Jim_Ohio had a very interesting post about whether high-income earners (above the ROTH limit) should direct money toward a taxable account or a non-deductible IRA. In the comments he asked me a series of questions, so I thought I'd blog a bit about our situation, and maybe if I'm lucky Jim will stop by and give me his take.
Currently DH makes about $130k. I have the choice to work or not -- currently I'm contracting 20 hr/wk and expect to gross about $60k. We'll probably have about $35k in deductions, plus $10k in exemptions. Last year we had $9k in dividends and $23k in capital gains.
Our tax situation this year will be very different from last year, since I only worked for 5 months and didn't start with as many hours. Last year, our AGI was $169k, my business income was $23k, our taxable income was $124k. I'm guessing our marginal tax bracket was 25%, but our effective tax rate was 10.5% federal and 9% state.
1) How much are you investing each year? In the taxable account?
$15,500 to DH's 401k
$13k to DH's ESPP
$4k to DH's traditional IRA
$4k to my traditional IRA
No new money to my taxable account.
The IRA contributions will likely come from selling existing taxable mutual funds rather than new income.
2) how many years to retirement? Is early retirement a desire?
We are almost 38 now, so theoretically 27 years. I'd like the option of retiring at 60, so 22 years.
3) is mortgage paid off? Is their any reason to NOT pay the mortgage off?
The mortgage is a 10-1 ARM that is fixed at 5.125% until 2012. I think it's more advantageous for us to have the mortgage deduction and invest in the stock market instead of paying it off. Also, there is a fair chance that we will want to move to a better school district in 3-5 years time.
4) What choices are available for health care (HSA?), child care (child care account available?) and other less used deductions.
DH has excellent medical coverage, completely employer-funded, so no HSA.
We're currently taking advantage of the FSA health deduction, although I've been burned with it in the past. The dependent care deduction is tricky -- currently the part-time nanny prefers to be on a cash basis. To use the deduction we'd have to set up tax withholding, etc.
Here's our current strategy:
I wait until TurboTax tells me whether we qualify to contribute to a ROTH or not. We qualified for a partial contribution the year that I was not working, or I could take a deduction on a spousal IRA.
When we don't qualify for ROTH, we contribute $4k each to non-deductible IRA.
Now that I have business income, I sell stock in my taxable account to make the maximum contribution to the SEP-IRA to reduce the taxable business income.
One wrinkle -- it's quite possible that we will be in a higher tax bracket in retirement than we are now. I've been playing with the retirement calculators at http://www.hughchou.org/calc/index.html#RET. Our current retirent accounts total $339k, and current taxable accounts total $357k. I asked for $200k income and assumed 10% return. If we save all that for retirement, and don't contribute another dime, the calculator says we're "set for life". If I just look at the retirement balance, and assume we add $24k to it each year, and assume a 10% return, we're still good for a $200k (current dollar) income.
So what do you think, Jim? Am I better off to leave that $8k each year in the taxable account, or move it over to the IRA?
Investing in Non-Deductible IRA vs Taxable Account for me
August 5th, 2008 at 11:56 pm
August 6th, 2008 at 12:55 am 1217984107
Joe
August 6th, 2008 at 01:31 am 1217986287
Think about it, no deductions really. & for now I am seeing social security income push a lot of my clients into higher tax brackets.
I'd personally put it in the IRA. You pay tax on it now. You don't pay tax on it while it grows. When you withdraw, you only pay tax on the earnings. It's kinda a half-a@@ed tax shelter, but it's a shelter all the same. & you may be able to convert it into ROTHs or do something else with it in the long run.
A HSA is a great tax shelter for someone in your shoes, but I'd take good benefits any day, over a HDHP.
August 6th, 2008 at 11:48 am 1218023307
Think of the tax brackets (see my other blog post). Think about the income you need in retirement and where that income will come from and how it will be taxed.
My suggestion- get your taxable accounts high enough such that you can withdraw your needed income for a series of years at beginning of retirement. During those same beginning years, start converting the traditional IRAs to Roths (only convert up to 15% tax bracket).
So even if you are in 28% bracket now, and expect to need MORE in retirement, you can lower your tax rate (in retirement) with solid long term planning.
To do this you would need taxable accounts to sustain retirement income for 10 years. If you can increase this to more than 10 years of expenses, you could retire earlier and give yourself more time for the Roth conversions (which Joe also mentioned). The earlier you retire, the less taxes you will pay overall.
I might ask what is your asset allocation and your holdings? Some asset classes work better in taxable accounts. For example PRPFX is a fund I like which is considered moderate allocation. Last I checked gold (25% of the fund) does not pay a dividend, so it's distributions are not large.
