Is Tax Diversification Overrated?

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ThankYouJack
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Is Tax Diversification Overrated?

Post by ThankYouJack »

I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
tashnewbie
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Re: Is Tax Diversification Overrated?

Post by tashnewbie »

Some people have more to save than what they can put into tax-deferred accounts.

For those people, other choices are available: Roth IRA and taxable, for example.

If you have no more than $19.5k to save each year, then putting it all into a traditional 401k is not a bad choice.

If you're in the 24% marginal federal tax bracket, I would work on maxing a Roth IRA ($6k) too, just because you're making fairly high income.
Silk McCue
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Re: Is Tax Diversification Overrated?

Post by Silk McCue »

Tax diversification isn’t overrated.

For many situations it can be very beneficial and for others not so much. Plenty of threads that discuss this that are ripe with examples of where it can be beneficial.

Early retirement, large pensions, Social Security taxation, surviving spouse tax rate ..

Cheers
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iceport
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Re: Is Tax Diversification Overrated?

Post by iceport »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
I think what you are missing is the element of uncertainty, or risk.

Tax laws don't change every year. In fact, they seem to change infrequently enough that when measured against our own lives, it seems like they are fairly static. But nothing could be further from the truth. Tax laws change all the time, even if there are many years between changes.

Besides tax laws, the circumstances of individuals change often. Spending spikes, family emergencies, etc., can all change one's tax liability adversely and drastically from one year to the next.

Will tax rates go up drastically? Will the rule for Roth IRAs be revised? Will you need to make an enormous portfolio withdrawal to address a family emergency?

Tax diversification is all about acknowledging that we cannot know the future, so we hedge against various outcomes. To that end, there could be value in having assets in different types of accounts that are taxed in different ways to draw from. The idea would be to draw from whatever account produces the most favorable tax treatment for a given person in a given circumstance.

You might be interested to read this 2005 Vanguard paper (now outdated), for a much better description of the concept: Tax Diversification and the Roth 401(k):
The history of continuous change in the tax code, along with these research findings, underscores the inherent uncertainty of future tax rates. Participants cannot be sure of their tax rate in retirement, and so cannot be sure of whether pre-tax or Roth savings are inherently superior. The tax system is dynamic and seems subject to almost continuous change. Current reform proposals call for everything from higher tax rates (favoring Roth savings) to a scrapping of the income tax entirely (possibly favoring pre-tax savings).

In this environment of uncertainty, how should participants manage the risk that taxes could be higher or lower in retirement? In the face of such risk, our recommendation is to diversify. In an uncertain tax world, participants should hold both pre-tax and Roth savings—the former to benefit in the event of lower tax rates in retirement, the latter to benefit in the event of higher tax rates. This is the notion of tax diversification—hedging the risk of uncertain future tax rates by holding both types of contributions.

There is a direct analogy between tax risk and investment risk. Investors may believe that common stocks are likely to generate a substantial equity risk premium. Yet they also recognize that higher equity returns are not guaranteed, and so diversify against that risk by holding other assets such as fixed income securities. In the case of taxes, participants may expect taxes to be lower (suggesting pre-tax savings) or higher (Roth savings) in retirement. But in pursuing a strategy of tax diversification, they will acknowledge the inherent uncertainty of forecasting any future tax rates, including their own, and so hold both types of savings.
"...acknowledge the inherent uncertainty of forecasting any future tax rates, including their own..."
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sycamore
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Re: Is Tax Diversification Overrated?

Post by sycamore »

Silk McCue wrote: Mon Sep 13, 2021 1:18 pm Tax diversification isn’t overrated.
+1

There's no official definition of what it means to be tax diversified.

It certainly doesn't mean everyone one should have 1/3 each in taxable / tax-deferred / tax-free.

5 / 90 / 5 might be appropriate for some - all tax-deferred except for some cash in taxable and some Roth contribution - for those who will be in lower bracket in retirement
10 / 70 / 20 - mostly tax-deferred, a little bit taxable and a bit more in Roth
50 / 25 / 25 - mostly taxable due to having high enough income to make post-tax contributions
5 / 0 / 95 - mostly Roth because low-ish income means a low tax bracket, and you're unlikely to be in a higher bracket
aristotelian
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Re: Is Tax Diversification Overrated?

Post by aristotelian »

The good thing about diversification is that you will never be wholly wrong. That said, I agree, traditional (pretax) is beneficial for most people. However, there are some exceptions to be aware of, such as students and low income savers, or anyone also contributing to a pension. There is also the bogeyman of tax rates increasing which could always happen at any point.
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Re: Is Tax Diversification Overrated?

Post by LittleMaggieMae »

Duplicate
Last edited by LittleMaggieMae on Mon Sep 13, 2021 1:48 pm, edited 1 time in total.
LittleMaggieMae
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Re: Is Tax Diversification Overrated?

