Question on "Tax-adjusted asset allocation" wiki entry

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Name=Random
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Question on "Tax-adjusted asset allocation" wiki entry

Post by Name=Random » Mon May 28, 2018 12:24 am

The wiki entry Tax-adjusted_asset_allocation claims the following:
Roth conversions
You can evaluate a conversion of a traditional IRA to a Roth by its effect on your after-tax asset allocation. If you are in the same tax bracket now that you expect to be in at retirement, and you pay taxes on the conversion with IRA money (or with money you would have otherwise contributed to a 401(k) or IRA), the conversion is break-even. For example, if you are in a 25% tax bracket and convert a $40,000 IRA, you will have $30,000 in the Roth after paying taxes. Previously, you owned $30,000 of the IRA and the IRS owned the other $10,000; after conversion, you own the entire $30,000 in the Roth.

In contrast, if you pay the taxes with taxable money, you have a net gain, and it may even be worth making the conversion if you are going to be in a slightly lower tax bracket at retirement. If you are in a 28% tax bracket but expect to retire in a 25% tax bracket, and have $11,200 in a taxable account and $40,000 in an IRA, you own 75% of the IRA and probably about 75% of the taxable account, a total of $38,400. If you convert to a Roth, paying the taxes with the taxable $11,200, you will have a Roth worth $40,000.
The 1st paragraph in the above quote appears to make sense to me. The scenario described in the 2nd paragraph makes no sense to me. Can someone please clarify how paying taxes at a higher rate than you would have in retirement somehow leaves one better off?
Last edited by Name=Random on Mon May 28, 2018 5:21 pm, edited 2 times in total.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by FiveK » Mon May 28, 2018 2:07 am

Name=Random wrote:
Mon May 28, 2018 12:24 am
Can someone please clarify how paying taxes at a higher rate than you would have in retirement somehow leaves one better off?
It does say "slightly" higher. The reason is the tax drag of the taxable account, vs. the completely tax-free nature of Roth growth.

See Maxing out your retirement accounts for more.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Name=Random » Mon May 28, 2018 11:46 am

If you're right and the below quote from the wiki means that an advantage is obtained by paying an extra 3% in taxes now in the hope that over the life of the investment you make up those 3% in reduced tax drag than the wiki entry should state it. The way it's written now seems to claim that an immediate benefit is obtained. Do people agree with FiveK's interpretation or are we missing something and the wiki is referring to something else?
Name=Random wrote:
Mon May 28, 2018 12:24 am
In contrast, if you pay the taxes with taxable money, you have a net gain, and it may even be worth making the conversion if you are going to be in a slightly lower tax bracket at retirement. If you are in a 28% tax bracket but expect to retire in a 25% tax bracket, and have $11,200 in a taxable account and $40,000 in an IRA, you own 75% of the IRA and probably about 75% of the taxable account, a total of $38,400. If you convert to a Roth, paying the taxes with the taxable $11,200, you will have a Roth worth $40,000.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by LadyGeek » Mon May 28, 2018 1:21 pm

The way I read the 2nd paragraph:

================
Don't convert, pay taxes at the 25% marginal rate in retirement

Taxable = $11,200
IRA = $40,000

Taxable = $8,400 = $11,200 - (0.25) * $11,200 (which is 75% of $11,200)
IRA = $30,000 = $40,000 - (0.25) * $40,000 (which is 75% of $40,000)

After-tax total in retirement = $38,400

================
Pay to convert $40,000 IRA to a Roth IRA now using the taxable account:

Taxable = $11,200
Taxes to pay for Roth conversion = $11,200 = $40,000 * (0.28) * $40,000 (which is 28% of $40,000)
Remaining for retirement = $0

After-tax total in retirement = $40,000

Advantage to convert now = $1,600 = $40,000 - $38,4000

Bear in mind that the wiki is only showing you the math. The assumption of having a lower marginal tax rate in retirement can't be guaranteed.* For this reason, it's best to diversify and have funds in each account.

