Roth IRa versus taxable account

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airahcaz
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Roth IRa versus taxable account

Post by airahcaz »

I am sure this has been debated many times, but I cannot find anything in the search.

If one assumes long term capital gains taxes remain at 15% for the foreseeable future, yes, an assumption, then for the flexibility of a taxable account, one is really only giving up 15% in LT taxes in not going with a Roth IRA?
Chuck
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Post by Chuck »

And 15% on qualified dividends every year and regular income tax on non-qualified dividends, and 15% LTCG on the compounded tax loss on those dividends every year for as long as you own the asset.
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airahcaz
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Post by airahcaz »

Chuck wrote:And 15% on qualified dividends every year and regular income tax on non-qualified dividends, and 15% LTCG on the compounded tax loss on those dividends every year for as long as you own the asset.
sorry, I don't quite follow, slightly more layman terms please?

you mean paying tax in a taxable account even after withdrawal versus a Roth where dividend gains would be treated tax free, etc?
DSInvestor
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Post by DSInvestor »

If you hold a 100K holding in a taxable account and you receive $2,000/yr in dividends a year, those dividends are taxable each year. The dividend income will be reported to you and to IRS via a 1099-DIV tax slip from your brokerage firm or mutual fund company. How much tax is due will depend on whether those dividends are qualified or non-qualified and your tax situation.

Qualified Dividends receive preferential tax treatment under current tax rules. Qualified dividends are taxable at 0% if the income falls in the 15% tax bracket or lower or 15% if it falls in the 25% or higher. If you're in 15% tax bracket, the fed tax on the $2K qualified dividend could be $0. If you're in a high tax bracket, the fed tax on 2K qualified dividend could be $300.

Non-qualified dividends are taxable at marginal tax rates. Bonds typically throw off non-qualified dividend income. Foreign stock funds may throw some non-qualified dividend income. If you're in a high tax bracket say 35% fed and you received $2000 of non-qualified dividend, the tax would be $700.

Dividends received in taxable accounts increase your AGI. This may increase your state income tax liability. If you're collecting social security, the higher AGI may make more social security benefits taxable. A higher AGI may make you ineligible for tax credits or direct Roth IRA contributions.

If you had the same 100K in a Roth IRA instead, the 2K/yr dividend is not taxable (fed or state). The Roth IRA container shields the investment from taxation. There will be no increase to your AGI and thus will not affect the taxation of social security and tax credits etc.

You can change investments inside a Roth IRA without tax consequences. If your 100K investment grows to 200K inside a Roth IRA, you can sell some to rebalance without any tax liability.

If you sell an appreciated security in a taxable account, you're realizing a capital gain and your brokerage will report the transaction to you and IRS via a 1099-B tax slip. Capital gains tax may apply if you have a net capital gain in that tax year.

IRA space can help you be more tax efficient. You can locate your tax inefficient investments (taxable bonds, REIT etc) in your IRA or 401k space.
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airahcaz
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Post by airahcaz »

DSInvestor wrote:If you hold a 100K holding in a taxable account and you receive $2,000/yr in dividends a year, those dividends are taxable each year. The dividend income will be reported to you and to IRS via a 1099-DIV tax slip from your brokerage firm or mutual fund company. How much tax is due will depend on whether those dividends are qualified or non-qualified and your tax situation.

Qualified Dividends receive preferential tax treatment under current tax rules. Qualified dividends are taxable at 0% if the income falls in the 15% tax bracket or lower or 15% if it falls in the 25% or higher. If you're in 15% tax bracket, the fed tax on the $2K qualified dividend could be $0. If you're in a high tax bracket, the fed tax on 2K qualified dividend could be $300.

Non-qualified dividends are taxable at marginal tax rates. Bonds typically throw off non-qualified dividend income. Foreign stock funds may throw some non-qualified dividend income. If you're in a high tax bracket say 35% fed and you received $2000 of non-qualified dividend, the tax would be $700.