Post by LittleMaggieMae »

I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts
This implies you have a high income - a really high income if your pretax savings are from income that would be taxed at 24%
For 2021: 24% single: $86,376 to $164,925 Married Filing Joint: $172,751 to $329,850

Which implies you may need a significant amount of income each year in retirement to maintain your life style which may mean you will have significant income above the 12% bracket:
For 2021: 12% single: $9,951 to $40,525 Married Filing Joint $19,901 to $81,050

Do you have a way to withdraw your tax differed money in retirement so that it will be taxed in the 12% bracket?
(what happens to the taxable income for a surviving spouse when they have to file Single.)
Onlineid3089
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Re: Is Tax Diversification Overrated?

Post by Onlineid3089 »

We intentionally save in all three. In our situation where I am already vested in my state's pension it would be silly to have all of our savings in pre-tax.
KlangFool
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Re: Is Tax Diversification Overrated?

Post by KlangFool »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm
am I missing something?
ThankYouJack,

It is very simple.

A) If your income is high enough and you save enough, then, you would end up with Roth IRA plus 401K.

B) If you save even more than Trad 401K and Roth IRAs, you would could only invest in the taxable account.

It is all have to do with how much you save and invest every year.

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pasadena
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Re: Is Tax Diversification Overrated?

Post by pasadena »

It's not about tax diversification, it's about... running out of tax-advantaged space, and overflow savings.

In a case like yours where current tax rate is expected to be higher than retirement tax rate (same as a lot of us) : Traditional > Roth > Taxable (all other things being equal).

Both Traditional and Roth have contribution limits. I wouldn't contribute to Roth if I didn't max out my Traditional. I wouldn't contribute to taxable if I didn't max out my Roth.
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

Thanks all.

In terms of taxes going up, I don't think tax rates are necessarily going to go up. In fact, they've actually been going down and continue to go down for my state. And I may retire in a income tax free state.

So right now, I have about 10% of my portfolio in a Roth, 10% in a taxable, the rest in pre-tax. I may be able to shift my taxable money into a tax-advantage account if I semi-retire. I think it's worth it for the tax savings, but I can see the other view that people would rather have more tax diversification (and possibly pay a bit more in taxes) but not have certain strings attached.
Da5id
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Re: Is Tax Diversification Overrated?

Post by Da5id »

ThankYouJack wrote: Mon Sep 13, 2021 2:16 pm Thanks all.

In terms of taxes going up, I don't think tax rates are necessarily going to go up. In fact, they've actually been going down and continue to go down for my state. And I may retire in a income tax free state.

So right now, I have about 10% of my portfolio in a Roth, 10% in a taxable, the rest in pre-tax. I may be able to shift my taxable money into a tax-advantage account if I semi-retire. I think it's worth it for the tax savings, but I can see the other view that people would rather have more tax diversification (and possibly pay a bit more in taxes) but not have certain strings attached.
We can't really discuss future tax rates meaningfully, just existing law. But part of the benefit of tax diversification is that it addresses this uncertainty by hedging ones bets.
pasadena
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Re: Is Tax Diversification Overrated?

Post by pasadena »

ThankYouJack wrote: Mon Sep 13, 2021 2:16 pm So right now, I have about 10% of my portfolio in a Roth, 10% in a taxable, the rest in pre-tax. I may be able to shift my taxable money into a tax-advantage account if I semi-retire. I think it's worth it for the tax savings, but I can see the other view that people would rather have more tax diversification (and possibly pay a bit more in taxes) but not have certain strings attached.
Yes, this is why I said "all other things being equal" in my answer above. Other features and limitations of each type of account can change the decision. But for tax diversification purposes, it always comes down to whether you expect your taxes to be higher or not in retirement. Some people have so much money in traditional that RMDs will push them into a higher tax bracket. There are also considerations about health insurance and misc benefits thresholds - in these cases, having the possibility to manage your taxes by choosing where your money comes from can be very beneficial.
Triple digit golfer
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Re: Is Tax Diversification Overrated?

Post by Triple digit golfer »

I don't know if overrated is a good word, but I do think being tax diversified just to be tax diversified is silly in some cases. For example, I wouldn't forego tax deferred savings just to use a taxable account, and in fact I wouldn't do it to use a Roth IRA, either.

My logic is that I'd rather save as much money as I can now (and that includes taxes) than pay more now and hope it turns out well.

I always say this, and I don't know how popular an opinion it is: I'd rather save the taxes now and end up rich in a high tax bracket in retirement than pay the taxes now and end up poor in a low tax bracket.

