Taxable vs. Tax Deferred - not much difference?

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pepperz
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Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Wed Dec 13, 2017 3:26 pm

I've always considered it 'best practice' to max out your tax-deferred accounts before taxable.

Exactly how much better is it though?

A friend recently made a case for not investing in tax deferred retirement accounts at all...

His point was that the benefit of tax-deferred accounts is not significant enough to justify tying up your money until retirement. Especially when you take contribution limits into account.

Thoughts?

UPDATE:

I ran the following hypothetical scenario using this calculator.

Current investment balance: 0
Annual Contributions: $18,000
Number of Years to invest: 30

After 30 years this scenario yielded:

Taxable account: $1,423,047
Tax-deferred (adjusted for taxes): $1,664,323

The difference appears to be exactly $241,276.00. That is no small amount however to my friend's point, it's not a staggering difference.

Plus you'd have the benefit of always having that money available (in taxable) should you need it for any reason.

Still interested in hearing thoughts from everyone in case there are additional perspectives I am missing.

SUMMARY:

Thanks for all the thoughtful comments here.

Sounds like the consensus is tax-deferred when you take the following into consideration:

- investing $18K into tax-deferred effectively gives you a return (of whatever your tax margin is) RIGHT AWAY... which allows that additional amount you would have otherwise paid to taxes to factor into compounding

- there is a “yearly drag” on taxable investments that most comparison calculators don’t factor... i.e. have to pay taxes on returns/investments over each year can take away 1% or more from your average returns each year.

- there are penalty-free ways to withdraw from tax-deferred before retirement if you ever want to. (Although these are admittedly complicated it is technically possible if one was motivated and organized to jump through all the hoops)

- withdrawing from tax-deferred post retirement allows you to plan for whatever tax bracket you “want” to be in at that time which is a degree of control you wouldn’t get with taxable
Last edited by pepperz on Sun Dec 17, 2017 2:44 pm, edited 5 times in total.

pepperz
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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Wed Dec 13, 2017 3:36 pm

I ran the following hypothetical scenario using this calculator.

Current investment balance: 0
Annual Contributions: $18,000
Number of Years to invest: 30

After 30 years this scenario yielded:

Taxable account: $1,423,047
Tax-deferred (adjusted for taxes): $1,664,323

The difference appears to be exactly $241,276.00. That is no small amount however to my friend's point, it's not a staggering difference.

Plus you'd have the benefit of always having that money available (in taxable) should you need it for any reason.

kaudrey
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Re: Taxable vs. Tax Deferred - not much difference?

Post by kaudrey » Wed Dec 13, 2017 3:38 pm

Well, along with anything, you can say "it depends".

Most people would like to put off paying taxes for as long as possible. Then you have more money that can grow until it gets taxed. Depending on your tax bracket now, it is often likely that you will be in a lower tax bracket when you retire, so when you withdraw the money later, not only has the larger pot grown for years, you'll pay less taxes than you would have today.

For me, in the 28% tax bracket, if I save money and can withdraw much of it later at 0%, or at most 15%, I don't consider that insignificant. Would you?

I'm not sure what you mean by "especially when you take contribution limits into account". I max out my 401(k) and also put money in a taxable brokerage account, because I plan to retire early and need some after-tax money to live on until I reach 59 1/2.

Does this help at all?

kaudrey
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Re: Taxable vs. Tax Deferred - not much difference?

Post by kaudrey » Wed Dec 13, 2017 3:39 pm

$240K sounds pretty darn significant to me! You must be rich if you don't consider that a big difference.

panhead
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Re: Taxable vs. Tax Deferred - not much difference?

Post by panhead » Wed Dec 13, 2017 3:41 pm

What is your marginal tax bracket? What tax bracket to you plan to be in when you retire? The nice thing about 401k (and other deferred vehicles) is that they reduce your taxes at your marginal rate. So if you are in the 33% bracket, You are saving $330 in taxes for each $1000 you invest as long as the contributions don't drop you into the 28% bracket, then you save $280, etc.

Now, when you withdraw from these accounts, you will likely pay some tax. If we assume that your only income source is withdrawals from these deferred vehicles, then your marginal rate no longer matters but your effective rate. Even if your marginal rate in retirement is the same as when working, you will still end up paying less in taxes as you will start being taxed from the bottom of the tax pyramid, ie, (0%, 10%, etc). This gets more complicated with other income streams (SS, pensions, etc), but those are things that can be modeled.

As for tying up money until you are 59.5, I used to worry about this too when I was younger, although I still maxed out these vehicles whenever possible before investing in taxable. It actually turns out that there are several methods for accessing these funds prior to 59.5. Look up 72t sepp withdrawals, or Roth conversion ladders for a start. If your friend thinks that contribution limits are so low (18500 a year for 401k in 2018) as to make these accounts irrelevant, then I would argue he has plenty of money to max them out as well as invest in taxable. So what's the problem?

Also, a big part of this is if your employer has a match. It's almost impossible to argue against investing enough to get the match in such a plan, unless you don't like free money.

As a last point, if you have a workplace 401k, its hard to beat how easy it is to invest. Set your contribution rate and investments and you can pretty much forget about it. I like simple.

Bottom line: I don't agree with your friend

livesoft
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Re: Taxable vs. Tax Deferred - not much difference?

Post by livesoft » Wed Dec 13, 2017 3:44 pm

I certainly don't believe everything my friends tell me. And I don't believe everything bogleheads tell me.

How about you? Did you do the math correctly yourself? Can you show us? Don't forget to include taxes in the results, too.
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sailaway
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Re: Taxable vs. Tax Deferred - not much difference?

Post by sailaway » Wed Dec 13, 2017 3:46 pm

Just from a logic perspective, how do contribution limits negate the benefits?

