Hedging tomorrow's tax rates

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samsdad
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Hedging tomorrow's tax rates

Post by samsdad » Mon Oct 22, 2018 3:30 pm

So I was doing online calculators figuring what our future marginal tax bracket would have to be for us to break even on using tax-deferred vehicles such as a tIRA or 401k vs. sticking it in a brokerage account and ponying up on taxes today.

For our savings rate and assuming 20 years of savings, and assuming our current bracket at 22% MFJ, our future selves would have to be taxed at just over a 36% marginal bracket in order for to start losing money by using tax-deferred investing. So, I thought, "Huh! There's no way that I'd be taxed at a 36% marginal bracket MFJ. That's quite a jump in income and tax!" Then I remembered that people have said the tax brackets from 30-40 years ago were much higher, and they're not kidding. I never stopped to look, but I just did and it was quite eye-watering: https://files.taxfoundation.org/legacy/ ... ominal.pdf

Yes, I know that inflation, etc. needs to figure into going through backwards-looking charts like this. So, I used the CPI Inflation Calculator https://data.bls.gov/cgi-bin/cpicalc.pl ... ar2=201809, and after some fiddling, I found out that $20,000 in January 1964 dollars has the purchasing power of about $163,000 today. Today's MFJ couples can make up to $165k and still be in the 22% marginal tax bracket. In 1964, if you made up to that much in yesteryear's dollars ($20,000), you'd have been in the 30.5% marginal bracket. Jumping forward to the groovy year of 1974, earning $30,000 would get you approx. the equivalent of $162,500 in todays dollars, but unfortunately, you'd be paying 39% to THE MAN.

So, with this in mind, I started wondering if the mantra espoused around here about always stuffing tax-deferred accounts first and putting any money into taxable with you last dollars you found in the couch makes any sense.

The three-fund portfolio is championed around here as being a great long-term hedge what with its mix of US and international equities and a solid chunk of bonds. People who are 100% equities (or worse, 100% US equities such as yours truly) are considered to have a much riskier portfolio. Conversely, people who have 50% or greater in bonds are rarely chastised for being running the risk of not keeping up with the silent thief of inflation.

Yet I rarely see anyone advocate for a 50/50 mix of investing in tax-deferred/tax-advantaged and taxable. It seems the only drumbeat I hear is about filling traditional IRAs/401ks first, and perhaps, only. Given the historical tax rates, and the possibilities of going back to those levels in the future, my question is why? Wouldn't it make sense to hedge and do a 50/50 mix?

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Artsdoctor
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Re: Hedging tomorrow's tax rates

Post by Artsdoctor » Mon Oct 22, 2018 3:36 pm

I think that the general concept in investing would be to make the best decisions based on today's tax code and not to try and predict future tax law. That doesn't mean that you'd invest blindly without regard to taxes, but it's just too difficult to predict future taxes.

All of that said, you'd do well to do whatever you can to try and invest in a Roth since your current marginal tax rate is relatively low. Obviously, you'd also want to invest in any retirement plan that your employer would match as your first step. If your employer offers a Roth 401k, so much the better.

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vineviz
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Re: Hedging tomorrow's tax rates

Post by vineviz » Mon Oct 22, 2018 3:49 pm

samsdad wrote:
Mon Oct 22, 2018 3:30 pm
So, with this in mind, I started wondering if the mantra espoused around here about always stuffing tax-deferred accounts first and putting any money into taxable with you last dollars you found in the couch makes any sense.
First, the premise: are you SURE that's the mantra here? I found over 7,500 references to the backdoor Roth on this site, and that's not a tax-deferred savings vehicle.
samsdad wrote:
Mon Oct 22, 2018 3:30 pm
Yet I rarely see anyone advocate for a 50/50 mix of investing in tax-deferred/tax-advantaged and taxable. It seems the only drumbeat I hear is about filling traditional IRAs/401ks first, and perhaps, only. Given the historical tax rates, and the possibilities of going back to those levels in the future, my question is why? Wouldn't it make sense to hedge and do a 50/50 mix?
Second, what makes a 50/50 mix of taxable/tax-deferred a better "hedge" than some other ratio (say, 25/75 or 67/33)? Good advice requires some objective and empirical grounding, and I'm not sure how you'd get that on this topic.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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ray.james
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Re: Hedging tomorrow's tax rates