What I mean by that is I can't predict the future. I plan on being well-off in retirement, but nobody knows what will happen. If I come upon bad times and end up being poor or not very well off, I'll be glad to have not paid the taxes early on and instead be paying low or even no taxes in retirement.

If I end up in a high tax bracket in retirement and have a lot of tax deferred withdrawals, I'll pay the taxes and be happy that I'm in the position that I'm in, even if I feel that the taxes are too high.
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Re: Is Tax Diversification Overrated?

Post by Miguelito »

pasadena wrote: Mon Sep 13, 2021 2:15 pm It's not about tax diversification, it's about... running out of tax-advantaged space, and overflow savings.

In a case like yours where current tax rate is expected to be higher than retirement tax rate (same as a lot of us) : Traditional > Roth > Taxable (all other things being equal).

Both Traditional and Roth have contribution limits. I wouldn't contribute to Roth if I didn't max out my Traditional. I wouldn't contribute to taxable if I didn't max out my Roth.
Agreed.

Now, do it long enough and you could be staring at a potentially enormous tax deferred account which may require adjusting or retiring sooner, but that falls under the "good problem" category.
pasadena
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Re: Is Tax Diversification Overrated?

Post by pasadena »

Miguelito wrote: Mon Sep 13, 2021 2:30 pm
pasadena wrote: Mon Sep 13, 2021 2:15 pm It's not about tax diversification, it's about... running out of tax-advantaged space, and overflow savings.

In a case like yours where current tax rate is expected to be higher than retirement tax rate (same as a lot of us) : Traditional > Roth > Taxable (all other things being equal).

Both Traditional and Roth have contribution limits. I wouldn't contribute to Roth if I didn't max out my Traditional. I wouldn't contribute to taxable if I didn't max out my Roth.
Agreed.

Now, do it long enough and you could be staring at a potentially enormous tax deferred account which may require adjusting or retiring sooner, but that falls under the "good problem" category.
True. But you do have some other options to avoid or mitigate that problem before slowing contributions. Asset location is a big one, another is switching contributions to Roth instead of PT, yet another may be Roth conversions during low income years.

But then an enormous tax deferred accounts simply means high RMD, and high taxes. Which means, tax rate assumptions need to be reviewed and one may fall out of the use case above (current tax rate < retirement tax rate).
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Wiggums
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Re: Is Tax Diversification Overrated?

Post by Wiggums »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
You received a lot of good answers and perspectives. There have been a lot of changes in the past 40 years with respect to brokers and tax provisions. Some investment ideas were learned late in life. Other things did not exist back then. I wish we had known more about taxes, but fortunate that we never lost our jobs or sold in a big downturn. Retirement planning can be difficult because some of the key variables are unknown. As you accumulate large amounts of wealth, it sometimes limits your options.
Investors need to be better informed about the costs they pay. “High fund fees can be hazardous to your wealth in the same way that high calories can be hazardous for your health.”
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
You're missing that life doesn't always turn out the way you anticipate.
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Re: Is Tax Diversification Overrated?

Post by JBTX »

Agree with ice port and many others. The idea of tax diversification is you can't predict the future

-tax laws frequently change
- your personal situation could change
- the markets could do much worse or better than expected.
- marginal Rates aren't always as obvious as they seem - social security and Medicaid can impact your marginal rates, and those laws could change in time. Quite often tax increases are implemented as phase ins that increase your marginal rate over a phase in range of income.
- at some point you may decide to leave money to kids or others in trusts. Trust tax brackets are high and Roth can be very advantageous there.
- having some of each gives you more flexibility year to year
- perhaps at some point you decide to go on ACA plan prior to Medicare
Topic Author
ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

tibbitts wrote: Mon Sep 13, 2021 2:53 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
You're missing that life doesn't always turn out the way you anticipate.
Sure, but I don’t think that’s a good reason to have a plan to pay more in taxes.
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dodecahedron
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Re: Is Tax Diversification Overrated?

Post by dodecahedron »

For some folks, tax diversification might be unnecessary. (E.g., your income is very modest, so you expect that your effective marginal tax rate will be zero for your entire life.). Might as well be 100% Roth in that case. There is no tax cost to putting their savings entirely in Roth, their available funds are unlikely to hit the ceilings on contributions, so no need for overflow into taxable, and Roth contributions can be accessed as an emergency fund whenever needed.

Some disabled folks who are capable of doing a small amount of paid work might be in the above category.
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Re: Is Tax Diversification Overrated?

Post by sureshoe »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
If I know for a fact I'm going to save 24% now and pay 12% later, then I'd follow your path. I just don't know if this is a good assumption. Part of what makes that 12% possible is tax diversification. If you only have $1M and do RMDs, that keeps you pretty close, assuming you don't have death interfere (or don't care about what you leave).
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Leif
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Re: Is Tax Diversification Overrated?