Also, see the disclaimer at the top of the page:
Adjusting your asset allocation based on taxation may have significant unintended consequences. Tax rates change, tax brackets change, or your tax preferences may change. What was a logical tax location one year may turn out to be a poor choice a few years later. Consider the implications carefully.
* An on-going discussion is here: Why do so many people quote "You will likely be in a lower tax bracket in retirement"
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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by FiveK » Mon May 28, 2018 1:35 pm

The "you own...probably about 75% of the taxable account" is probably not correct if the 75% is correct for the IRA, at least with current law regarding tax treatment of qualified dividends and capital gains.

Thus the wiki example could probably be improved, but the fact remains that any tax drag will make a taxable holding perform worse than a Roth holding.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by h8(N)++ » Mon May 28, 2018 1:49 pm

I understand 5K's point, but don't understand Lady Geek's reasoning. Why would one owe taxes on the taxable account in scenario 1 (25% of $11,200), but not owe any tax on the taxable account in scenario 2?

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by LadyGeek » Mon May 28, 2018 1:58 pm

I was only focusing on the math itself. Scenario 2 (only the Roth IRA remains) does not have taxes included because withdrawals from a Roth IRA are not taxed. You pay taxes on the money going into a Roth IRA. When it comes out, it's not taxed again.

Compare to a "traditional IRA" - You don't pay taxes on the money going into an IRA. You pay taxes when it comes out.

There are a ton of moving parts to figure out (future income, future tax bracket) that can't be predicted in advance. Hence, the many discussions on strategy.

The situation FiveK describes is reasonable, but not stated in the wiki.
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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Kevin M » Mon May 28, 2018 2:08 pm

I think the your share / government share paradigm works OK for IRAs, but I think what you're really concerned with in terms of asset allocation is your share of the risk (not the account value). This eliminates a lot of confusion in thinking about taxable accounts, and works for IRAs too.

If you know you will pay 30% in federal and state income tax on IRA distributions, then you are only taking 70% of the risk, and the governments are taking the other 30% of the risk. If account value goes up $100, you get $70 of that upon distribution, and if goes down by $100, you only lose $70 of that upon distribution. In this case, you can also think of it as owning 70% of the account, and that gains on that 70% are tax free.

For stocks in a taxable account, assuming you'll pay 20% in federal LTCG and state income tax on gains (or save 20% on losses), your share of the risk is 80%. If you gain $100 before taxes, you only gain $80 after taxes.

Since your AA is a balance of expected return and risk, and what really matters is your after-tax returns, it's rational to think about the after-tax risk, as illustrated above.

What part of the taxable account you "own" depends on unrealized gains, but your share of risk has nothing to do with unrealized gains, so IMO, it's simpler and more rational to think in terms of risk share rather than account share.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Name=Random » Mon May 28, 2018 3:07 pm

What everyone is saying mostly makes sense. I was just having trouble following the examples in the wiki.

Here is the issue I see with LadyGeek's math:
In conversion scenario, if you're paying the taxes on the conversion using the money from the taxable account and the assumption is that you only own 75% of the money in the taxable account, then you don't actually have enough money to pay the taxes on the conversion and extra money is being created.

Tax on conversion = 28% of 40,000 = 11,200
Money available in taxable account to pay for conversion = 75% of 11,200 = 8400
Extra money needed from outside source to pay for taxes on conversion = 11,200 - 8,400 = 2,800

I think the example in the wiki is assuming that you own 100% of the taxable balance if you do the conversion now, but if you wait till retirement you'll only own 75% of the taxable balance. Why is that a reasonable assumption?

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by triceratop » Mon May 28, 2018 3:09 pm

Kevin M wrote: If you know you will pay 30% in federal and state income tax on IRA distributions, then you are only taking 70% of the risk, and the governments are taking the other 30% of the risk. If account value goes up $100, you get $70 of that upon distribution, and if goes down by $100, you only lose $70 of that upon distribution. In this case, you can also think of it as owning 70% of the account, and that gains on that 70% are tax free.
While I know Kevin M knows this, I just want to add that this is only the first-order effect. The precise relationship is not fully linear: if you have massive gains in a (non-roth) IRA it will not be the case that you only took 70% of the risk and 70% of the gains because your RMDs may push you higher.