Post by ray.james » Mon Oct 22, 2018 4:11 pm

I have thought about it a few times over the years. There are indeed cut off points of wealth, where this can happen. A very simplified analysis in my view:

Assumptions
1) Social security at FRA
2) probable retirement at 55-60
3) State tax rate at 5%(I live in Ca and used 9.) Most states have state income tax.
4) 1 of spouse always has work, other spouse 50% of time.

Social security will fill up to 50K of the brackets. The next 75-100k is probably either lower or at the same marginal bracket. So in my view 100K at 4% SWR is 2.5 million. There is a possibility of not able to use joint filing at later stages and to counter that, there might be early withdrawal during early retirement.
So I ended up with 1.25 million at 45 in tax deferred accounts as my critical number. If I hit that number before 45, I will reduce/reevaluate based on the tax rates, social security and other things at that time.

I did do a lot more complex analysis like job losses, 2 people working all the time, 401k matches, possible income growth but it is just a variant of above things. It added complexity but no clarity or anything more helpful. I think having a target tax Yellow /orange line numbers in mind half-way through earnings years is a good strategy. So I will evaluate at 45 :)
When in doubt, http://www.bogleheads.org/forum/viewtopic.php?f=1&t=79939

samsdad
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Re: Hedging tomorrow's tax rates

Post by samsdad » Mon Oct 22, 2018 5:23 pm

Perhaps I was imprecise in my wording, but backdoor Roth’s certainly have presumed tax advantages, else why go through the headache?

As for the 50/50 mix, I’d argue that that’s about as good as a guess about the future regarding tax rates as you’re gonna ever get: they’re probably going to be higher or lower than your current rate; you probably have a 50% chance of being right. Though idly speculating about the future and future legislation is of course frowned upon around here. That said, looking backwards, it appears that our current tax rates are fairly low historically, and can reach stratospheric levels pretty quickly, compare 1916’s rates to 1917; 1931 and 1932; 1940 and 1941.

Startled Cat
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Re: Hedging tomorrow's tax rates

Post by Startled Cat » Mon Oct 22, 2018 7:02 pm

samsdad wrote:
Mon Oct 22, 2018 3:30 pm
So I was doing online calculators figuring what our future marginal tax bracket would have to be for us to break even on using tax-deferred vehicles such as a tIRA or 401k vs. sticking it in a brokerage account and ponying up on taxes today.
This premise doesn't seem right. The taxable scenario also involves the possibility of paying capital gains taxes in the future. Those rates could hypothetically be much higher going forward. I don't see how foregoing tax-deferred investing hedges the possibility of higher tax rates.

megabad
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Re: Hedging tomorrow's tax rates

Post by megabad » Mon Oct 22, 2018 7:31 pm

samsdad wrote:
Mon Oct 22, 2018 3:30 pm
So I was doing online calculators figuring what our future marginal tax bracket would have to be for us to break even on using tax-deferred vehicles such as a tIRA or 401k vs. sticking it in a brokerage account and ponying up on taxes today.