Post by Leif »

I think tax diversification is a good thing. The tax laws can change at any point, so I would like to have to options on how best to handle.

Like most Bogleheads I saved a lot of my income. Maxing out pre-tax and dropping the rest in taxable. But since Roths became available I saw the advantages; starting to save in these post tax accounts.

Now retired and not yet on SS/RMD I'm doing some Roth conversions. Not that putting savings in pre-tax was bad. Tax rates were higher then. I would just not bet on that pattern being repeated in the future. That is why I encouraged my daughter to save in a Roth 401K. If taxes go up, or her tax bracket increases, then that can be revisited. But for now she has investments growing tax free.

With SS@70, RMDs, pension, and other income, my tax bracket, without conversions, will go up. The OP should, if he has not already, try to estimate the impact of RMDs and other income. If you are now at 24%, and 80% tax deferred, perhaps when RMDs start you may not be at 12%.
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

ThankYouJack wrote: Mon Sep 13, 2021 3:26 pm
tibbitts wrote: Mon Sep 13, 2021 2:53 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
You're missing that life doesn't always turn out the way you anticipate.
Sure, but I don’t think that’s a good reason to have a plan to pay more in taxes.
It's as good a reason as some of us use to not invest in 100% stocks (or 100% US stocks, etc.), despite knowing that we are choosing a path that will likely result in us earning less.
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Re: Is Tax Diversification Overrated?

Post by solarcub »

Having some Roth available might allow you to save on an ACA healthcare plan, or avoid IRMAA cliffs. But no way to know without more details. Maybe your 10% Roth is enough. Or maybe you plan to just have low expenses.

I plan to have fairly high expenses in retirement, if I can, because there are things I want to do. If things don't work out that way, I can cut back, but if things go well, I think having taxable, Roth, and traditional 401k will give me some flexibility with taxes.
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

ThankYouJack wrote: Mon Sep 13, 2021 2:16 pm Thanks all.

In terms of taxes going up, I don't think tax rates are necessarily going to go up. In fact, they've actually been going down and continue to go down for my state. And I may retire in a income tax free state.

So right now, I have about 10% of my portfolio in a Roth, 10% in a taxable, the rest in pre-tax. I may be able to shift my taxable money into a tax-advantage account if I semi-retire. I think it's worth it for the tax savings, but I can see the other view that people would rather have more tax diversification (and possibly pay a bit more in taxes) but not have certain strings attached.
IMHO, tax diversification is not usually a meaningful goal to seek after. Tax-advantaged accounts will nearly always beat a taxable account, so that pretty much limits the discussion to tax-deferred vs. Roth accounts (excepting HSA, which should generally be maxed out immediately after obtaining a 401k or similar match). And the split of one's tax-deferred and Roth contributions should typically be driven primarily by an anticipated tax arbitrage opportunity; in the absence of such an opportunity, other factors can take precedence.

I've lost count of the number of posts I've seen here over the years implicitly or even explicitly advocating contributions to taxable accounts over tax-advantaged in the name of 'tax diversification'.
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Re: Is Tax Diversification Overrated?

Post by Da5id »

willthrill81 wrote: Mon Sep 13, 2021 4:51 pm And the split of one's tax-deferred and Roth contributions should typically be driven primarily by an anticipated tax arbitrage opportunity; in the absence of such an opportunity, other factors can take precedence.
While I agree with what you say mostly, I think the further in the future one attempts to look with one's crystal ball the harder it is to determine what the tax laws will be.
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Re: Is Tax Diversification Overrated?

Post by Mike Scott »

I don't think tax diversification is really a thing where there is some built in and quantifiable value/benefit to mixing and matching account types. I do think that there are some strategies for investing now and managing taxes that make sense in individual cases for their individual circumstances. This may often involve multiple acoounts but not always. Tax considerations can certainly change over time, but the closer I get to retirement the better I think I can make some plans. If things turn out differently, I will adjust any as needed.
Last edited by Mike Scott on Mon Sep 13, 2021 5:58 pm, edited 1 time in total.
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Re: Is Tax Diversification Overrated?

Post by bsteiner »

It depends. Sometimes it makes sense to contribute or convert some but not all to Roth. Other times it makes sense to contribute all or none to Roth.
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Re: Is Tax Diversification Overrated?