KlangFool
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Re: Taxable vs. Tax Deferred - not much difference?

Post by KlangFool » Wed Dec 13, 2017 3:48 pm

pepperz wrote:
Wed Dec 13, 2017 3:26 pm
I've always considered it 'best practice' to max out your tax-deferred accounts before taxable.

Exactly how much better is it though?

A friend recently made a case for not investing in tax deferred retirement accounts at all...

His point was that the benefit of tax-deferred accounts is not significant enough to justify tying up your money until retirement. Especially when you take contribution limits into account.

Thoughts?
pepperz,

<< His point was that the benefit of tax-deferred accounts is not significant enough to justify tying up your money until retirement.>>

You should know that you could withdraw from your tax-deferred accounts before retirement age without paying penalty. If you know this, then, all his arguments are basically pointless.

KlangFool

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Re: Taxable vs. Tax Deferred - not much difference?

Post by mcraepat9 » Wed Dec 13, 2017 3:51 pm

sailaway wrote:
Wed Dec 13, 2017 3:46 pm
Just from a logic perspective, how do contribution limits negate the benefits?
Agree, this is seems to be a confusing statement. I guess in theory if the contribution limit were $100 per year, you might have some sort of cost-benefit analysis that would counsel against spending your time with 401k accounts. But $18,500 (inflation adjusted for future years) is significant to many people.
Amateur investors are not cool-headed logicians.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by KlangFool » Wed Dec 13, 2017 3:54 pm

pepperz wrote:
Wed Dec 13, 2017 3:36 pm
I ran the following hypothetical scenario using this calculator.

Current investment balance: 0
Annual Contributions: $18,000
Number of Years to invest: 30

After 30 years this scenario yielded:

Taxable account: $1,423,047
Tax-deferred (adjusted for taxes): $1,664,323

The difference appears to be exactly $241,276.00. That is no small amount however to my friend's point, it's not a staggering difference.

Plus you'd have the benefit of always having that money available (in taxable) should you need it for any reason.
pepperz,

That calculator is flawed. It does not ask for the marginal tax rate.

If you can defer paying tax by contributing to tax-deferred account at 25% and then withdraw the money and paying tax at 0%, you gain 25% just from that.

KlangFool

bhsince87
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Re: Taxable vs. Tax Deferred - not much difference?

Post by bhsince87 » Wed Dec 13, 2017 3:54 pm

It depends. In some cases your friend is correct. In other cases, taxable may even be BETTER than tax deferred.

But there are more common scenarios where tax deferred does have the advantage.

So while deferred might often be better, it's not good to assume that's always the case.
BH87

pepperz
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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Wed Dec 13, 2017 3:55 pm

I edited my original post to include a scenario I calculated and what the result would be. Curious to what others think after seeing those numbers as well.
livesoft wrote:
Wed Dec 13, 2017 3:44 pm
I certainly don't believe everything my friends tell me. And I don't believe everything bogleheads tell me.

How about you? Did you do the math correctly yourself? Can you show us? Don't forget to include taxes in the results, too.

johne417
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Re: Taxable vs. Tax Deferred - not much difference?

Post by johne417 » Wed Dec 13, 2017 4:02 pm

That calculator doesn't take into account re-invested dividends or the annual dividend tax drag on the taxable account. Both would affect the output.

pepperz
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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Wed Dec 13, 2017 4:03 pm

panhead wrote:
Wed Dec 13, 2017 3:41 pm
Also, a big part of this is if your employer has a match. It's almost impossible to argue against investing enough to get the match in such a plan, unless you don't like free money.

As a last point, if you have a workplace 401k, its hard to beat how easy it is to invest. Set your contribution rate and investments and you can pretty much forget about it. I like simple.
Nobody can argue with "free money" for sure. My friend and I own our business so the free money was not even a talking point for our particular conversation.

pepperz
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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Wed Dec 13, 2017 4:04 pm

KlangFool wrote:
Wed Dec 13, 2017 3:48 pm
You should know that you could withdraw from your tax-deferred accounts before retirement age without paying penalty. If you know this, then, all his arguments are basically pointless.

KlangFool
Can you please enlighten me here? How can you withdraw from tax-deferred accounts before retirement without paying a penalty?

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triceratop
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Re: Taxable vs. Tax Deferred - not much difference?

Post by triceratop » Wed Dec 13, 2017 4:10 pm

pepperz wrote:
Wed Dec 13, 2017 4:04 pm
KlangFool wrote:
Wed Dec 13, 2017 3:48 pm
You should know that you could withdraw from your tax-deferred accounts before retirement age without paying penalty. If you know this, then, all his arguments are basically pointless.

KlangFool
Can you please enlighten me here? How can you withdraw from tax-deferred accounts before retirement without paying a penalty?
Look up Substantially Equal Periodic Payment.

Bogleheads wiki: https://www.bogleheads.org/wiki/Substan ... c_payments
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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Wed Dec 13, 2017 4:11 pm

johne417 wrote:
Wed Dec 13, 2017 4:02 pm
That calculator doesn't take into account re-invested dividends or the annual dividend tax drag on the taxable account. Both would affect the output.
I didn't know that, John. Might you be able to point me to a more accurate calculator for this exercise? I've tried all sorts of googling and am just confusing myself.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by triceratop » Wed Dec 13, 2017 4:12 pm

pepperz wrote:
Wed Dec 13, 2017 4:11 pm
johne417 wrote:
Wed Dec 13, 2017 4:02 pm
That calculator doesn't take into account re-invested dividends or the annual dividend tax drag on the taxable account. Both would affect the output.
I didn't know that, John. Might you be able to point me to a more accurate calculator for this exercise? I've tried all sorts of googling and am just confusing myself.
Tax drag on investments: viewtopic.php?t=208818
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

panhead
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Re: Taxable vs. Tax Deferred - not much difference?