For our savings rate and assuming 20 years of savings, and assuming our current bracket at 22% MFJ, our future selves would have to be taxed at just over a 36% marginal bracket in order for to start losing money by using tax-deferred investing. So, I thought, "Huh! There's no way that I'd be taxed at a 36% marginal bracket MFJ. That's quite a jump in income and tax!" Then I remembered that people have said the tax brackets from 30-40 years ago were much higher, and they're not kidding. I never stopped to look, but I just did and it was quite eye-watering: https://files.taxfoundation.org/legacy/ ... ominal.pdf

Yes, I know that inflation, etc. needs to figure into going through backwards-looking charts like this. So, I used the CPI Inflation Calculator https://data.bls.gov/cgi-bin/cpicalc.pl ... ar2=201809, and after some fiddling, I found out that $20,000 in January 1964 dollars has the purchasing power of about $163,000 today. Today's MFJ couples can make up to $165k and still be in the 22% marginal tax bracket. In 1964, if you made up to that much in yesteryear's dollars ($20,000), you'd have been in the 30.5% marginal bracket. Jumping forward to the groovy year of 1974, earning $30,000 would get you approx. the equivalent of $162,500 in todays dollars, but unfortunately, you'd be paying 39% to THE MAN.

So, with this in mind, I started wondering if the mantra espoused around here about always stuffing tax-deferred accounts first and putting any money into taxable with you last dollars you found in the couch makes any sense.

The three-fund portfolio is championed around here as being a great long-term hedge what with its mix of US and international equities and a solid chunk of bonds. People who are 100% equities (or worse, 100% US equities such as yours truly) are considered to have a much riskier portfolio. Conversely, people who have 50% or greater in bonds are rarely chastised for being running the risk of not keeping up with the silent thief of inflation.

Yet I rarely see anyone advocate for a 50/50 mix of investing in tax-deferred/tax-advantaged and taxable. It seems the only drumbeat I hear is about filling traditional IRAs/401ks first, and perhaps, only. Given the historical tax rates, and the possibilities of going back to those levels in the future, my question is why? Wouldn't it make sense to hedge and do a 50/50 mix?
I agree with Startled Cat in that I don't understand the comparison between a taxable brokerage account and a tax advantaged retirement account as in almost all cases the taxable account will come out worse off by design (at least not better off).

Instead, I assume this is an attempt to compare Roth to Traditional. This is an age old topic, and I generally agree that diversity is key with taxes as it is with other elements of your portfolio. Allowable deductions and credits have changed over the years to the point that I am unable to analyze true effective and marginal tax rates anymore using historical info. Huge differences in depreciation, capital gains, business income have resulted in massive swings in taxes paid over the years and I think it is likely that these elements change in the future in some way.

I think I agree with the above poster that I can't tell if 50/50 is the right split, 25/75, 100/0 or anything in between. In my opinion, the best guess is determined by predicting your future tax rate based on today's tax code. This may or may not be 50/50. I am fairly confident that this will not provide the perfect split between Roth and Traditional, but it utilizes the only information I have available at this time pertaining to taxes.

ralph124cf
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Re: Hedging tomorrow's tax rates

Post by ralph124cf » Mon Oct 22, 2018 9:08 pm

When trying to analyze a question like this, I like to examine the margins.

SUPPOSE you have the earnings to contribute to either a tax deferred plan or a ROTH, BUT you do not have the cash to do so. Suppose you borrow $10,000 at 4% interest. You can use the money for ROTH, tax deferred, or a taxable account

You can invest the $10,000 in stock XYZ in ROTH, tax deferred, or in a taxable account. XYZ doubles in two years. You sell the stock for $20,000.

Assuming you are old enough, you can then pull the $20,000 out. For the ROTH, you would pay back the $10,000 loan, plus the $800 interest (ignoring compounding) and have $9,200 to spend. No taxes are due.

For the tax deferred, you would have to pay back the loan plus the interest, again leaving $9,200, but then you would owe taxes on the full $20,000 withdrawal. Assuming the 22% tax bracket, that would be $4,400. This $4,400 tax assumption needs to be reduced by the $2,200 tax savings for depositing the initial $10,000 into tax deferred (plus interest on the $2,200 for two years, which I choose not to include). This leaves $7,000 spendable. This clearly shows that the ROTH is superior to the tax deferred IF your time horizon is two years and you double your money in that time period.

If the return of the investment is negative, or below the prevailing interest rates, then tax deferred wins. Tax deferred generally wins if your tax rate in retirement is below your tax rate while working, something which is very hard to predict.