For a Roth of course you take 100% of the risk and 100% of the gains, which is why you get cases like these
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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by LadyGeek » Mon May 28, 2018 7:00 pm

Name=Random wrote:
Mon May 28, 2018 3:07 pm
What everyone is saying mostly makes sense. I was just having trouble following the examples in the wiki.

Here is the issue I see with LadyGeek's math:
In conversion scenario, if you're paying the taxes on the conversion using the money from the taxable account and the assumption is that you only own 75% of the money in the taxable account, then you don't actually have enough money to pay the taxes on the conversion and extra money is being created.

Tax on conversion = 28% of 40,000 = 11,200
Money available in taxable account to pay for conversion = 75% of 11,200 = 8400
Extra money needed from outside source to pay for taxes on conversion = 11,200 - 8,400 = 2,800

I think the example in the wiki is assuming that you own 100% of the taxable balance if you do the conversion now, but if you wait till retirement you'll only own 75% of the taxable balance. Why is that a reasonable assumption?
You ask a good question, but the answer can't be addressed in the wiki. Why? Because investing depends on each individual investor's own situation. It's not possible to give specific investing advice when writing a general article. The last thing we want to do is to give the wrong advice. So, we strike a balance between educating investors and not providing specific advice. We give you enough information to understand the topic and let you proceed on your own.

That being said, I honestly don't think any practical assumptions were made on 75%. It was simply a mathematical convenience to use round numbers. Notice that 28% of $40,000 is $11,200 - the exact amount in the taxable account.

Discussion of how to use the wiki is done here in the forum, where we can apply the guidance directly to your own situation.
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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Name=Random » Mon May 28, 2018 7:43 pm

I'm still unclear how one is going to pay a 11,200 tax bill on the conversion by using money from a taxable account. I understand the taxable account has 11,200 in it, but the scenario set up in the wiki states that only 75% of it is owned by you, because the rest is owned by some other entity (I assume taxes to the government).

My question in my previous post was why the analysis for the conversion assumed 100% of the 11,200 is available to pay taxes on the conversion, but assumed that, if one doesn't do the conversion, only 75% of the 11,200 taxable balance is available in retirement. To make things simple, lets say you retire tomorrow than the amount of the 11,200 taxable balance that is available to you to either pay for a Roth conversion or to withdraw should be the same (ignoring the possibility that the conversion bumps up your tax bracket).
LadyGeek wrote:
Mon May 28, 2018 1:21 pm
Pay to convert $40,000 IRA to a Roth IRA now using the taxable account:

Taxable = $11,200
Taxes to pay for Roth conversion = $11,200 = $40,000 * (0.28) * $40,000 (which is 28% of $40,000)
Remaining for retirement = $0

After-tax total in retirement = $40,000
It seems like above quoted math should say
Taxable = $11,200
Taxes to pay for Roth conversion = $11,200 = $40,000 * (0.28) * $40,000 (which is 28% of $40,000)
Remaining for retirement in taxable = (Amount that can be withdrawn from taxable) - (Tax on Roth conversion) = $11,200*.75 - $11,200 = -$2,800

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Kevin M » Mon May 28, 2018 8:33 pm

I will say it again: the problem is using the account ownership paradigm for taxable accounts, and I think the wording of this particular section of the Wiki article propagates confusion about this.

You are absolutely right: if you only own 75% of the $11,200, how can you use 100% of it to pay the taxes? I think you have identified a real problem with the way this particular part of the article is worded.

I think what the author was actually thinking about is that you have about 75% of the risk of the taxable account, so this might be the adjustment you use for tax-adjusted AA purposes. The reason that this is higher than the 85% (100% minus the 15% tax on LTCG) is because over many years, the tax drag on the dividends increases the adjustment factor. Forum member grabiner has done the math to show this (and I have done something similar to verify it), but it is fairly complicated to understand, and I still am not convinced it's a valid way to think about your risk share.