Post by panhead » Wed Dec 13, 2017 4:12 pm

pepperz wrote:
Wed Dec 13, 2017 4:03 pm
panhead wrote:
Wed Dec 13, 2017 3:41 pm
Also, a big part of this is if your employer has a match. It's almost impossible to argue against investing enough to get the match in such a plan, unless you don't like free money.

As a last point, if you have a workplace 401k, its hard to beat how easy it is to invest. Set your contribution rate and investments and you can pretty much forget about it. I like simple.
Nobody can argue with "free money" for sure. My friend and I own our business so the free money was not even a talking point for our particular conversation.
So the match doesn't apply. I am only familiar with individual 401ks which allow the standard deferral amount plus a profit sharing amount. Assuming you can set up something similar, you may be able to defer even more from your taxes than a w2 employee.
I completely understand the thinking when you are young (how old are you?) about putting away this money for 30 or more years seems crazy, but pretty much everyone here is happy they did, as the time does fly.

bhsince87
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Re: Taxable vs. Tax Deferred - not much difference?

Post by bhsince87 » Wed Dec 13, 2017 4:16 pm

Here's an example of what can go wrong. And also an example of why you're not going to find a calculator that will give you the "correct" answer.

The same thing can happen with ACA subsidies at younger ages.

http://www.oregonlive.com/finance/index ... _rang.html
BH87

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onthecusp
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Re: Taxable vs. Tax Deferred - not much difference?

Post by onthecusp » Wed Dec 13, 2017 4:20 pm

panhead wrote:
Wed Dec 13, 2017 3:41 pm
What is your marginal tax bracket? What tax bracket to you plan to be in when you retire? The nice thing about 401k (and other deferred vehicles) is that they reduce your taxes at your marginal rate. So if you are in the 33% bracket, You are saving $330 in taxes for each $1000 you invest as long as the contributions don't drop you into the 28% bracket, then you save $280, etc.

Now, when you withdraw from these accounts, you will likely pay some tax. If we assume that your only income source is withdrawals from these deferred vehicles, then your marginal rate no longer matters but your effective rate. Even if your marginal rate in retirement is the same as when working, you will still end up paying less in taxes as you will start being taxed from the bottom of the tax pyramid, ie, (0%, 10%, etc). This gets more complicated with other income streams (SS, pensions, etc), but those are things that can be modeled.
panhead,

Thanks so much for making this distinction between marginal tax savings at saving and effective (overall) tax cost on withdrawal! It is a bit late to affect my choice which has always been to save in a 401k whenever possible, but now I feel so much better about it. I always thought I would have to lower my marginal rate to get any significant benefit from the deferral. (Still a good idea to manage the marginal rate as you can for the many positive tax effects.)

It seems so obvious now that you pointed it out, but I don't think this distinction is made in print very often.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by KlangFool » Wed Dec 13, 2017 4:21 pm

triceratop wrote:
Wed Dec 13, 2017 4:10 pm
pepperz wrote:
Wed Dec 13, 2017 4:04 pm
KlangFool wrote:
Wed Dec 13, 2017 3:48 pm
You should know that you could withdraw from your tax-deferred accounts before retirement age without paying penalty. If you know this, then, all his arguments are basically pointless.

KlangFool
Can you please enlighten me here? How can you withdraw from tax-deferred accounts before retirement without paying a penalty?
Look up Substantially Equal Periodic Payment.

Bogleheads wiki: https://www.bogleheads.org/wiki/Substan ... c_payments
+1.

The following URL showed a few other methods.

https://www.madfientist.com/how-to-acce ... nds-early/

KlangFool

johne417
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Re: Taxable vs. Tax Deferred - not much difference?

Post by johne417 » Wed Dec 13, 2017 4:46 pm

You're also only looking at the resultant portfolio itself, and ignoring the tax benefits of lowering your taxable AGI 18K every year.

Let's say you're in the 25% marginal tax bracket, lowering your AGI 18K/yr is worth $4500 a yr. Toss that into a compound interest calculator over 30 years and have fun.

goingup
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Re: Taxable vs. Tax Deferred - not much difference?

Post by goingup » Wed Dec 13, 2017 4:56 pm

pepperz wrote:
Wed Dec 13, 2017 3:26 pm
Plus you'd have the benefit of always having that money available (in taxable) should you need it for any reason.
This really isn't a benefit. Retirement savings should be locked in the vault, so it's hard to get to, and ready for you when you no longer earn income. A guy posted here recently who had $2.1M in his 401K after 30 years working at the same company. Amazing.

johne417
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Re: Taxable vs. Tax Deferred - not much difference?

Post by johne417 » Wed Dec 13, 2017 5:18 pm

pepperz wrote:
Wed Dec 13, 2017 4:11 pm
johne417 wrote:
Wed Dec 13, 2017 4:02 pm
That calculator doesn't take into account re-invested dividends or the annual dividend tax drag on the taxable account. Both would affect the output.
I didn't know that, John. Might you be able to point me to a more accurate calculator for this exercise? I've tried all sorts of googling and am just confusing myself.
Me, I don't like hoops, so I'd just assume 1% lower return in taxable as a rough ballpark estimate to account for the re-invested dividends and dividend tax drag factors. That bumps the after tax delta up to ~$400K in the accounts after 30 years. Plus, if you're smart and invest the extra $ saved each year via income taxes, let's say $4500, at 8% over 30 years, that'll yield an additional after-tax net close to a half mill. Is $900K much of a difference to you? If not, good on ya mate, seriously.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by grabiner » Wed Dec 13, 2017 8:49 pm

Here's how I would look at it, one year at a time.

Say you invest $18,000 in a Roth 401(k) for 30 years, in a a stock fund which grows by 8% annually. In 30 years, you will have $181,128.