A taxable account is in the middle due to LTCG rates and the deductibility of investment interest (unless that changed this year?).

Ralph

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FiveK
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Re: Hedging tomorrow's tax rates

Post by FiveK » Mon Oct 22, 2018 9:41 pm

samsdad wrote:
Mon Oct 22, 2018 3:30 pm
For our savings rate and assuming 20 years of savings, and assuming our current bracket at 22% MFJ, our future selves would have to be taxed at just over a 36% marginal bracket in order for to start losing money by using tax-deferred investing.
...
So, with this in mind, I started wondering if the mantra espoused around here about always stuffing tax-deferred accounts first and putting any money into taxable with you last dollars you found in the couch makes any sense.
...
Yet I rarely see anyone advocate for a 50/50 mix of investing in tax-deferred/tax-advantaged and taxable. It seems the only drumbeat I hear is about filling traditional IRAs/401ks first, and perhaps, only. Given the historical tax rates, and the possibilities of going back to those levels in the future, my question is why? Wouldn't it make sense to hedge and do a 50/50 mix?
A 50/50 anything often has the feature that you can't be more than 50% wrong, so there is that.

If you have reason to believe you will be paying a much higher marginal rate in the future, using Roth instead of traditional (and instead of taxable) is your logical strategy.

The mantra of using tax-advantaged accounts before taxable remains a good one. It is however up to you to decide whether that advantage should be Traditional or Roth.

See the '401k vs Taxable' tab in the personal finance toolbox spreadsheet if you want to compare traditional vs. Roth vs. taxable on the same chart.

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willthrill81
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Re: Hedging tomorrow's tax rates

Post by willthrill81 » Mon Oct 22, 2018 9:45 pm

I too have thought about how to hedge against changing tax rates in the future. For myself, I've rather recently come across what I believe is an excellent solution.

I have a six figure rollover traditional IRA from an old employer's 401k plan. I have a large amount of tax-advantaged space, about $68k annually, and in two years, I should be able to max out all of it. Doing so will bring us down from the 22% bracket into the 12% bracket. My plan is to convert just enough of my rollover traditional IRA into my Roth IRA to bring us up to the top of the 12% bracket. This effectively trades tax-deferred space for Roth space, and it should work out that about the time the funds in the rollover IRA are exhausted, I'll retire. This will probably enable us to have roughly double the Roth assets in retirement that we would otherwise have by just making the standard $11k annual contributions. Given that we should still have plenty of tax-deferred assets to fill up the 10% bracket in retirement and probably most of the 12% bracket as well, I see no downside to this strategy unless tax rates fall even lower than they are now, which I very much doubt will happen when I'm in retirement.

To be honest, I'm really thinking that we won't need most of our Roth assets during retirement. Our daughter, and preferably her children or grandchildren, will probably inherit the bulk of it. And then when they pass on, the fifth generation will have an estate tax problem. :D
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Nate79
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Re: Hedging tomorrow's tax rates

Post by Nate79 » Mon Oct 22, 2018 10:26 pm

Tax law can change so many times over your career I don't find it useful to put too much thought into this area. I believe the lower tax brackets have been pretty consistently where they are today but the higher brackets have fluctuated significantly. What that tells me is that I feel I'm pretty safe to fill up to at least the 12% bracket in traditional accounts @4% SWR (MFJ tax filing) along with using Roth IRAs and taxable for additional investing after maxing our 401k. I would probably take it to the top of the 22% bracket but I have some time before then.

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UpsetRaptor
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Re: Hedging tomorrow's tax rates

Post by UpsetRaptor » Mon Oct 22, 2018 10:33 pm

The top marginal tax rate has steadily dropped since the 30s. Passing on tax deferral thinking taxes will go up has generally been a losing bet for almost a century now.