I do think it's misleading to think that you magically convert $38,400 to $40,000 by doing the Roth conversion, and that that part should be rewritten, unless grabiner or someone else can show us the math that supports it. I recommend that you PM grabiner to ask him to weigh in on this.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Name=Random » Mon May 28, 2018 9:06 pm

Thanks for the reply Kevin, i think you really followed what i was getting at. I took your advice and messaged Grabiner. The wiki entry piqued my interest because it seemed to suggest some bit of new financial magic that somehow allowed one to do a Roth conversion, while in a higher tax bracket than in retirement, and still benefit somehow. I'll accept that reduced tax drag may be a benefit of doing a conversion, but the way the wiki is worded makes it seem like there is something else going on and one immediately realizes some magic benefit. I'm beginning to think there is no magic here and the wording of the wiki entry is just misleading.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by grabiner » Mon May 28, 2018 9:52 pm

Name=Random wrote:
Mon May 28, 2018 3:07 pm
What everyone is saying mostly makes sense. I was just having trouble following the examples in the wiki.

Here is the issue I see with LadyGeek's math:
In conversion scenario, if you're paying the taxes on the conversion using the money from the taxable account and the assumption is that you only own 75% of the money in the taxable account, then you don't actually have enough money to pay the taxes on the conversion and extra money is being created.

Tax on conversion = 28% of 40,000 = 11,200
Money available in taxable account to pay for conversion = 75% of 11,200 = 8400
Extra money needed from outside source to pay for taxes on conversion = 11,200 - 8,400 = 2,800

I think the example in the wiki is assuming that you own 100% of the taxable balance if you do the conversion now, but if you wait till retirement you'll only own 75% of the taxable balance. Why is that a reasonable assumption?
If you have the money available in your taxable account, and use it to make a conversion, then you will lose nothing more to taxes; the money will all be in the Roth.

If you leave the money in your taxable account, you will pay taxes on dividends and capital gains, so you will get less than the full value.

Say you have $40,000 in a traditional account, $11,200 in a taxable account, and the market will grow eightfold before you withdraw the money. (The reason for assuming eightfold nominal growth is that this strategy only makes sense if you are a long way from retirement. If you are close to retirement, it is better to wait a few years to retire and convert at 25%, even if you must pay capital-gains tax, rather than converting at 28% now.)

If you convert, you have $40,000 in a Roth, which grows to $320,000. If you don't convert, you have $40,000 in a traditional account, which grows to $320,000, and that $320,000 is $240,000 after tax. In addition, the $11,200 will grow. It would grow to $89,600 tax-free. If it grows to $80,000 taxable (an 11% loss to taxes), you break even, but for this long a holding period, you expect a much higher tax bill unless you never sell and leave the stock to your heirs. If you lose 25% of the taxable account to taxes, the $11,200 grows to only $67,200, and you wind up slightly ahead if you get rid of the taxable account.

This is the same logic as maxing out a Roth when you are in a slightly higher tax bracket than you would be at retirement. You effectively tax-defer more money, which makes up for the tax cost.
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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Name=Random » Mon May 28, 2018 10:30 pm

What Grabiner described above is a Roth conversion that leads to reduced tax drag (0 taxes going forward for money in the Roth). Unless i'm missing something, the benefit described in the wiki paragraph in question has nothing to do with tax-adjusted asset allocation. The benefit stems from having more money in a Roth account vs. leaving it in a taxable account over the long term.