Say you invest $18,000 in a taxable account, in a stock index fund which has a 2% qualified dividend yield taxed at 15%, and reinvest the after-tax dividends. Your balance grows by 7.7% annually, to $166,626.

But the real difference is much more than that 8% difference, because you need to sell the taxable account in order to use the money. You have a $114,254 capital gain, so after you pay $17,138 in tax, you are left with $149,488. You have lost 18% of your account, and 20% of your gain, to taxes by holding it in a taxable account rather than a Roth 401(k).

If you contributed $18,000 to a traditional 401(k), and withdrew in a 25% tax bracket, you would have $135,846. But that cost you only $13,500 out of pocket because of the tax deduction, and that $13,500 would be $112,116 in a taxable account, the same 18% difference.
David Grabiner

pepperz
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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Sat Dec 16, 2017 6:07 am

Thanks for all the thoughtful comments here.

Sounds like the consensus is tax-deferred when you take the following into consideration:

- investing $18K into tax-deferred effectively gives you a return (of whatever your tax margin is) RIGHT AWAY... which allows that additional amount you would have otherwise paid to taxes to factor into compounding

- there is a “yearly drag” on taxable investments that most comparison calculators don’t factor... i.e. have to pay taxes on returns/investments over each year can take away 1% or more from your average returns each year.

- there are penalty-free ways to withdraw from tax-deferred before retirement if you ever want to. (Although these are admittedly complicated it is technically possible if one was motivated and organized to jump through all the hoops)

- withdrawing from tax-deferred post retirement allows you to plan for whatever tax bracket you “want” to be in at that time which is a degree of control you wouldn’t get with taxable

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Re: Taxable vs. Tax Deferred - not much difference?

Post by angler-39 » Sat Dec 16, 2017 6:44 am

One question: is your friend an insurance salesman and trying to sell you products? Does your friend have any kind of significant financial, tax, or investment training (post-graduate level, or a deep personal desire to learn about investing, taxes, personal financial planning (a la the Bogleheads))? Or is this person just speaking off the top of his head without the benefit of academic studies or real-world situations?

For someone to expound on the virtues of entirely passing on tax-deferred benefits to invest solely in taxable accounts seems a little disingenuous to me. Good luck and stay the course!
George M.

CenTexan
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Re: Taxable vs. Tax Deferred - not much difference?

Post by CenTexan » Sat Dec 16, 2017 5:06 pm

Thanks for the summary, pepperz. Wish all the posts here would have one (ideally at the top of the chain!) :happy

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Re: Taxable vs. Tax Deferred - not much difference?

Post by CurlyDave » Sun Dec 17, 2017 3:05 am

pepperz wrote:
Wed Dec 13, 2017 3:26 pm
...Current investment balance: 0
Annual Contributions: $18,000
Number of Years to invest: 30

After 30 years this scenario yielded:

Taxable account: $1,423,047
Tax-deferred (adjusted for taxes): $1,664,323

The difference appears to be exactly $241,276.00. That is no small amount however to my friend's point, it's not a staggering difference.

Plus you'd have the benefit of always having that money available (in taxable) should you need it for any reason.

Still interested in hearing thoughts from everyone in case there are additional perspectives I am missing.
The real problem is that it takes much more income than $18k to invest an after-tax $18k in an account. It takes $18k * (1/(1-MR)) where MR is the marginal tax rate expresses a a decimal fraction. I.e., if your marginal tax rate is 25% investing $18k requires (18/.75) = $24 k of pre-tax income. Investing $18k in a tax advantaged account only requires $18k of pre-tax income.

When you write "Tax-deferred (adjusted for taxes)" exactly what does that mean? What is the mathematical expression for it?

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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Sun Dec 17, 2017 6:02 am

pepperz wrote:
Wed Dec 13, 2017 4:04 pm
KlangFool wrote:
Wed Dec 13, 2017 3:48 pm
You should know that you could withdraw from your tax-deferred accounts before retirement age without paying penalty. If you know this, then, all his arguments are basically pointless.
KlangFool
Can you please enlighten me here? How can you withdraw from tax-deferred accounts before retirement without paying a penalty?
There is a difference between "retirement" and "retirement age". In addition to the madfientist article, see also How to withdraw funds from your IRA and 401k without penalty before age 59.5.

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FiveK
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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Sun Dec 17, 2017 6:43 am

panhead wrote:
Wed Dec 13, 2017 3:41 pm
What is your marginal tax bracket? What tax bracket to you plan to be in when you retire? The nice thing about 401k (and other deferred vehicles) is that they reduce your taxes at your marginal rate. So if you are in the 33% bracket, You are saving $330 in taxes for each $1000 you invest as long as the contributions don't drop you into the 28% bracket, then you save $280, etc.
Yes, so far so good.
Now, when you withdraw from these accounts, you will likely pay some tax. If we assume that your only income source is withdrawals from these deferred vehicles, then your marginal rate no longer matters but your effective rate.
Not correct, unless you have made an irrevocable, career-long decision on using traditional vs. Roth.
Even if your marginal rate in retirement is the same as when working, you will still end up paying less in taxes as you will start being taxed from the bottom of the tax pyramid, ie, (0%, 10%, etc).
Withdrawals based on one's first few years of traditional contributions, after those have compounded over time, fill those bottom layers.

E.g., a single person contributing a 401k+tIRA amount of $23,500/yr from age 26-29 (only 4 years), having it grow at 4%/yr until withdrawing 4%/yr starting at age 55, would be withdrawing $11,067/yr. That's already enough to fill the 0% bracket completely, and start on the 10% bracket.

Similarly, it would take only 8 years (e.g., age 26-33) at $23,500/yr until withdrawals at age 55 would put one into the 15% bracket.