Startled Cat
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Re: Hedging tomorrow's tax rates

Post by Startled Cat » Tue Oct 23, 2018 1:14 am

I know it's akin to saying "let them eat cake", but since you mentioned 20 more years of savings, is it possible that over that time you'll increase your earnings enough to run out of tax-advantaged space and be forced to direct some of your savings to taxable accounts anyway? If that's a realistic possibility, you probably want to maximize tax-advantaged space right now while you can, even if you hope to end up with some balanced mix between tax-advantaged and taxable assets. In the same vein, keep in mind that there's no guarantee that contributions to retirement accounts will provide such generous tax deferral opportunities under future tax regimes.

k73
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Re: Hedging tomorrow's tax rates

Post by k73 » Tue Oct 23, 2018 6:21 am

This is something I've been trying to wrap my head around. I'm having a real hangup with RMDs. I think taxes are fairly friendly right now, compared to the past. Also, in my phase of life, I have tax benefits which I will not have later (kids, mortgage interest, etc). It seems there would be thresholds where it makes more sense to use something other than a 401k. Even something like a normal taxable account, which would be (unknown future) LTCG rate while the 401k, with its RMDs, would be the (unknown future) income tax rate for the corresponding (unknown future) tax bracket. LTCG always seem to be viewed more favorably than income.

Since the future is unknown, using today's rates as a reference point, with some assumptions and simplifications. At one extreme, you withdraw an entire amount as soon as you retire. A 1M 401k versus a 800K taxable. You'll pay 35-40% income tax on the 401k withdrawal versus 15% on the taxable. You'll walk away with 600k-650k from the 401k and 680k from the taxable. On the other extreme end, you never withdraw any money except what the IRS says you must. Your heir will get the full taxable account, with a step up in cost basis which effectively wipes out any taxes due. The 401k will have RMDs putting you in the (current) 24% tax bracket some years, even though you don't want to take any money out. This ignores standard deductions, which seem more friendly towards LTCG than regular income. And the flexibility to withdraw what you want, versus what the IRS wants, that comes with a taxable account. Also recurring dividends, which can be minimized by investment choice. This also excludes techniques such as harvesting and roth rollovers.

It feels like this is something that would be thoroughly discussed, perhaps even with graphs/calculators, but I've not had much luck finding the info. Am I way off base here? Is this info out there somewhere already?

samsdad
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Re: Hedging tomorrow's tax rates

Post by samsdad » Tue Oct 23, 2018 8:02 am

Sorry about the confusion yesterday re taxable vs roth. It was a really long day already by the time I posted and I was wiped out mentally. Infant twins will do that to you. Yes, my point was who knows what the future tax regime is going to look like; why not hedge some between paying taxes now and paying later. Thanks

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UpsetRaptor
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Re: Hedging tomorrow's tax rates

Post by UpsetRaptor » Tue Oct 23, 2018 9:13 am

k73 wrote:
Tue Oct 23, 2018 6:21 am
This is something I've been trying to wrap my head around. I'm having a real hangup with RMDs. I think taxes are fairly friendly right now, compared to the past. Also, in my phase of life, I have tax benefits which I will not have later (kids, mortgage interest, etc). It seems there would be thresholds where it makes more sense to use something other than a 401k. Even something like a normal taxable account, which would be (unknown future) LTCG rate while the 401k, with its RMDs, would be the (unknown future) income tax rate for the corresponding (unknown future) tax bracket. LTCG always seem to be viewed more favorably than income.

Since the future is unknown, using today's rates as a reference point, with some assumptions and simplifications. At one extreme, you withdraw an entire amount as soon as you retire. A 1M 401k versus a 800K taxable. You'll pay 35-40% income tax on the 401k withdrawal versus 15% on the taxable. You'll walk away with 600k-650k from the 401k and 680k from the taxable. On the other extreme end, you never withdraw any money except what the IRS says you must. Your heir will get the full taxable account, with a step up in cost basis which effectively wipes out any taxes due. The 401k will have RMDs putting you in the (current) 24% tax bracket some years, even though you don't want to take any money out. This ignores standard deductions, which seem more friendly towards LTCG than regular income. And the flexibility to withdraw what you want, versus what the IRS wants, that comes with a taxable account. Also recurring dividends, which can be minimized by investment choice. This also excludes techniques such as harvesting and roth rollovers.