The paragraph from the wiki i'm talking about is this:
In contrast, if you pay the taxes with taxable money, you have a net gain, and it may even be worth making the conversion if you are going to be in a slightly lower tax bracket at retirement. If you are in a 28% tax bracket but expect to retire in a 25% tax bracket, and have $11,200 in a taxable account and $40,000 in an IRA, you own 75% of the IRA and probably about 75% of the taxable account, a total of $38,400. If you convert to a Roth, paying the taxes with the taxable $11,200, you will have a Roth worth $40,000.
Would it make sense to remove it from that wiki entry to avoid all this confusion or at least modify it to make it clear that the benefit comes from reduced tax drag. I'm not sure the paragraph makes any sense as is, since it doesn't talk about a scenario like Grabiner described above where the money has had time to grow 8 fold.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by grabiner » Mon May 28, 2018 11:26 pm

Name=Random wrote:
Mon May 28, 2018 10:30 pm
What Grabiner described above is a Roth conversion that leads to reduced tax drag (0 taxes going forward for money in the Roth). Unless i'm missing something, the benefit described in the wiki paragraph in question has nothing to do with tax-adjusted asset allocation. The benefit stems from having more money in a Roth account vs. leaving it in a taxable account over the long term.

The paragraph from the wiki i'm talking about is this:
In contrast, if you pay the taxes with taxable money, you have a net gain, and it may even be worth making the conversion if you are going to be in a slightly lower tax bracket at retirement. If you are in a 28% tax bracket but expect to retire in a 25% tax bracket, and have $11,200 in a taxable account and $40,000 in an IRA, you own 75% of the IRA and probably about 75% of the taxable account, a total of $38,400. If you convert to a Roth, paying the taxes with the taxable $11,200, you will have a Roth worth $40,000.
Would it make sense to remove it from that wiki entry to avoid all this confusion or at least modify it to make it clear that the benefit comes from reduced tax drag. I'm not sure the paragraph makes any sense as is, since it doesn't talk about a scenario like Grabiner described above where the money has had time to grow 8 fold.
The 8-fold is an example of why your $11,200 in a taxable account might only be worth $8400; if it loses 25% of its value to taxes, then it is as good as $11,200 tax-free. The break-even tax loss is 11% regardless of how much the account grows, but the actual tax loss depends on the amount of growth. The reason for the 8-fold in my example is that a 25% tax loss in a taxable account is only likely if the account grows considerably.
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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by Kevin M » Tue May 29, 2018 10:30 am

Nevertheless, the wording in the Wiki article does not make what grabiner is explaining here clear. It would be more clear if the wording was expanded to explain what grabiner is explaining here.

I think it would be even more clear to say something like, by paying the income tax with the $11,200 in taxable, you essentially move $11,200 from taxable into the Roth, where it can grow tax free for many years. Assuming x years of growth at y% per year, it would grow to n$ in the roth. Assuming total taxes paid of 25% if left in taxable, it would grow to only 75% of that value.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by tadamsmar » Tue May 29, 2018 1:27 pm

Looks to me like the math assumes a 25% future capital gains rate and no basis.

These assumptions are implied, but not stated. The stated assumption is a 25% tax bracket.

If you use the assumption of a 15% capital gains rate and some taxable dividends and some basis, then the math still slightly favors conversion if the current tax bracket is 25%. Not so sure about 28%.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by grabiner » Tue May 29, 2018 8:42 pm

tadamsmar wrote:
Tue May 29, 2018 1:27 pm
Looks to me like the math assumes a 25% future capital gains rate and no basis.
The 25% tax cost includes tax on dividends as well, not just capital gains. These can be more costly because of compounding.

For example, suppose you have a $10,000 investment, all basis, in a fund with a 2% dividend yield, all qualified; this is probably the best case. You hold the fund for 30 years, with an 8% pre-tax return which becomes 7.7% after tax. The fund would have been worth $100,627 tax-free, and is instead $92,570. Now, when you sell, 6%/7.7% of the $82,570 gain is taxed as a capital gain; the other 1.7%/7.7% is the after-tax dividend reinvestment. Thus your capital gain is $64,340, for a tax of $9651 and a final after-tax value of $82,919. In this example, you lost 18% of the fund's value and 20% of your gain to taxes, despite the tax rate of only 15%. Add occasional non-qualified dividends, higher yields, or tax phase-outs (for example, the child tax credit raising your marginal rate from 15% to 20% while you are working), and you can easily reach 25%.
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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by tadamsmar » Wed May 30, 2018 7:18 am

grabiner wrote:
Tue May 29, 2018 8:42 pm
tadamsmar wrote:
Tue May 29, 2018 1:27 pm
Looks to me like the math assumes a 25% future capital gains rate and no basis.
The 25% tax cost includes tax on dividends as well, not just capital gains. These can be more costly because of compounding.