After that, there is no more 0% or 10% "bottom of the withdrawal tax pyramid" available for traditional contributions at age 34 and above. Any further traditional contributions will be taxed at 15% at least - in other words, at the marginal withdrawal tax rate. Effective rate is irrelevant at best and misleading at worst.

See Traditional versus Roth, Marginal Vs Effective Tax Rates And When To Use Each, etc.

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FiveK
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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Sun Dec 17, 2017 6:54 am

onthecusp wrote:
Wed Dec 13, 2017 4:20 pm
Thanks so much for making this distinction between marginal tax savings at saving and effective (overall) tax cost on withdrawal! It is a bit late to affect my choice which has always been to save in a 401k whenever possible, but now I feel so much better about it. I always thought I would have to lower my marginal rate to get any significant benefit from the deferral. (Still a good idea to manage the marginal rate as you can for the many positive tax effects.)

It seems so obvious now that you pointed it out, but I don't think this distinction is made in print very often.
Yes it "seems obvious" but as I hope the previous post explained, it isn't correct.

In the absence of pension and SS, traditional contributions are still best for most. Although one reaches the 15% withdrawal tax bracket relatively quickly (8 years in the example given), it would take 26 years under those conditions to reach the 25% bracket.

Any extra retirement income, e.g., pension, dividends from taxable accounts, etc., would cause one to reach higher marginal withdrawal rates that much quicker. In any case, it is the withdrawal marginal rate that one should use.

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FiveK
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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Sun Dec 17, 2017 7:11 am

pepperz wrote:
Wed Dec 13, 2017 3:36 pm
I ran the following hypothetical scenario using this calculator.

Current investment balance: 0
Annual Contributions: $18,000
Number of Years to invest: 30

After 30 years this scenario yielded:

Taxable account: $1,423,047
Not correct, unless the default 8%/yr return is fully taxed each year at the default 25% rate.

If instead, the 8%/yr comes from 2% dividends taxed at 15%, and a final 15% capital gain tax at the end of the 30 years, the result is $1,767,720.

See rows 127-145 on the 'Misc. calcs' tab of the the personal finance toolbox spreadsheet.

pepperz wrote:
Wed Dec 13, 2017 3:36 pm
Tax-deferred (adjusted for taxes): $1,664,323
This is 1 - 25% = 75% of the Future Value of $18K/yr at 8% for 30 years. But as already noted, this is not a fair comparison to the taxable account because it would take $24K/yr at a 25% tax rate to invest $18K/yr taxably.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by Olemiss540 » Sun Dec 17, 2017 7:48 am

FiveK wrote:
Sun Dec 17, 2017 6:43 am
panhead wrote:
Wed Dec 13, 2017 3:41 pm
What is your marginal tax bracket? What tax bracket to you plan to be in when you retire? The nice thing about 401k (and other deferred vehicles) is that they reduce your taxes at your marginal rate. So if you are in the 33% bracket, You are saving $330 in taxes for each $1000 you invest as long as the contributions don't drop you into the 28% bracket, then you save $280, etc.
Yes, so far so good.
Now, when you withdraw from these accounts, you will likely pay some tax. If we assume that your only income source is withdrawals from these deferred vehicles, then your marginal rate no longer matters but your effective rate.
Not correct, unless you have made an irrevocable, career-long decision on using traditional vs. Roth.
Even if your marginal rate in retirement is the same as when working, you will still end up paying less in taxes as you will start being taxed from the bottom of the tax pyramid, ie, (0%, 10%, etc).
Withdrawals based on one's first few years of traditional contributions, after those have compounded over time, fill those bottom layers.

E.g., a single person contributing a 401k+tIRA amount of $23,500/yr from age 26-29 (only 4 years), having it grow at 4%/yr until withdrawing 4%/yr starting at age 55, would be withdrawing $11,067/yr. That's already enough to fill the 0% bracket completely, and start on the 10% bracket.

Similarly, it would take only 8 years (e.g., age 26-33) at $23,500/yr until withdrawals at age 55 would put one into the 15% bracket.

After that, there is no more 0% or 10% "bottom of the withdrawal tax pyramid" available for traditional contributions at age 34 and above. Any further traditional contributions will be taxed at 15% at least - in other words, at the marginal withdrawal tax rate. Effective rate is irrelevant at best and misleading at worst.

See Traditional versus Roth, Marginal Vs Effective Tax Rates And When To Use Each, etc.
Can you just allow that using effective tax is an effective way to discuss the tax saved by using traditional accounts (as the article describes) over Roth type accounts? It seems like the moment effective tax is mentioned you have an alert set so you can jump in and police.

The OP did not post their numbers in specific so it is not an analysis of their marginal rates in order to decide next dollar investing. You cannot perform this task without more specific information on an individual's planned contributions, expenses, current taxes, etc etc.

A poster was using the above discription of effective tax rate to show the POTENTIAL advantages of tax deferred investing, NOT telling the OP that his next invested dollar should be traditional over Roth.

Also, re-run your calculations using married tax brackets and 18k of traditional versus 5500 of RIRA contributions as is also just as likely if a scenario.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Sun Dec 17, 2017 8:04 am

Olemiss540 wrote:
Sun Dec 17, 2017 7:48 am
Can you just allow that using effective tax is an effective way to discuss the tax saved by using traditional accounts (as the article describes) over Roth type accounts?
Why would we want to tell people something that is not true?

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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Sun Dec 17, 2017 3:10 pm

No, my friend is not a salesman. :) Just two life-long friends sharing their take.

My friend is cynical about the financial industry and that 'regular people' are not who it's designed to primarily benefit... he just did the arithmetic after our conversation and exclaimed the difference in savings is not as staggering as most people act like it is. Based on those numbers (from my first post) I felt the same way.