Dividends received in taxable accounts increase your AGI. This may increase your state income tax liability. If you're collecting social security, the higher AGI may make more social security benefits taxable. A higher AGI may make you ineligible for tax credits or direct Roth IRA contributions.

If you had the same 100K in a Roth IRA instead, the 2K/yr dividend is not taxable (fed or state). The Roth IRA container shields the investment from taxation. There will be no increase to your AGI and thus will not affect the taxation of social security and tax credits etc.

You can change investments inside a Roth IRA without tax consequences. If your 100K investment grows to 200K inside a Roth IRA, you can sell some to rebalance without any tax liability.

If you sell an appreciated security in a taxable account, you're realizing a capital gain and your brokerage will report the transaction to you and IRS via a 1099-B tax slip. Capital gains tax may apply if you have a net capital gain in that tax year.

IRA space can help you be more tax efficient. You can locate your tax inefficient investments (taxable bonds, REIT etc) in your IRA or 401k space.
Aha, thanks! So even holding a tax efficient ETF, like SPY, and holding forever, it will still throw off some taxable dividends annually I suppose, which can be significant as the portfolio grows?

and some of those dividends may be taxed at higher tax bracket than the 15% is the moral of the story?
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Post by cliffedelgado »

airahcaz wrote: Aha, thanks! So even holding a tax efficient ETF, like SPY, and holding forever, it will still throw off some taxable dividends annually I suppose, which can be significant as the portfolio grows?

and some of those dividends may be taxed at higher tax bracket than the 15% is the moral of the story?
Close! The fact that those dividends may be taxed at all is the moral of the story. In the Roth IRA, they are not taxed at all.
DSInvestor
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Post by DSInvestor »

I cannot speak for SPY ETF but here's a list of vanguard funds and ETFs showing the percentage qualified dividend income (QDI) for 2009.
https://personal.vanguard.com/us/insigh ... ncome-2009

Vanguard Total Stock Market VTI ETF is very tax efficient and threw off 100% QDI in 2009.

Vanguard FTSE All World ex-US VEU ETF is also very tax efficient and threw off 76% QDI in 2009. If you received $1000 of dividends from VEU in 2009, $760 would have been QDI and $240 non-QDI. The $240 non-QDI would have been taxable at marginal tax rates.

Now that we've covered dividends (QDI and non-QDI), you need to be aware of capital gains distributions. Some funds may distribute capital gains distributions even if you have never sold shares of the fund. Here's a link to the distribution page of Vanguard's FTSE All World ex-US small cap fund:
https://personal.vanguard.com/us/funds/ ... st=tab%3A4

Capital gains distributions and dividends are not taxable inside Roth IRA accounts.
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Re: Roth IRa versus taxable account

Post by grabiner »

airahcaz wrote:I am sure this has been debated many times, but I cannot find anything in the search.

If one assumes long term capital gains taxes remain at 15% for the foreseeable future, yes, an assumption, then for the flexibility of a taxable account, one is really only giving up 15% in LT taxes in not going with a Roth IRA?
You also save taxes on dividends, and on capital-gains taxes paid before withdrawal if you rebalance or if the stock funds distribute gains of their own/

In addition, you don't have as much of a gain in flexibility as it might appear. You can withdraw contributions to a Roth IRA at any time with no tax penalty.
Wiki David Grabiner
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airahcaz
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Post by airahcaz »

DSInvestor wrote:I cannot speak for SPY ETF but here's a list of vanguard funds and ETFs showing the percentage qualified dividend income (QDI) for 2009.
https://personal.vanguard.com/us/insigh ... ncome-2009

Vanguard Total Stock Market VTI ETF is very tax efficient and threw off 100% QDI in 2009.

Vanguard FTSE All World ex-US VEU ETF is also very tax efficient and threw off 76% QDI in 2009. If you received $1000 of dividends from VEU in 2009, $760 would have been QDI and $240 non-QDI. The $240 non-QDI would have been taxable at marginal tax rates.