Post by LilyFleur »

Da5id wrote: Mon Sep 13, 2021 5:15 pm
willthrill81 wrote: Mon Sep 13, 2021 4:51 pm And the split of one's tax-deferred and Roth contributions should typically be driven primarily by an anticipated tax arbitrage opportunity; in the absence of such an opportunity, other factors can take precedence.
While I agree with what you say mostly, I think the further in the future one attempts to look with one's crystal ball the harder it is to determine what the tax laws will be.
I agree. And the longer the horizon, the less you can predict the earnings by age 72 in a tax-deferred account. I have an 11 year horizon, and if I play with the earnings % on the Schwab RMD calculator, it can put me into different tax brackets. So, I have done some Roth conversions. Next year I am 62, and the year after that, my income will determine IRMAA. There are many factors at play.
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Re: Is Tax Diversification Overrated?

Post by FiveK »

A recent article, Tax Diversification Limits And Roth Optimization Benefits goes into some detail on this. E.g.,
...the reality is that splitting dollars between traditional and Roth retirement accounts isn’t just a form of diversification; because the outcomes are correlated to each other (as a change in tax rates that benefits one type of account adversely impacts the other type by the same amount), the net result is that tax diversification doesn’t actually diversify the risk, it simply neutralizes the opportunity altogether.
The article goes on to acknowledge that some guesswork is needed, but suggests
the better approach is to try to Roth-optimize by timing when to shift between traditional and Roth accounts. Which, in practice, is easier than most realize, as while a household’s future is never certain, the Roth-vs-traditional decision has the most impact in years that are especially high or low in income… which are actually the years that are most easy to identify in the moment for a Roth optimization timing decision!
This is pretty much the primary philosophy in the Traditional versus Roth - Bogleheads wiki: take a back-of-the-envelope guess at your retirement marginal tax rate, compare to your current rate, and choose Roth vs. traditional accordingly.
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Re: Is Tax Diversification Overrated?

Post by JBTX »

willthrill81 wrote: Mon Sep 13, 2021 4:51 pm
ThankYouJack wrote: Mon Sep 13, 2021 2:16 pm Thanks all.

In terms of taxes going up, I don't think tax rates are necessarily going to go up. In fact, they've actually been going down and continue to go down for my state. And I may retire in a income tax free state.

So right now, I have about 10% of my portfolio in a Roth, 10% in a taxable, the rest in pre-tax. I may be able to shift my taxable money into a tax-advantage account if I semi-retire. I think it's worth it for the tax savings, but I can see the other view that people would rather have more tax diversification (and possibly pay a bit more in taxes) but not have certain strings attached.
IMHO, tax diversification is not usually a meaningful goal to seek after. Tax-advantaged accounts will nearly always beat a taxable account, so that pretty much limits the discussion to tax-deferred vs. Roth accounts (excepting HSA, which should generally be maxed out immediately after obtaining a 401k or similar match). And the split of one's tax-deferred and Roth contributions should typically be driven primarily by an anticipated tax arbitrage opportunity; in the absence of such an opportunity, other factors can take precedence.

I've lost count of the number of posts I've seen here over the years implicitly or even explicitly advocating contributions to taxable accounts over tax-advantaged in the name of 'tax diversification'.
If one just looks at statutory rates as a proxy for marginal rates, yes you can reasonably model what is best, and most of the time traditional wins out, especially assuming the ability to selectively Roth convert opportunistically.

Where it becomes a little less clear is when social security, Medicare, phase ins and ACA subsidies take place. Phase ins are popular ways to increase taxes (and marginal rates) without increasing statutory rstes

Also, if you get into estate planning it's more complex. The secure act accelerated most payout to 10 years for iras, and if your heir is somebody in 50s at high income, they may have been better off in a taxable account, with step up, the capital gains rates. Of course Roth is almost always better than taxable, but the assumption is always the ability to Roth convert will always be there. As a recent proposal indicates that curbs Roth conversions (only for very high incomes and not until a decade into the future) it shows that there are no guarantees.

If you plan to leave substantial money in trust, traditional IRAS, liquidated at trust tax rates at 37% (may go up to 39.6) over $12,500, and now must be liquidated with 10 years in many cases.

Are all of these rare exceptions? I don't know but I doubt it. As people accumulate more money often things get more complex.
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Re: Is Tax Diversification Overrated?

Post by randomguy »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
1) Your goal in life probably isn't to minimize taxes. It is to maximize your spendable money and net worth. Those aren't the same thing. Paying less in taxes often helps you maximize spending but not if you have to pay a lot to get minimize taxes.

2) Yes at a high level you will almost always come out ahead by paying 12% instead of 24%. But figuring out the future rates can be very hard. How confident are you that avoiding 24% now isn't going to cause you to pay 27% on your long term capital gains or a 40% SS tax hump rate? Or some crazy IRMAA tax burden (i.e. you make an extra 500 bucks and pay an extra 1800 to medicare)? Or the effects of having a good 20 years before you retire (you make 10% real) versus a bad 20 years (you make 5%). Effects of early death of a spouse/divorce. And so on. You make your guesses and go with them.

