax rate. If they are going to be the same, put it in taxable, especially if you are in the 25% bracket or above. Long term gains in taxable will be 15%, but will be taxed at ordinary income rates when you withdraw from tax deferred. But if your retirement tax rate is likely to be lower, tax deferred is probably better.


Other things can complicate this, like pushing more social security benefits into being taxed, ACA subsidies in ER, ability to convert tIRA/401K to Roth in ER, and future changes in tax laws (changed rates, ACA repeal, etc).


Funding ER before you can access tax deferred is another issue, but there are often ways around that. It'd be good to figure that out soon to see if you don't need to worry about enough in taxable.

 

[scrabbler1]

Part of me ER plan (to retire at 45, 8 years ago) was moving a large chunk of money from me tax-advantaged account to my taxable account upon the start of my ER. Before I ERed, I had 2/3 of my money in a tax-advantaged account and 1/3 in a taxable account. I took 1/2 of my tax-advantaged account (1/3 of my overall money) and moved it to my taxable account, effectively reversing my overall split to 2/3 taxable, 1/3 tax-advantaged.


My ER plan was in two parts. The first part, and far more important part, was getting from age 45 to age ~60 intact using only my taxable account. Once I get to age ~60, I have my "reinforcements" beginning to arrive. They are (1) unfettered access to my IRA, (2) my frozen company pension, and (3) Social Security.


Right now, I am living solely off most of the dividends from my taxable account. I do anticipate having to tap into principal a little as I approach age 60 but that is fine because once I turn ~60 the added income from these new sources will vastly improve my overall situation. I have run this through Fidelity's retirement planning software and it shows the same thing.


I always made sure to contribute to my 401k to get the maximum company match. But the last few years I was working I became ineligible for the match (I had reduced my weekly hours worked) so I stopped contributing to it. I also needed the money to meet my day-to-day expenses because my income had become fairly low.

 

[RunningBum]

Part of me ER plan (to retire at 45, 8 years ago) was moving a large chunk of money from me tax-advantaged account to my taxable account upon the start of my ER. Before I ERed, I had 2/3 of my money in a tax-advantaged account and 1/3 in a taxable account. I took 1/2 of my tax-advantaged account (1/3 of my overall money) and moved it to my taxable account, effectively reversing my overall split to 2/3 taxable, 1/3 tax-advantaged.

...

How did you do that, and at what tax rate?

 

[scrabbler1]

How did you do that, and at what tax rate?

I had 1/2 of my tax-advantaged money (1/3 of my total portfolio) in company stock - an ESOP program. When I left the company, I had a one-time chance to cash out the ESOP using NUA (Net Unrealized Appreciation) with the top tax rate the LTCG rate of 15% on the appreciated value of the company stock. For me, the NUA's portion of the stock value was 97%, so only 3% of the stock was taxable at ordinary income.

I still had to pay about 25% of the stock's value in federal and state income taxes. But without the NUA provision, I would have had to pay close to 50% in taxes. An important part of the tax equation I didn't realize until it came time to pay my tax bill - the 10% tax penalty for withdrawing tax-advantaged money prior to reaching the right age applied only to whatever part got taxed as ordinary income, NOT what was taken out as NUA. Discovering that at tax time saved me $29k.

 

[FireFool]

If you want to RE before 55, you will need something outside the tax advantaged accounts. If retired, you can tap your 401K at 55 and the IRA's of course at 59 1/2. Save only what you need in a taxable account, get your 401k match, and put the rest in the Roth.

Before you make the assumption about tapping 401k's using the age 55 provision make certain that your company's plan doesn't require you to convert to an IRA upon first distribution from the 401k. I didn't find out, know to ask, about that restriction until post retirement. Because I have significant funds outside my tax advantage accounts it isn't really impacting me but I could see it as being a surprise to someone counting on it. A financial planner friend of mine indicated that my company's plan provision in regards to this is not typical, but that doesn't mean anything in regards to getting access to those funds. I'm glad that I'm not in a situation where that would have turned my retirement upside down.

 

[LOL!]

We never faced this decision because if we had not contributed the maximum possible to tax-advantaged accounts, all the money went into them until we had done so. Only then did we put any money in a taxable account.

 

[DrBrisket]

....

Funding ER before you can access tax deferred is another issue, but there are often ways around that. It'd be good to figure that out soon to see if you don't need to worry about enough in taxable.

Tapping tax deferred accounts in ER are a viable option for some folks. To avoid the 10% early withdrawal penalty, take a look at Rule 72t withdrawals (very inflexible) or a Roth Conversion Ladder (have to fill 5 "gap" years).

If I had it to do all over again, I would have always hit the legal limit for my tax deferred accounts--be it 401k/403b, TIRA, non-deductible IRA, and/or Roth IRA depending on the given year's tax situation before funding my taxable accounts and then used a Roth Conversion Ladder as needed in ER.