Now that we've covered dividends (QDI and non-QDI), you need to be aware of capital gains distributions. Some funds may distribute capital gains distributions even if you have never sold shares of the fund. Here's a link to the distribution page of Vanguard's FTSE All World ex-US small cap fund:
https://personal.vanguard.com/us/funds/ ... st=tab%3A4

Capital gains distributions and dividends are not taxable inside Roth IRA accounts.
Would love Vanguard ETF, but I'm with Fidelity, so commission free etf's like ACWI - should also be tax efficient?
DSInvestor
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Post by DSInvestor »

Funds that hold foreign stocks and bonds may pay foreign taxes. If you hold these funds in taxable accounts, you will get a 1099-DIV that shows dividends, qualified dividends and foreign tax paid. This allows you to claim the foreign tax credit on your tax returns.

Hold the same fund in an IRA and your fund will still pay those foreign taxes but you will not be able to claim the foreign tax credit because those taxes are not disclosed in a 1099-DIV.
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airahcaz
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Post by airahcaz »

DSInvestor wrote:Funds that hold foreign stocks and bonds may pay foreign taxes. If you hold these funds in taxable accounts, you will get a 1099-DIV that shows dividends, qualified dividends and foreign tax paid. This allows you to claim the foreign tax credit on your tax returns.

Hold the same fund in an IRA and your fund will still pay those foreign taxes but you will not be able to claim the foreign tax credit because those taxes are not disclosed in a 1099-DIV.
yet another disadvantage of the taxable account?
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Post by natureexplorer »

There are scenarios under which the taxable account would have been the preferred one.
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Post by airahcaz »

natureexplorer wrote:There are scenarios under which the taxable account would have been the preferred one.
Now really confused. Such as? (other than the flexibility)
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Post by DSInvestor »

airahcaz wrote:
DSInvestor wrote:Funds that hold foreign stocks and bonds may pay foreign taxes. If you hold these funds in taxable accounts, you will get a 1099-DIV that shows dividends, qualified dividends and foreign tax paid. This allows you to claim the foreign tax credit on your tax returns.

Hold the same fund in an IRA and your fund will still pay those foreign taxes but you will not be able to claim the foreign tax credit because those taxes are not disclosed in a 1099-DIV.
yet another disadvantage of the taxable account?
No, the ability to claim the foreign tax credit is an advantage of the taxable account. If your fund paid $100 of foreign taxes, you get to claim a $100 tax credit (i.e. a $100 reduction in your fed tax bill) if you hold the fund in a taxable account.

If you hold the same fund in an IRA, the fund may pay $100 in foreign taxes but you will not have the ability to get a tax credit for those taxes paid.

If you're considering what how to place funds to build a portfolio using tax advantaged and taxable space, see this Wiki article link: Principles of Tax-Efficient Fund Placement
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Post by natureexplorer »

airahcaz wrote:
natureexplorer wrote:There are scenarios under which the taxable account would have been the preferred one.
Now really confused. Such as? (other than the flexibility)
For example, let's assume you are in the highest tax bracket and you invest $360k in a taxable account. It was a bad investment and you lose half. But over the years (let's say 60 years) you can recoup some of these losses, and the loss saves you $45k in taxes. So in this example you come out $45k ahead when compared to having invested the $180k in a Roth.
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Post by assurancefp »

airahcaz,

One thing to also note. You are able to withdraw up to your cost basis (how much you put in) on a Roth IRA account. This means, even if the money is meant for retirement, what you put in can be withdrawn penalty free. It sounds like this is the flexibility you are looking for.

Example:
Roth IRA Account: $14K
Cost basis: $10K ($5K deposited from 2009 and $5K deposited from 2010)

Therefore, if you need to, you can withdraw the $10K cost basis without any penalty. As soon as you withdraw more than the cost basis, you will get hit with a 10% penalty.