It feels like this is something that would be thoroughly discussed, perhaps even with graphs/calculators, but I've not had much luck finding the info. Am I way off base here? Is this info out there somewhere already?
Here's one example. Let's say you invest 1M in 401k (which you can't do because of limits, but just for argument sake, it's close to your #s). Let's say you're currently in the 22% tax bracket, with no state tax (indeed, fairly income-tax friendly right now, historically speaking), so alternatively with the same money you could invest $780K in taxable.

Over the next 15 years, both are invested in the same thing and earn the same rate of return, let's say 6%. Taxable will be .3% lower due to 2 * 15% div/cap gains tax.
401K: 1M, 6% over 15 years: 2.4M
Taxable: $780K, 5.7% over 15 yeas: 1.8M

If income tax rate is the same in the future, and the 401K withdrawal rate is 22%, the 401K is 2.4M - 22% = 1.9M after tax
Let's say LTCG tax is 15% on your 1M gains in taxable, 1.8M - 150K tax = 1.65M after tax

In this example, in order for the tax deferred not to come out ahead, the 401k withdrawals in the future would have to come out something along the lines of ~32% or so, or ~10% higher than your current income tax rate.

Also consider:
1) Most people have a lower income in retirement than their working years, so they're in a lower income tax bracket. Even if tax rates were to increase overall, that may not matter to you or this analysis, if your income is lower and coming out at a lower bracket in your retirement future.

2) Any analysis along these lines that would favor taxable would be based on the speculation that income tax rates would increase measurably in the future while long term cap gains tax rates do not. Outside of TCJA expiration, I do not see why one would assume this, but we can't talk future tax policy here.

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Re: Hedging tomorrow's tax rates

Post by Ping Pong » Tue Oct 23, 2018 9:48 am

OP mentions 165K of taxable retirement income. This is far above the norm. If you rerun your analysis with more normal numbers, I think the outcome would be different. Also, if you're saving enough so that you'll have 165K of taxable income in retirement (which means your income is higher than that due to deductions), you'll almost certainly have a large chunk of that in taxable, due to 401(k) limits. So your argument for 50/50 tax advantaged/taxable sort of takes care of itself at the required asset levels.

Ron Scott
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Re: Hedging tomorrow's tax rates

Post by Ron Scott » Tue Oct 23, 2018 10:10 am

Artsdoctor wrote:
Mon Oct 22, 2018 3:36 pm
I think that the general concept in investing would be to make the best decisions based on today's tax code and not to try and predict future tax law.
I think making the assumption that taxes will be higher in the future and Roth converting more aggressively now might be prudent.
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.

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Re: Hedging tomorrow's tax rates

Post by k73 » Tue Oct 23, 2018 10:26 am

UpsetRaptor wrote:
Tue Oct 23, 2018 9:13 am
Also consider:
1) Most people have a lower income in retirement than their working years, so they're in a lower income tax bracket. Even if tax rates were to increase overall, that may not matter to you or this analysis, if your income is lower and coming out at a lower bracket in your retirement future.

2) Any analysis along these lines that would favor taxable would be based on the speculation that income tax rates would increase measurably in the future while long term cap gains tax rates do not. Outside of TCJA expiration, I do not see why one would assume this, but we can't talk future tax policy here.
Lower income does not always mean lower effective tax rate. Things like tax credits, filing status, etc, can make current effective tax rates pretty low, especially if you're not a high wage earner. Also, if you are lucky enough to have your 401k do very well, it appears the RMDs once you reach 80+ years old could easily surpass pre-retirement income, especially if your retirement retirement plan was the 401k and/or you had a generous employer match.