 

[Regulator]

Thanks for all of the replies. I had never heard of a Roth conversion ladder. Basically, my taxable investments would only need to last five years while I was converting. Brilliant. I'll go back and take a look at this.

 

[DrBrisket]

Thanks for all of the replies. I had never heard of a Roth conversion ladder. Basically, my taxable investments would only need to last five years while I was converting. Brilliant. I'll go back and take a look at this.

BINGO!

I was pulling my hair out trying to figure out how to tap my 401k/403b funds well before 59 1/2 without paying the early withdrawal penalty when I stumbled across this option. Blog posts at RootOfGood and MadFientist were my personal favorites for getting my head wrapped around this extraordinarily simple, life-changing (at least for me) strategy. It was like I had suddenly developed a Sixth Sense on how to escape from w*rk....Every day since, it has been strange walking into w*rk--I see unFIRE'd people everywhere....

 

[Markola]

BINGO!

I was pulling my hair out trying to figure out how to tap my 401k/403b funds well before 59 1/2 without paying the early withdrawal penalty when I stumbled across this option. Blog posts at RootOfGood and MadFientist were my personal favorites for getting my head wrapped around this extraordinarily simple, life-changing (at least for me) strategy. It was like I had suddenly developed a Sixth Sense on how to escape from w*rk....Every day since, it has been strange walking into w*rk--I see unFIRE'd people everywhere....

On the other hand, the Radical Personal Finance guy did the math and was pretty persuasive that simply paying the 10% penalty works out the same or slightly better. The reason is that paying tax during the Roth conversion takes a hunk of cash off the table earlier, reducing the amount that compounds. He says it's better to pay the 10% penalty later than the tax earlier. YMMV.

 

[Koolau]

I have no magic formula nor sage advice. Clearly, you need to get the company match on a 401(k). After that, there is a lot of guess work on what future tax rates will be AND you just about have to be a tax expert to look for the looming tax land-mines (such as SS taxability rules, ACA subsidies - or maybe not, Medicare income limits, AMT and probably a host of others.) My point is that it will be difficult to do everything right.

Having said that, I put too much in tax deferred and not enough in taxable. It's not that I didn't also max out my Roths. I'm not so certain my taxes (as such) were the main issue. I think the issue is that flexibility was hampered by potential tax consequences. For instance, I often did not have enough taxable money to pay the taxes on my Roth conversions from tIRAs. That had been my goal and I was not always able to make it work.

Again, I don't know what the ratio should be, but my tax sheltered was WAY out of line with the total ER stash. YMMV

 

[DrBrisket]

.... YMMV.

... My point is that it will be difficult to do everything right. ... YMMV

Very sage input from @Markol and @Koolau.

@Regulator: Each person's situation can impact which path is best. The Roth Conversion Ladder was best for my own situation. I will still be able to claim several dependents in addition to DW along with itemized deductions well into ER which will allow a Roth Conversion Ladder at very low (or no) tax based on the amounts involved. Change the $ amounts involved or the tax situation and the 10% penalty may be just a "cost of doing business" that nets out better.

Another area that impacted our taxable/non-taxable/tax-deferred planning was having assets be non-reportable on the FAFSA (college financial aid application) along with minimizing our AGI to improve financial aid eligibility as our younger children enter college. Equity in your primary residence, 401k/403b, IRA, and Roth accounts are among the types of assets are not reported on the FAFSA. Only Roth conversions, but not qualified Roth distributions, add to AGI giving us a chance to better time the various moving parts.

Some quality time with a spreadsheet looking at the different options for your particular situation may (will?) give you different results. Even with all the planning, stuff happens, so I like to think in terms of knowing/exploring the various paths and what change(s) that might occur that could impact which path is best as the future unfolds. It seems that reality always has a way of misbehaving at the most unexpected times causing a recalculation of our course for the future. For example, we had an unexpected windfall from an investment at the exact wrong time for our eldest child's FAFSA and then the gubmint changed the FAFSA rules so that we have to use that year's tax return for 2 of the years our eldest is in college. Turned our precious child into what college administrators gleefully call a "full-freighter".

In short, YMMV!

 

[NgineER]

On the other hand, the Radical Personal Finance guy did the math and was pretty persuasive that simply paying the 10% penalty works out the same or slightly better. The reason is that paying tax during the Roth conversion takes a hunk of cash off the table earlier, reducing the amount that compounds. He says it's better to pay the 10% penalty later than the tax earlier. YMMV.

I'm thinking that 72t-ing a t-IRA would be even better then.
I think madfientist argued that that all come out pretty close together, Roth conversion ladder, 72t and 10% penalty withdrawal.