Geoff
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airahcaz
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Post by airahcaz »

natureexplorer wrote:
airahcaz wrote:
natureexplorer wrote:There are scenarios under which the taxable account would have been the preferred one.
Now really confused. Such as? (other than the flexibility)
For example, let's assume you are in the highest tax bracket and you invest $360k in a taxable account. It was a bad investment and you lose half. But over the years (let's say 60 years) you can recoup some of these losses, and the loss saves you $45k in taxes. So in this example you come out $45k ahead when compared to having invested the $180k in a Roth.
ah, for losses, but anything significant otherwise?
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Post by LadyGeek »

The wiki has some background info:

Wiki article link: Foreign tax credit

For those who want to deep dive into Vanguard fund tax info: Vanguard Funds: Distributions They're kept up to date.

(airahcaz - This is for the "advanced" investing crowd. If it's hard to understand, don't worry about it.)
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Post by airahcaz »

LadyGeek wrote:The wiki has some background info:

Wiki article link: Foreign tax credit

For those who want to deep dive into Vanguard fund tax info: Vanguard Funds: Distributions They're kept up to date.

(airahcaz - This is for the "advanced" investing crowd. If it's hard to understand, don't worry about it.)
nothing is too advanced for someone willing to learn, thanks for the info

this is good for deciding where to hold a security that has a foreign aspect to it, but doesn't play that huge a factor if deciding to go Roth IRA or taxable account, seems like the answer is to have both
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Post by DSInvestor »

airahcaz wrote:this is good for deciding where to hold a security that has a foreign aspect to it, but doesn't play that huge a factor if deciding to go Roth IRA or taxable account, seems like the answer is to have both
The fund placement decisions should consider the entire portfolio. From your older posts, you indicated that you do not have a 401k. If sounds like you're investing using Roth IRA and taxable accounts. If I was in this situation, I'd do this:

1. First, place taxable bond funds in tax advantaged (Roth-IRA).
2. If bond allocation is larger than Roth space, place bonds in taxable account. Those in high tax brackets may consider tax exempt bonds in the taxable account. Also consider Series I bonds.
3. Place stocks in Roth only if there is room after placing bonds.
4. Place tax efficient stock funds in taxable.

This would still work even if you were to add a 401k, it just makes more tax advantaged space available for your bond allocation which would reduce the need to use tax exempt bond funds in taxable if you're in a high tax bracket.
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Post by LadyGeek »

airahcaz wrote:nothing is too advanced for someone willing to learn, thanks for the info

this is good for deciding where to hold a security that has a foreign aspect to it, but doesn't play that huge a factor if deciding to go Roth IRA or taxable account, seems like the answer is to have both
That's good, I'm also learning a lot. This will give you a good background on what DSInvestor is saying:

Wiki article link: Principles of Tax-Efficient Fund Placement

Also take a look at the topics on the right side top menu.
Last edited by LadyGeek on Wed Jan 12, 2011 4:26 pm, edited 1 time in total.
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airahcaz
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Post by airahcaz »

DSInvestor wrote:
airahcaz wrote:this is good for deciding where to hold a security that has a foreign aspect to it, but doesn't play that huge a factor if deciding to go Roth IRA or taxable account, seems like the answer is to have both
The fund placement decisions should consider the entire portfolio. From your older posts, you indicated that you do not have a 401k. If sounds like you're investing using Roth IRA and taxable accounts. If I was in this situation, I'd do this:

1. First, place taxable bond funds in tax advantaged (Roth-IRA).
2. If bond allocation is larger than Roth space, place bonds in taxable account. Those in high tax brackets may consider tax exempt bonds in the taxable account. Also consider Series I bonds.
3. Place stocks in Roth only if there is room after placing bonds.
4. Place tax efficient stock funds in taxable.

This would still work even if you were to add a 401k, it just makes more tax advantaged space available for your bond allocation which would reduce the need to use tax exempt bond funds in taxable if you're in a high tax bracket.
I posted no 401K on behalf of a relative :)

I do have a 401K I hold no bonds. I have a 529. I'm contemplating a Roth IRA.
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Re: Roth IRa versus taxable account

Post by iceport »

airahcaz wrote:If one assumes long term capital gains taxes remain at 15% for the foreseeable future, yes, an assumption, then for the flexibility of a taxable account, one is really only giving up 15% in LT taxes in not going with a Roth IRA?
Am I the only one that has an issue with the premise of this question?