That being said, I would pay about 0 dollars for tax diversification. My account balances are driven by taxes and ability to contribute to the accounts. Not some desire to hold some ratio of accounts..
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Re: Is Tax Diversification Overrated?

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Da5id wrote: Mon Sep 13, 2021 5:15 pm
willthrill81 wrote: Mon Sep 13, 2021 4:51 pm And the split of one's tax-deferred and Roth contributions should typically be driven primarily by an anticipated tax arbitrage opportunity; in the absence of such an opportunity, other factors can take precedence.
While I agree with what you say mostly, I think the further in the future one attempts to look with one's crystal ball the harder it is to determine what the tax laws will be.
True, but the essential elements of how tax-deferred and Roth accounts work seems unlikely to change much in the future, at least by my reckoning. However, the rates can and likely will change, which can certainly alter which types of account is 'optimal' in a given situation.

In our situation, where our saving rate is over 50% and we're planning on early retirement, we don't need a working crystal ball to know that unless there are radical changes to the tax code, tax-deferred contributions will come out far ahead of Roth. Tax 'diversification' for us would be 'worsification'.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Is Tax Diversification Overrated?

Post by Trader Joe »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
"Is Tax Diversification Overrated?"

No it is not.
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Re: Is Tax Diversification Overrated?

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Thanks for the replies. One thing to note is that I'm not ultra-wealthy and my family is perfectly happy spending < $100k a year. During retirement, when we're empty nesters, we may even spend less than we spend now.

I'm still torn on converting my taxable into roth or pre-tax, but I'd rather not plan to pay more, especially with my state income tax rate continuing to drop and the possibility of moving to an income tax free state. So I'm still leaning towards pre-tax.
tibbitts wrote: Mon Sep 13, 2021 4:28 pm
ThankYouJack wrote: Mon Sep 13, 2021 3:26 pm
tibbitts wrote: Mon Sep 13, 2021 2:53 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
You're missing that life doesn't always turn out the way you anticipate.
Sure, but I don’t think that’s a good reason to have a plan to pay more in taxes.
It's as good a reason as some of us use to not invest in 100% stocks (or 100% US stocks, etc.), despite knowing that we are choosing a path that will likely result in us earning less.
I don't agree that's it's as good of a reason because I think that's an apples to oranges comparison. I (like I think many Bogleheads) hold bonds to minimize risk of a major stock market downturn and the psychological impact of losing ~50% of one's portfolio "overnight", losing sleep, then panic selling, etc. With taxes, there's nowhere near that sort of risk.

But I get your overall point and I guess if someone is especially concerned about future tax rates increasing, paying more now could be like insurance incase tax laws do change significantly.
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Re: Is Tax Diversification Overrated?

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ThankYouJack wrote: Tue Sep 14, 2021 7:18 am Thanks for the replies. One thing to note is that I'm not ultra-wealthy and my family is perfectly happy spending < $100k a year. During retirement, when we're empty nesters, we may even spend less than we spend now.

I'm still torn on converting my taxable into roth or pre-tax, but I'd rather not plan to pay more, especially with my state income tax rate continuing to drop and the possibility of moving to an income tax free state. So I'm still leaning towards pre-tax.
tibbitts wrote: Mon Sep 13, 2021 4:28 pm
ThankYouJack wrote: Mon Sep 13, 2021 3:26 pm
tibbitts wrote: Mon Sep 13, 2021 2:53 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
You're missing that life doesn't always turn out the way you anticipate.
Sure, but I don’t think that’s a good reason to have a plan to pay more in taxes.
It's as good a reason as some of us use to not invest in 100% stocks (or 100% US stocks, etc.), despite knowing that we are choosing a path that will likely result in us earning less.
I don't agree that's it's as good of a reason because I think that's an apples to oranges comparison. I (like I think many Bogleheads) hold bonds to minimize risk of a major stock market downturn and the psychological impact of losing ~50% of one's portfolio "overnight", losing sleep, then panic selling, etc. With taxes, there's nowhere near that sort of risk.

But I get your overall point and I guess if someone is especially concerned about future tax rates increasing, paying more now could be like insurance incase tax laws do change significantly.
I agree that for all we debate Roth conversions, they're unlikely to make a huge difference in the total taxes (even including IRMAA, etc.) that most people pay, and whatever difference they do make will likely be dependent on future tax rates and/or personal filing status. For me at least the much, much bigger difference would have come by better balancing deferred, Roth, and taxable during the contribution years. Maximizing deferred account contributions was definitely not the optimal path for me.
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Re: Is Tax Diversification Overrated?

Post by GoneOnTilt »

I think tax diversification is underrated. I don't put all my money in tax free or tax deferred. I like having a percentage in taxable accounts, so I can do what I want/need, when I want/need to. I can't imagine it won't help me control taxes when I retire as well. We'll see I suppose.
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Re: Is Tax Diversification Overrated?