That's why I started this thread. To get some other's perspective. :)
angler-39 wrote:
Sat Dec 16, 2017 6:44 am
One question: is your friend an insurance salesman and trying to sell you products? Does your friend have any kind of significant financial, tax, or investment training (post-graduate level, or a deep personal desire to learn about investing, taxes, personal financial planning (a la the Bogleheads))? Or is this person just speaking off the top of his head without the benefit of academic studies or real-world situations?

For someone to expound on the virtues of entirely passing on tax-deferred benefits to invest solely in taxable accounts seems a little disingenuous to me. Good luck and stay the course!
George M.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by pepperz » Sun Dec 17, 2017 3:10 pm

Great idea. I have edited my first post with it. :)
CenTexan wrote:
Sat Dec 16, 2017 5:06 pm
Thanks for the summary, pepperz. Wish all the posts here would have one (ideally at the top of the chain!) :happy

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Re: Taxable vs. Tax Deferred - not much difference?

Post by bhsince87 » Sun Dec 17, 2017 3:28 pm

You can expect to get biased replies on this board, because most folks here really do benefit from tax deferred accounts.

But with the US median household income around $60k per year, many folks will be in the 0% Dividend and Capital Gains tax rate brackets.

For those people, it is doubtful a traditional 401k/IRA ever makes sense from a total return perspective, and even a Roth becomes questionable.

However, there may be other advantages, such as better legal protection, forced savings, employer match, etc.

So I agree with your friend. Tax deferred should not automatically be assumed to be the best for all people.
BH87

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Re: Taxable vs. Tax Deferred - not much difference?

Post by onthecusp » Mon Dec 18, 2017 12:10 pm

FiveK wrote:
Sun Dec 17, 2017 6:54 am
onthecusp wrote:
Wed Dec 13, 2017 4:20 pm
Thanks so much for making this distinction between marginal tax savings at saving and effective (overall) tax cost on withdrawal! It is a bit late to affect my choice which has always been to save in a 401k whenever possible, but now I feel so much better about it. I always thought I would have to lower my marginal rate to get any significant benefit from the deferral. (Still a good idea to manage the marginal rate as you can for the many positive tax effects.)

It seems so obvious now that you pointed it out, but I don't think this distinction is made in print very often.
Yes it "seems obvious" but as I hope the previous post explained, it isn't correct.

In the absence of pension and SS, traditional contributions are still best for most. Although one reaches the 15% withdrawal tax bracket relatively quickly (8 years in the example given), it would take 26 years under those conditions to reach the 25% bracket.

Any extra retirement income, e.g., pension, dividends from taxable accounts, etc., would cause one to reach higher marginal withdrawal rates that much quicker. In any case, it is the withdrawal marginal rate that one should use.
Well yes, I see your point even if it is somewhat debated later on.

It seems to me that a "small effective rate factor" could be produced by funding that comes mostly from a higher tax bracket and only a little in the next lower bracket in the accumulation years and being lucky that withdrawals are mostly in a lower tax bracket and only a little from the higher marginal bracket in the distribution years. So just looking at the highest marginal rates might not be accurate either. Of course my scenario could just as easily be reversed, or different over the years, and in any case it is probably a math exercise rather than a useful planning tool since the actions take place years apart.

Like many such issues it appears that "it depends on your specific circumstances." In my circumstances, I expect a decent SS payout, and to do Roth conversions, both of which are common and would dominate any possible effect of blended tax brackets.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Mon Dec 18, 2017 2:03 pm

onthecusp wrote:
Mon Dec 18, 2017 12:10 pm
Well yes, I see your point even if it is somewhat debated later on.
Yes, unfortunately threads on this go back ~10 years here. See @redbeard's and Greenberry's (and some other) posts in that thread. Anyway, ....
It seems to me that a "small effective rate factor" could be produced by funding that comes mostly from a higher tax bracket and only a little in the next lower bracket in the accumulation years and being lucky that withdrawals are mostly in a lower tax bracket and only a little from the higher marginal bracket in the distribution years. So just looking at the highest marginal rates might not be accurate either. Of course my scenario could just as easily be reversed, or different over the years, and in any case it is probably a math exercise rather than a useful planning tool since the actions take place years apart.
I think you perceive where semantics gets in the way for many. When considering an action that incurs multiple tax rates at different points, "the" marginal rate of interest is the weighted average of all those point rates. See the marginal tax rate wiki entry.

E.g., if one contributes $15K to a t401k and the first $10K save 30% while the last $5K save 15%, the marginal saving rate for that $15K contribution is 25%. If one wants to increase that $15K to $18K, however, the marginal rate on the extra $3K is 15%.

It works the same way on the withdrawal end. E.g., if a 4% withdrawal from a tIRA with a certain balance causes some to be taxed at 15% and some at 25%, the marginal rate on that withdrawal is somewhere between 15% and 25%. If that tIRA balance becomes higher, however, the marginal rate on the 4% of the increased balance is the full 25%.

Pretty much everyone understands the contribution side. Advice such as "contribute to traditional while in the 25% bracket, but switch to Roth once you drop into the 15% bracket" is based on that understanding.

Understanding the withdrawal side seems less universal. As noted above, if some of the withdrawal is already being taxed at 25%, any amount added to that withdrawal will be taxed at 25%. One doesn't get to tell the IRS that some of the extra will be taxed at 0%, 10%, etc.
Like many such issues it appears that "it depends on your specific circumstances." In my circumstances, I expect a decent SS payout, and to do Roth conversions, both of which are common and would dominate any possible effect of blended tax brackets.
Yes, answers depending on circumstances is indeed a common occurrence. :)

Helping people understand good ways to frame questions, so they get useful answers, is a significant "reason for existence" of this forum and its associated wiki.