First, please note grabiner's comment, as he correctly notes that there is not that much additional "flexibility" offered by a taxable account over a Roth.
grabiner wrote:In addition, you don't have as much of a gain in flexibility as it might appear. You can withdraw contributions to a Roth IRA at any time with no tax penalty.
But the real issue is the "only giving up 15% in taxes" part. Only?

Wow. Folks in these parts go through all kinds of contortions just to reduce an expense ratio from 0.25% to 0.18%. And you think nothing of dropping 15.00% to Uncle Sam in one fell swoop for some (probably erroneous) notion of added "flexibility?

The Roth is a pretty sweet deal. Taxable accounts aren't as bad as they are often made out to be, but compared to a Roth, there's just no comparison.

(That's my 2¢.)

--Pete
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Post by hsv_climber »

natureexplorer wrote:For example, let's assume you are in the highest tax bracket and you invest $360k in a taxable account. It was a bad investment and you lose half. But over the years (let's say 60 years) you can recoup some of these losses, and the loss saves you $45k in taxes. So in this example you come out $45k ahead when compared to having invested the $180k in a Roth.
Bad example.
In this case you'd close your Roth and write it off taxes.
I've done it after 2000-2001 crash.
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airahcaz
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Re: Roth IRa versus taxable account

Post by airahcaz »

petrico wrote:
airahcaz wrote:If one assumes long term capital gains taxes remain at 15% for the foreseeable future, yes, an assumption, then for the flexibility of a taxable account, one is really only giving up 15% in LT taxes in not going with a Roth IRA?
Am I the only one that has an issue with the premise of this question?

First, please note grabiner's comment, as he correctly notes that there is not that much additional "flexibility" offered by a taxable account over a Roth.
grabiner wrote:In addition, you don't have as much of a gain in flexibility as it might appear. You can withdraw contributions to a Roth IRA at any time with no tax penalty.
But the real issue is the "only giving up 15% in taxes" part. Only?

Wow. Folks in these parts go through all kinds of contortions just to reduce an expense ratio from 0.25% to 0.18%. And you think nothing of dropping 15.00% to Uncle Sam in one fell swoop for some (probably erroneous) notion of added "flexibility?

The Roth is a pretty sweet deal. Taxable accounts aren't as bad as they are often made out to be, but compared to a Roth, there's just no comparison.

(That's my 2¢.)

--Pete
Great points and I fully agree, looking to get the full $5000 in a Roth asap for the 2010 year, and then the 2011 year. I should also caveat that I have a 529 and may also look to the Roth's contributions for college funding.
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Re: Roth IRa versus taxable account

Post by DSInvestor »

petrico wrote:The Roth is a pretty sweet deal. Taxable accounts aren't as bad as they are often made out to be, but compared to a Roth, there's just no comparison.
I agree. Roth's tax free growth, tax free withdrawals and ability to withdraw contributions without tax or penalty beats a taxable account any day. Given the low contribution limits of Roth IRA, I think it makes sense to max out Roth IRA (if eligible) before using taxable accounts. Taxable accounts are great for those looking to invest above and beyond their tax advantaged accounts.

Roth IRA is also recommended here at Bogleheads for young investors who are struggling to build cash reserves. If an emergency cash need arises, they can tap the Roth IRA. If no emergency arises, they have a larger Roth IRA balance having taken advantage of the 5K/yr annual contribution limit. The retirement contribution schemes in the US do not allow us to make up for missed contributions in later years.

I just saw that you have 529s as well. I would suggest maxing out all retirement plans first before making 529 contributions. Your assets in retirement accounts will not work against you for financial aid purposes. Roth IRA assets can be used for retirement or for college or many other purposes.
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