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ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
Not Overrated.

Perhaps you have seen the not to be discussed proposals that large tax advantaged accounts have and immediate 50% excess RMD. Talk about a tax torpedo!

Obviously, if you are certain current tax rate is 24% and future is 12%, then your strategy is sound.

Of course, if you are that certain of future events, I'd be happy to meet you local pony track and get both a ships set.

Another issue that tIRA have somewhat restrictive withdrawal rules, especially if you are in FI/RE crowd. 401K somewhat less so. Taxable no rules. Roth between.
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Re: Is Tax Diversification Overrated?

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GoneOnTilt wrote: Tue Sep 14, 2021 10:57 am I think tax diversification is underrated. I don't put all my money in tax free or tax deferred. I like having a percentage in taxable accounts, so I can do what I want/need, when I want/need to. I can't imagine it won't help me control taxes when I retire as well. We'll see I suppose.
Historically there's seemed to be an over-emphasis on maximizing deferred accounts and not much discussion of the potential downsides. I think that's because for many years contributions to tax-deferred were much more limited than now, so only now are larger numbers of people facing substantial RMDs. The increase in contribution limits, combined with an increasing emphasis on defined contribution vs. defined benefit employer plans, plus strong investment market performance over the last decade or so have created somewhat of a perfect storm for RMDs.
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Re: Is Tax Diversification Overrated?

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Juice3 wrote: Tue Sep 14, 2021 11:09 am Obviously, if you are certain current tax rate is 24% and future is 12%, then your strategy is sound.

Of course, if you are that certain of future events, I'd be happy to meet you local pony track and get both a ships set.
There is significant asymmetric risk in the tax-deferred vs. Roth issue, as discussed in this thread. The short explanation is that the implications of saving too much in tax-deferred are less bad than saving too much in Roth.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Is Tax Diversification Overrated?

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tibbitts wrote: Tue Sep 14, 2021 11:14 am
GoneOnTilt wrote: Tue Sep 14, 2021 10:57 am I think tax diversification is underrated. I don't put all my money in tax free or tax deferred. I like having a percentage in taxable accounts, so I can do what I want/need, when I want/need to. I can't imagine it won't help me control taxes when I retire as well. We'll see I suppose.
Historically there's seemed to be an over-emphasis on maximizing deferred accounts and not much discussion of the potential downsides. I think that's because for many years contributions to tax-deferred were much more limited than now, so only now are larger numbers of people facing substantial RMDs. The increase in contribution limits, combined with an increasing emphasis on defined contribution vs. defined benefit employer plans, plus strong investment market performance over the last decade or so have created somewhat of a perfect storm for RMDs.
If tax-deferred balances are so large that RMDs will create a genuine tax issue, then the individuals in question can retire earlier than they had originally planned, perhaps much earlier.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Is Tax Diversification Overrated?

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Based off other locked threads, if something appears to be a loophole or of benefit only to some people take advantage of it while you can but don't assume it will be there forever. I'd say the same would apply to people who were making assumptions about SALT deductions and Stretch IRAs before 2017 TJCA.
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Re: Is Tax Diversification Overrated?

Post by IowaFarmBoy »

If your assumption is that you are 24% now and will only be 12% in retirement is correct, you strategy is sound.

One consideration that I don't think has been mentioned yet is that if you are currently filing as married, it is unfortunately likely that either you or your spouse will be filing as single at some point in the future, probably when RMDs have kicked in. This will likely increase your marginal rate- maybe not beyond the 24% your currently pay but it would likely go up.
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Re: Is Tax Diversification Overrated?

Post by SGM »

Up until 2010 when Roth conversions were allowed regardless of income I had only tax deferred or taxable. accounts. I filled up tax deferred accounts first then taxable. In 2010 I began making Roth conversions. I now have only taxable and Roth accounts. I considered keeping some tax deferred accounts for donations, but DW was against it. Now I do donations from taxable accounts using stock or stock funds with large capital gains. We set up a charitable donation account. I am okay with that as I don't really want to pay all those capital gains taxes. I would rather have larger Roth accounts than have some left in tax deferred accounts.
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

IowaFarmBoy wrote: Tue Sep 14, 2021 11:30 am If your assumption is that you are 24% now and will only be 12% in retirement is correct, you strategy is sound.

One consideration that I don't think has been mentioned yet is that if you are currently filing as married, it is unfortunately likely that either you or your spouse will be filing as single at some point in the future, probably when RMDs have kicked in. This will likely increase your marginal rate- maybe not beyond the 24% your currently pay but it would likely go up.
The 'surviving spouse is thrust into a higher tax bracket due to RMDs' problem is real, but as you note, that alone is unlikely to make it worthwhile to make Roth contributions in lieu of tax-deferred for those currently in the 24% bracket but in the 12% bracket during retirement. About the worst case scenario there is that the surviving spouse would be in the 22% bracket, though SS benefits also impact this.