For example, suppose you have a $10,000 investment, all basis, in a fund with a 2% dividend yield, all qualified; this is probably the best case. You hold the fund for 30 years, with an 8% pre-tax return which becomes 7.7% after tax. The fund would have been worth $100,627 tax-free, and is instead $92,570. Now, when you sell, 6%/7.7% of the $82,570 gain is taxed as a capital gain; the other 1.7%/7.7% is the after-tax dividend reinvestment. Thus your capital gain is $64,340, for a tax of $9651 and a final after-tax value of $82,919. In this example, you lost 18% of the fund's value and 20% of your gain to taxes, despite the tax rate of only 15%. Add occasional non-qualified dividends, higher yields, or tax phase-outs (for example, the child tax credit raising your marginal rate from 15% to 20% while you are working), and you can easily reach 25%.
Thanks. Isn't there an inflation effect that makes it even worse? I don't see that you factored that in, but maybe I don't fully understand your example.

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Re: Question on "Tax-adjusted asset allocation" wiki entry

Post by grabiner » Wed May 30, 2018 9:50 am

tadamsmar wrote:
Wed May 30, 2018 7:18 am
grabiner wrote:
Tue May 29, 2018 8:42 pm
tadamsmar wrote:
Tue May 29, 2018 1:27 pm
Looks to me like the math assumes a 25% future capital gains rate and no basis.
The 25% tax cost includes tax on dividends as well, not just capital gains. These can be more costly because of compounding.

For example, suppose you have a $10,000 investment, all basis, in a fund with a 2% dividend yield, all qualified; this is probably the best case. You hold the fund for 30 years, with an 8% pre-tax return which becomes 7.7% after tax. The fund would have been worth $100,627 tax-free, and is instead $92,570. Now, when you sell, 6%/7.7% of the $82,570 gain is taxed as a capital gain; the other 1.7%/7.7% is the after-tax dividend reinvestment. Thus your capital gain is $64,340, for a tax of $9651 and a final after-tax value of $82,919. In this example, you lost 18% of the fund's value and 20% of your gain to taxes, despite the tax rate of only 15%. Add occasional non-qualified dividends, higher yields, or tax phase-outs (for example, the child tax credit raising your marginal rate from 15% to 20% while you are working), and you can easily reach 25%.
Thanks. Isn't there an inflation effect that makes it even worse? I don't see that you factored that in, but maybe I don't fully understand your example.
Inflation affects all numbers equally. If prices double, the purchasing power of your Roth, traditional, and taxable account will all be halved.

The effect of inflation is significant only in that it increases the effective tax rate on your taxable account. If you hold stocks in a taxable account, you pay capital-gains tax on the entire growth in the stock value, even the part which only keeps up with inflation. If you hold bonds in a taxable account, getting the same return with high inflation implies higher yields, and thus a larger tax bill (or a larger spread between taxable and muni bonds if you use munis).

For stocks, this is a relatively small effect. In the example above, suppose that the stock returns were 11% instead of 8%, but inflation was 3% higher than you expected and thus the real tax-free returns were no better. The pre-tax value after 30 years would be $228,923, reduced to $211,071 by dividend taxes. There would be $25,369 tax due on the $169,125 capital gain, leaving you with $185,702. This would be a loss to taxes of 19% rather than 18%.

For bonds, the effect is much greater. If you are in a 25% tax bracket, then when bonds yield 3%, the tax cost is 0.75% per year; there would instead be the same 0.75% cost to avoid taxes if you buy munis yielding 2.25% instead. When bonds yield 6%, the tax cost is 1.5% per year, and munis are likely to yield 4.5%.
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