One final example for this post: if one is paying 15% marginal now and knows that in retirement the marginal tax rate will be 25% and the effective (aka average) tax rate will be 11%, should one
a) contribute to traditional because 15% > 11%, or
b) contribute to Roth because 15% < 25%?

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Re: Taxable vs. Tax Deferred - not much difference?

Post by Reb Tevye » Mon Dec 18, 2017 2:43 pm

For the IRS's list of the penalty exceptions, which vary depending on account type, look at this table:

https://www.irs.gov/retirement-plans/pl ... tributions

To the OP,
1. Know YOUR circumstances.
2. Know the current tax rules.
3. Know that both can change.

Without me knowing 1, 2, or 3, I'd say defer tax now on money you are sure you won't need until age 50. Adjust as you go along.

Since you said you "might need some sooner", then that amount you may not want to take the penalty risk on, or risk being in a high bracket that year.

Here's an onion peeling anecdote for a smart young relative of mine.

a. Conventional wisdom: defer taxes now.
b. But he young, smart, hard working in a lucrative field. So he's likely to be in a high bracket and past Roth exemptions later including in retirement, so he should pay taxes now at "only" 15-25%.
c. Oh, wait. But he may go back to school and have some low earnings years. So he should defer taxes now, withdraw and/or convert to Roth at a low/no tax rate while in school and then take out tax free in old age. Potentially zero taxes all the way through.

Also, deferring is somewhat 'defensive'. A better bad-case scenario. You can end up with more spending money if you lose your income, the market has a huge drop. In doing that math, don't forget 0% (up to the deduction) and 10-15% bracket an income-less person is in.

And don't forget state taxes if you got them or might move.
"So, what would have been so terrible if I had a small fortune?"

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Re: Taxable vs. Tax Deferred - not much difference?

Post by panhead » Wed Dec 20, 2017 12:01 pm

FiveK wrote:
Sun Dec 17, 2017 6:43 am
panhead wrote:
Wed Dec 13, 2017 3:41 pm
What is your marginal tax bracket? What tax bracket to you plan to be in when you retire? The nice thing about 401k (and other deferred vehicles) is that they reduce your taxes at your marginal rate. So if you are in the 33% bracket, You are saving $330 in taxes for each $1000 you invest as long as the contributions don't drop you into the 28% bracket, then you save $280, etc.
Yes, so far so good.
Yup, I think so too
FiveK wrote:
Sun Dec 17, 2017 6:43 am
Now, when you withdraw from these accounts, you will likely pay some tax. If we assume that your only income source is withdrawals from these deferred vehicles, then your marginal rate no longer matters but your effective rate.
Not correct, unless you have made an irrevocable, career-long decision on using traditional vs. Roth.
Notice that this thread is discussing "tax deferred" not "tax free" so I didn't bring up Roth and it is not necessary for this example. I submit that this being the case, the above is absolutely true. This is because withdrawals are creating income from the bottom up, while contributions are from your top marginal rate and down
FiveK wrote:
Sun Dec 17, 2017 6:43 am
Even if your marginal rate in retirement is the same as when working, you will still end up paying less in taxes as you will start being taxed from the bottom of the tax pyramid, ie, (0%, 10%, etc).
Withdrawals based on one's first few years of traditional contributions, after those have compounded over time, fill those bottom layers.

E.g., a single person contributing a 401k+tIRA amount of $23,500/yr from age 26-29 (only 4 years), having it grow at 4%/yr until withdrawing 4%/yr starting at age 55, would be withdrawing $11,067/yr. That's already enough to fill the 0% bracket completely, and start on the 10% bracket.

Similarly, it would take only 8 years (e.g., age 26-33) at $23,500/yr until withdrawals at age 55 would put one into the 15% bracket.

After that, there is no more 0% or 10% "bottom of the withdrawal tax pyramid" available for traditional contributions at age 34 and above. Any further traditional contributions will be taxed at 15% at least - in other words, at the marginal withdrawal tax rate. Effective rate is irrelevant at best and misleading at worst.
Look, if I'm contributing 18,000/year at the 33% marginal rate, I'm saving $5,940 in taxes while contributing. Now if I start withdrawing when I'm unemployed with no other sources of income, and basing this off of current tax code, about the first $10k is 0% (single, std ded+xmpt) The next $8k is at 10% or $800. I saved 5940-800 or %5140 in taxes. The average tax rate is much lower than the 10% bracket, it's actually 4.44%. This is why marginal matters during contributions and average matters for withdrawals. Yes there will be earnings, and yes the tax brackets will go up with inflation or tax policy, but you still start at the 0% rate, not at your marginal contribution rate of 33%.

Now, with all that being said, your point about Roth IRAs is an important one that would need to be incorporated in the full strategy such as backdoor Roth conversions, Mega-backdoor Roth, and probably most importantly, when to do Roth conversions and up to what tax brackets.

I submit again that the above is correct.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Wed Dec 20, 2017 6:31 pm

panhead wrote:
Wed Dec 20, 2017 12:01 pm
FiveK wrote:
Sun Dec 17, 2017 6:43 am
Now, when you withdraw from these accounts, you will likely pay some tax. If we assume that your only income source is withdrawals from these deferred vehicles, then your marginal rate no longer matters but your effective rate.
Not correct, unless you have made an irrevocable, career-long decision on using traditional vs. Roth.
Notice that this thread is discussing "tax deferred" not "tax free" so I didn't bring up Roth and it is not necessary for this example. I submit that this being the case, the above is absolutely true. This is because withdrawals are creating income from the bottom up, while contributions are from your top marginal rate and down
Yes, we could substitute "taxable" for Roth without changing the marginal vs. effective issue. For that matter, substituting "or not" for "vs. Roth" in "traditional vs. Roth" would also work - agreed?
Look, if I'm contributing 18,000/year at the 33% marginal rate, I'm saving $5,940 in taxes while contributing. Now if I start withdrawing when I'm unemployed with no other sources of income, and basing this off of current tax code, about the first $10k is 0% (single, std ded+xmpt) The next $8k is at 10% or $800.
When the withdrawal marginal rate is less than the contribution marginal rate, we all agree (because the effective rate will be even lower than the marginal rate) that traditional contributions are correct.