Another idea is to pay the mortgage off sooner. You have 22 years to retirement. You could spend 5-10 years paying off the mortgage, then use the last 12 to aggressively increase the value of taxable accounts.
You would also need to truly see the value of your mortgage deduction (is the 10k the interest paid or the deduction because you paid close to 30k or 40k in interest?)
So you need a plan...
it might look like this:
1) max 401k and SEP
2) increase size of taxable accounts by $X per year
3) plan for Roth conversions in early retirement and put $10k per year into traditional/ non deductable IRAs
4) pay down mortgage aggressively
then once 4 is done, increase 2) and then have the amount you need in the taxable account known. You would only have a bad tax situation any year you still were employed.
Take the capital gains and direct them to more tax efficient investments if you need a short term solution.
August 6th, 2008 at 11:49 am 1218023396
Sorry, I find the opposite to be true, the risk of being in a higher bracket [at retirement] is minimal.
I wrote at length about this on my blog post titled "Loving that Roth" at
http://www.blog.joetaxpayer.com/archives/183
I cite not only the current tax rates, but also AARP forcasts for boomers retiring over the next 20 years.
The horribly saving rate supports my view.
Joe
August 6th, 2008 at 11:54 am 1218023643
August 6th, 2008 at 02:43 pm 1218033812
But there is little mention of it in the press. I have never seen an article on the subject, but is discussed much in my profession. Why I call it the dirty little secret.
Clearly Zetta is in a category where she has to worry about this (not one who won't have enough savings).
August 6th, 2008 at 03:47 pm 1218037678
Given the traditional pensions are all but gone from most companies, people's only income at retirement, besides SS, will be their own savings.
In today's dollars, it would take nearly $850K to generate withdrawals that have a top marginal rate of 10%. $1M is in the 15% bracket.
So, unless your clientelle is well off, or planning to be at the top of the bell curve at retirement, the numbers just don't support that the majority will be at that level. Retirees worth $1M are in the top 20% or so.
This may be spliting hairs, because your clients, for the fact of having you as an advisor, may very well all be on that path, toward greater wealth. And this issue may impact them.
Joe
August 6th, 2008 at 07:01 pm 1218049316
I think our difference is in mostly different audiences. For most people on the financial ball I don't think many have thought about the potential of their taxes rising with age (or being higher at 70 than at 30). Which I think it is important for people in a forum like this to be aware of.
& I can write an essay on it - a huge myriad of reasons - few of which have gotten any notice from the press or masses. I don't see much info out there on the topic at all. But I Can certainly see all the future headlines (give it a few years).
I won't argue that people with no money won't have lower tax bills. Of course they will. So I think beyond that, yeah, we're splitting hairs.
Anyway, but just a point. If you are single (which many retirees are - widowed unexpectedly, etc.) you only need an income of $40k to be hitting the 25% tax bracket. (Assume you only get the standard deduction and one personal exemption - unlikely to have any other deductions). & realistically, social security could come close to that. You don't need a lot of income to hit the 25% bracket, at that point.
My AGI on the other hand, was six figures last year. I was nowhere near the 25% tax bracket. Miles away...
Kind of more my point. I understand not all young people live in expensive states, and are married with children. But I have so many retired clients with much lower income with $12k federal income tax bills while their younger counterparts pay something like $2k-$5k in federal income taxes for MUCH more income.
& then I read over and over - "your taxes will go down in retirement." & I think, "huh?"
I really don't have that many younger clients hitting a higher tax bracket than 15%. But wow, most of my retired clients are hitting 25%, on much lower incomes.
So that's my angle, but I think I understand yours as well. Different audiences/perspectives.
August 6th, 2008 at 07:23 pm 1218050628
If the IRA withdraw is being taxed at 28% marginal rate, the equivalent capital gains rate is 15% (nearly a 50% savings in taxes).
That is my whole point. Yes you will pay more taxes when accumulating, but my stand point is retirement is 40 years or so, getting favorable tax treatment for those 40 years is more important than the 30 years a person works in my eyes.
Others can disagree. The shorter you work, the more likely the taxable account comes out ahead. The earlier you retire, the more the taxable account also comes out ahead.
Zetta- a suggestion is to create a retirement plan which puts you in the 15% tax bracket. A majority of people in this country live on less than $66100 in taxable income.
Your expenses can be higher than $66100, you just need to fund those expenses with monies which are NOT taxed at marginal rates.
Muni bonds, capital gains, dividends all come to mind.