 

[NgineER]

I am a big proponent of after tax-401k contributions as well, roll them over to Roth-ira immediately. Plan to have these cover the five years during Roth conversion laddering. Plan to have enough after tax savings to be able to pay the taxes on Roth rollovers at least. Ideally planning to have a four legged chair with equal amounts of tax free, tax deferred, after tax and rental income to be able to handle market ups and downs without much worry.

 

[Regulator]

I am a big proponent of after tax-401k contributions as well, roll them over to Roth-ira immediately. Plan to have these cover the five years during Roth conversion laddering. Plan to have enough after tax savings to be able to pay the taxes on Roth rollovers at least. Ideally planning to have a four legged chair with equal amounts of tax free, tax deferred, after tax and rental income to be able to handle market ups and downs without much worry.

Good advice from everyone. I'm going to hit the spreadsheets and try to estimate how much taxable I'd need to augment my military pension and pay conversion taxes for those 5 years.

All of our money outside of emergency funds is in home equity, Roth or Traditional retirement accounts, or 529s. I was struggling with what goal to set with taxable accounts, but you've all given me some real take aways.

 

[sengsational]

Another area that impacted our taxable/non-taxable/tax-deferred planning was having assets be non-reportable on the FAFSA (college financial aid application) along with minimizing our AGI to improve financial aid eligibility as our younger children enter college.

You beat me to it. Not a whole lot of folks on this forum factor-in the kids' college education costs, but retirement assets don't hit the financial aid formula. Those formulas expect you to drop about 6% of your after tax savings annually to the kids' education, so it pays not to have after tax savings. You give-up flexibility by having more retirement assets, but it generated huge grants, even when I was working. Now, not working and even larger grants. But I wouldn't trust the FAO if they say that Roth conversions won't hurt your award. That's what they told me, so I did a conversion (which increases AGI), and the next year, the award was lower. But still, much more effective than trying to find "free money" scholarships that usually only come to $200 per semester or something pitiful like that. DD2 is graduating in May, but I haven't written a check in years.

 

[misanman]

We ended up with too much in our traditional IRA despite efforts to spend it down and defer SS. RMDs start this year and they are going to really hurt tax-wise.

Wish we had done Roth conversions earlier and pumped up the after tax accounts more.

 

[DrBrisket]

We ended up with too much in our traditional IRA despite efforts to spend it down and defer SS. RMDs start this year and they are going to really hurt tax-wise.

Wish we had done Roth conversions earlier ....

Excellent point. RMD is another constraint that may rear its ugly head and cause issues.

For us, FAFSA, RMD, and ER make it a challenging needle to thread with respect to when and how much to convert from TIRA to Roth. It was only by accident that I noticed the looming tax issue a couple of years ago when reviewing an ER planning spreadsheet cobbled together over the past couple of decades. We are fortunate to have enough time to avoid most if not all of the pain. When I showed DW what I found, she was astonished as to how folks could be punished severely by the tax code for taking the steps to save/invest/prepare for a comfortable (not extravagant) retirement.

 

[kgtest]

the ole Ruin My Day RMDs.

RMD is a double-edged sword. You need to fill your non-taxable Roth as much as possible, utilizing backdoor conversions.

Convert up to the income limit of your tax bracket. Especially during low income years.

Otherwise, you limit future earnings as soon as you turn 71.5 by giving it to uncle sam.

 

[surf n turf]

We are close to the same age as you two are. We just went through this. Her 401k is maxed to get her back into the 25% bracket and my 401k contribution is just enough to get me into the 15% bracket. Roths both maxed. All the rest goes into a taxable that we just started fall of 2016. We're trying to retire in about 8 years so we are going to need some money to "bridge the gap" and the taxable investments will come in handy. Also since our income should be in the 15% bracket or under during retirement we will enjoy the 0% tax on LTCG on our taxable. At this level of income I just don't see the point in deferring taxes while I'm in the 15% bracket just to have it taxed again at 15. In the long run I believe the taxable account will give us more flexibility and protect our retirement investments and social security from higher taxes.

 

[JohnnyBGoode]

Yes, I've been dutifully maxing out tax-deferred accounts as much as we can. Though in the back of my mind I've had a nagging concern about the basic premise of tax defered accounts for two reasons:
1. I am setting up our retirement funding so that it has enough income to last us a long time at a withdrawal rate that allows us to live a comfortable lifestyle (similar to what we have now) -- meaning that the income level could be close to what we have now
2. I also assume with the overall graying of the population and the coming financial crisis around SS and Medicare, tax rates will HAVE to go up (no matter what party is in charge in DC).

So basically one of the main assumptions of the goodness of tax-deferred accounts is that tax rates will be lower once one retires - and I guess I'm not convinced that will be the case.

That being said, 401K's still make a lot of sense if there is some matching at w*rk (and it is convenient they take out the funds from your paycheck automatically - so you never really "miss" it)