But what if one would save 15% marginal now, and know that in retirement the marginal tax rate will be 25% and the effective tax rate will be 11%? Should one
a) contribute to traditional because 15% > 11%, or
b) contribute to Roth because 15% < 25%?

Similarly, let's follow your example and consider what happens to the extra $500 when the contribution limit goes to $18,500 and there is the same unemployment situation. Will the extra $500 be taxed at the marginal or the effective rate when withdrawn?

Every new traditional contribution increases the amount that can be withdrawn. The tax paid on the increase gets paid at the marginal rate.

You aren't the first (and neither was I) to be misled by the "marginal vs. effective" approach. It sounds so right, but it is not.

See also this post viewtopic.php?f=1&t=200071&p=3066486#p3065160 - perhaps that person's thought process will be clearer to you than the thoughts above.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by triceratop » Wed Dec 20, 2017 7:56 pm

bhsince87 wrote:
Sun Dec 17, 2017 3:28 pm
You can expect to get biased replies on this board, because most folks here really do benefit from tax deferred accounts.

But with the US median household income around $60k per year, many folks will be in the 0% Dividend and Capital Gains tax rate brackets.

For those people, it is doubtful a traditional 401k/IRA ever makes sense from a total return perspective, and even a Roth becomes questionable.

However, there may be other advantages, such as better legal protection, forced savings, employer match, etc.

So I agree with your friend. Tax deferred should not automatically be assumed to be the best for all people.
Incorrect, though it is true the benefit is less than some may assume. Since you still receive the benefit of a 12% deduction and initial withdrawals start from the 0% bracket it still benefits the median family. This is true even if you remain in the 12% bracket in retirement. There is also the saver's credit.

A Roth is always preferable to taxable investing. This is always true.
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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Wed Dec 20, 2017 9:07 pm

triceratop wrote:
Wed Dec 20, 2017 7:56 pm
A Roth is always preferable to taxable investing. This is always true.
Unless your investment loses money, in which case one may tax loss harvest in taxable but not Roth. Thus, for anyone planning to lose money, taxable is preferable to Roth. ;)

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Re: Taxable vs. Tax Deferred - not much difference?

Post by bhsince87 » Wed Dec 20, 2017 9:14 pm

triceratop wrote:
Wed Dec 20, 2017 7:56 pm


A Roth is always preferable to taxable investing. This is always true.
I agree with that 100%!

But the original question was not about Roth vs taxable. It's taxable versus tax deferred.
BH87

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Re: Taxable vs. Tax Deferred - not much difference?

Post by triceratop » Wed Dec 20, 2017 9:27 pm

bhsince87 wrote:
Wed Dec 20, 2017 9:14 pm
triceratop wrote:
Wed Dec 20, 2017 7:56 pm


A Roth is always preferable to taxable investing. This is always true.
I agree with that 100%!

But the original question was not about Roth vs taxable. It's taxable versus tax deferred.
The part of my post you snipped out dealt with the taxable versus tax deferred, where your analysis was flawed.

The "Roth is always preferable to taxable investing" statement was in reference to "even a Roth becomes questionable" which is the other clear falsehood in your post.
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Re: Taxable vs. Tax Deferred - not much difference?

Post by FiveK » Wed Dec 20, 2017 9:28 pm

bhsince87 wrote:
Wed Dec 20, 2017 9:14 pm
But the original question was not about Roth vs taxable. It's taxable versus tax deferred.
Assuming
- any tax at all on the annual earnings and eventual capital gains in a taxable account
- positive returns
- equal returns (i.e., identical expense ratios for the same investments)
Roth will always be better than taxable.

Then, if
- the pre-tax amount in question is less than or equal to the IRS maximum for traditional contributions,
- using the return assumptions above,
- the marginal rate at withdrawal (e.g., 28%) is less than the marginal rate at contribution (e.g., 33%),
traditional will always be better than Roth.

In short, for the conditions given above, traditional > Roth > taxable.

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Re: Taxable vs. Tax Deferred - not much difference?

Post by triceratop » Wed Dec 20, 2017 9:37 pm

FiveK wrote:
Wed Dec 20, 2017 9:28 pm
bhsince87 wrote:
Wed Dec 20, 2017 9:14 pm
But the original question was not about Roth vs taxable. It's taxable versus tax deferred.
Assuming
- any tax at all on the annual earnings and eventual capital gains in a taxable account
- positive returns
- equal returns (i.e., identical expense ratios for the same investments)
Roth will always be better than taxable.

Then, if
- the pre-tax amount in question is less than or equal to the IRS maximum for traditional contributions,
- using the return assumptions above,
- the marginal rate at withdrawal (e.g., 28%) is less than the marginal rate at contribution (e.g., 33%),
traditional will always be better than Roth.

In short, for the conditions given above, traditional > Roth > taxable.
You can also prove that traditional > taxable, even given some severe restrictions and the return assumptions you posited. That is, it is true even when marginal rate at withdrawal is equal to the marginal rate at contribution, and even when ignoring the saver's credit (which I don't see why we would ignore, but okay, we're trying to find a scenario where taxable is preferred). That is what my above post.

A way to turn it around is this: what good is it to fill up the 0% (standard deduction) and 10% brackets with LTCG sales of taxable investments if you can fill it up with money from deductible tIRA contributions? Viewed this way there should be some clear benefit of tax deferred to taxable, even for a median household. It is not a particularly large benefit, but it is there.
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