August 6th, 2008 at 07:28 pm 1218050907
This year, 28% starts at $131,450, and from your post, describing your increased income, that's where you are likely to land.
Joe
August 6th, 2008 at 08:30 pm 1218054604
I don't disagree (haven't) with much you have said Jim. But I do have one major issue with most of your posts on long-range tax planning. You are 35, right? & isn't Zetta in this age range?
The general rule of thumb in the tax profession is not to do long range tax planning. The tax law is too volatile and it rarely pans out.
Likewise, when you meet with a CPA, most will say take all the tax breaks you can now (the only thing that is for sure), and never put all your eggs in one basket.
If I were Zetta I would probably honestly split my money 3 ways. Nondeductible IRA, Taxable accounts, and pay down mortgage. Spreading out those eggs...
IT is not given that capital gains rates will always be so favorable, that mortgages will always be fully deductible, and that IRAs will always taxed at ordinary rates.
Just another perspective to share.
I think you touched on that in your blog - how you need to look at things differently if you have a shorter time horizon to retirement than if it is a longer horizon. This is another reason why.
Another point - even investment income raises tax rates in that it increases the amount that social security income is taxed. Most of my clients are getting pushed into higher tax brackets by social security income. They don't necessarily have a lot of other income taxed at ordinary rates. It is VERY complex - but just another point how tax planning is such shaky ground. You can focus all your time on "x" and "Y" is going to knock you over the head because you weren't looking.
Likewise, a good financial planner should be really well versed in tax law - indeed.
August 6th, 2008 at 10:50 pm 1218063028
MonkeyMama makes a lot of sense in that I should optimize my tax situation for today, and optimize the retirement tax situation when it is a lot closer.
August 7th, 2008 at 07:18 am 1218093493
A Roth IRA is long term tax planning- pay taxes now, pay none later. Yet it appears most advice by posters in various forums and blogs is to use the Roth first. HMMM.
There will probably be tiered tax brackets for the rest of my life. The current rates are 10-15-25-28-33-35%. These rates will change, and the income thresholds will change, but the probability of seeing a flat tax (one rate for one bracket) is minimal/extreme.
In addition there will be a rate for capital gains- 5/15% now (depending on bracket above). Again this rate is subject to change.
Based on this uncertainty with all the above, my general advice, and the advice of joetaxpayer can still hold true:
1) try to stay in that second tax bracket (currently 15%) in retirement. Drawing income from sources other than tax deferred IRAs, Roths and taxable accounts will allow this.
2) If you accomplish #1, you can convert other assets to a Roth. This helps #1 get accomplished in subsequent years.
3) If capital gains rates do not become favorable in a given year, stop doing #2 and look for a different way to do #1, which is the foundation for the plan.
example #3: stop cashing in taxable mutual funds and use money in savings accounts or cash based investments instead.
One comment I make often:
What is most tax efficient going in (401k) is the least tax efficient coming out. What is least efficient going in (Roth) is most tax efficient coming out. Taxable accounts sit between the others.
The conclusion to draw (and was stated before) is the longer you are retired, the more taxable accounts benefit you.
August 7th, 2008 at 10:42 pm 1218148971
http://groups.google.com/group/misc.invest.financial-plan/br...
August 8th, 2008 at 11:29 pm 1218238151
you should also think about your buckets (see my two blog entries today) and I will summarize a planning strategy for these later this weekend.
January 1st, 2009 at 02:02 pm 1230818560
I was browsing the internet, and stumbled upon this blog on your situation. Have you ever considered the tax and earning benefits of Whole Life Insurance. I understand the negative steriotype of this type of account, but it would benefit your financial situation. Why?
- There is complete Tax protection/0 Capital Gains Taxes/0 Withdrawal Fees.
- Guaranteed Rates of Return
- No Limits on How Much you can Contribute/Pull Out.
- You get a Death Benefit with this account.
- You can potentially Become Your Own Banking System.
This type of account is awful with some financial institutions, but if placed with a financially strong company, it will be a tremendous asset within your portfolio. These strong companies include, 1. Northwestern Mutual, 2. Mass Mutual 3. Guardian Life.
Northwestern Mutual has averaged a rate of return of 9.03% over the last 30 years, and guarantees 4.5%. So your money will never back up due to market volatility.
Bill Gates, Harley Davidson, and GE are some large corporations that put millions of dollars a year into these contracts(Specifically Northwestern Mutual), and I guarantee they don't do this for the death benefit, but rather for the tax protection and for significant cash accumulation.
Would you rather pay taxes on one dollar today, or 100,000+ in the future, and I assume like most that taxes will increase and also your tax bracket.....