Doing Roth conversions to the top of the 12% bracket in retirement is usually a very good move.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

Juice3 wrote: Tue Sep 14, 2021 11:09 am
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
Not Overrated.

Perhaps you have seen the not to be discussed proposals that large tax advantaged accounts have and immediate 50% excess RMD. Talk about a tax torpedo!

Obviously, if you are certain current tax rate is 24% and future is 12%, then your strategy is sound.

Of course, if you are that certain of future events, I'd be happy to meet you local pony track and get both a ships set.

Another issue that tIRA have somewhat restrictive withdrawal rules, especially if you are in FI/RE crowd. 401K somewhat less so. Taxable no rules. Roth between.
That's why I said "figured" and "about 12%". Obviously I don't know the exact amount and unfortunately can't predict horse winners either :wink:

If I decide to FIRE, I would have access to a 457, 72t, or could set up a Roth ladder. So not really a concern and I don't plan to pay any early withdrawal 10% penalty but even if I had to, I might still come out ahead than a taxable or Roth.
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

willthrill81 wrote: Tue Sep 14, 2021 11:36 am
IowaFarmBoy wrote: Tue Sep 14, 2021 11:30 am If your assumption is that you are 24% now and will only be 12% in retirement is correct, you strategy is sound.

One consideration that I don't think has been mentioned yet is that if you are currently filing as married, it is unfortunately likely that either you or your spouse will be filing as single at some point in the future, probably when RMDs have kicked in. This will likely increase your marginal rate- maybe not beyond the 24% your currently pay but it would likely go up.
The 'surviving spouse is thrust into a higher tax bracket due to RMDs' problem is real, but as you note, that alone is unlikely to make it worthwhile to make Roth contributions in lieu of tax-deferred for those currently in the 24% bracket but in the 12% bracket during retirement. About the worst case scenario there is that the surviving spouse would be in the 22% bracket, though SS benefits also impact this.

Doing Roth conversions to the top of the 12% bracket in retirement is usually a very good move.
Good point about the surving spouse and RMDs. A few years ago I had started this post and there was some great info about them - viewtopic.php?f=2&t=276183

The 12% bracket is where I'm torn between Roth and traditional. I realize there's a lot of factors, but would you go Roth if your state income tax rate was going to drop by 1.26% over the next few years?

I'm starting to lean a bit more towards Roth, at least if in the 12% bracket.
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

ThankYouJack wrote: Tue Sep 14, 2021 12:27 pm
willthrill81 wrote: Tue Sep 14, 2021 11:36 am
IowaFarmBoy wrote: Tue Sep 14, 2021 11:30 am If your assumption is that you are 24% now and will only be 12% in retirement is correct, you strategy is sound.

One consideration that I don't think has been mentioned yet is that if you are currently filing as married, it is unfortunately likely that either you or your spouse will be filing as single at some point in the future, probably when RMDs have kicked in. This will likely increase your marginal rate- maybe not beyond the 24% your currently pay but it would likely go up.
The 'surviving spouse is thrust into a higher tax bracket due to RMDs' problem is real, but as you note, that alone is unlikely to make it worthwhile to make Roth contributions in lieu of tax-deferred for those currently in the 24% bracket but in the 12% bracket during retirement. About the worst case scenario there is that the surviving spouse would be in the 22% bracket, though SS benefits also impact this.

Doing Roth conversions to the top of the 12% bracket in retirement is usually a very good move.
Good point about the surving spouse and RMDs. A few years ago I had started this post and there was some great info about them - viewtopic.php?f=2&t=276183

The 12% bracket is where I'm torn between Roth and traditional. I realize there's a lot of factors, but would you go Roth if your state income tax rate was going to drop by 1.26% over the next few years?

I'm starting to lean a bit more towards Roth, at least if in the 12% bracket.
Once SS benefits begin, it can be very difficult to remain in the 12% bracket. As noted on this Wiki page, $30k of SS benefits and $24k of other taxable income is enough to put a MFJ couple into a 15% marginal tax rate. For a single filer, $30k of SS benefits and $14k of other taxable income is enough to move into the 15% marginal tax rate. Note that these marginal rates can be as high as 40.7%, and the thresholds for increasing marginal rates go up every year because this is not all adjusted for inflation.

Consequently, unless one is planning on retiring early enough to convert tax-deferred assets into Roth using the standard deduction, there isn't much reason not to do Roth contributions and conversions in the 12% bracket.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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