I'm looking at current tax policy. I know that I will lose the mortgage interest deduction in the future as there is a point in the timeline of the mortgage where the interest falls low enough that it is no longer is beneficial for me to itemize and I'll take the standard deduction instead. I know that I will lose the child tax credit in the future as my kids get older. I know that, as the law currently sits, the TCJA will expire in the future - assuming otherwise is speculation. There's a very high probability that my spouse or I will outlive the other and have to file taxes as single (with a single std deduction) rather than our current married filing jointly status (with two std deductions). When I'm retired, I won't be making pre-tax 401k contributions that lower my current year tax burden. These aren't speculations. This is what I was thinking about as I read the original post - differences in today's tax situation versus future tax situation, both viewed under current tax policy. That said' it'd probably be wise to take steps to mitigate the possibility that future tax policy is going to be 'worse' than current - without attempting to speculate what it may be.

I'm looking at this like a spectrum. On one end, there's people who can't/won't/don't save for retirement or save little. Taxes most likely aren't going to be that big of a concern if you 'retire' and have 20k annual SS income and a 401k with $200k in it. On the other end of the spectrum are current high earners who are socking away lots for retirement, using every means they have to legally avoid/defer today's taxes as they're paying high tax rates - 20%, 30%, etc. Somewhere in the middle are people who aren't high earners, who currently pay low effective tax rates and will end up with low 7 figure retirement accounts (along with ~40k in annual SS income). RMDs seem like a time bomb for these people. They may need 65k to live on, get 40k of that from SS and the IRS is saying, you also have to take 100k out of your 401k as an RMD. That's a lot of extra income they don't need, but will have to pay taxes on.

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vineviz
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Re: Hedging tomorrow's tax rates

Post by vineviz » Tue Oct 23, 2018 10:33 am

Artsdoctor wrote:
Mon Oct 22, 2018 3:36 pm
I think that the general concept in investing would be to make the best decisions based on today's tax code and not to try and predict future tax law. That doesn't mean that you'd invest blindly without regard to taxes, but it's just too difficult to predict future taxes.
I agree with this, especially since the overall average federal tax rates have not historically changed very much over time. The average federal tax rate for the highest quintile of household income was 27.1% in 1979 and 26.7% in 2014. In the intervening years it was never lower than 23.6% and never higher than 27.8%.

In short, the best estimate for future tax rates is probably today's tax rates.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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willthrill81
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Re: Hedging tomorrow's tax rates

Post by willthrill81 » Tue Oct 23, 2018 12:20 pm

k73 wrote:
Tue Oct 23, 2018 10:26 am
UpsetRaptor wrote:
Tue Oct 23, 2018 9:13 am
Also consider:
1) Most people have a lower income in retirement than their working years, so they're in a lower income tax bracket. Even if tax rates were to increase overall, that may not matter to you or this analysis, if your income is lower and coming out at a lower bracket in your retirement future.

2) Any analysis along these lines that would favor taxable would be based on the speculation that income tax rates would increase measurably in the future while long term cap gains tax rates do not. Outside of TCJA expiration, I do not see why one would assume this, but we can't talk future tax policy here.
Lower income does not always mean lower effective tax rate. Things like tax credits, filing status, etc, can make current effective tax rates pretty low, especially if you're not a high wage earner. Also, if you are lucky enough to have your 401k do very well, it appears the RMDs once you reach 80+ years old could easily surpass pre-retirement income, especially if your retirement retirement plan was the 401k and/or you had a generous employer match.
On an inflation-adjusted basis, this is unlikely unless you were a 'super saver' with tax-deferred accounts. Yes, the percentage of the your tax-deferred assets that must be withdrawn increases over time, but since this cuts into the growth of your account and inflation reduces the value of those withdrawals, the inflation-adjusted value of RMDs doesn't necessarily increase much over time.

For instance, if you started with $1 million in a traditional IRA and experienced 5% average nominal growth, at 70.5 your RMD would be ~$36k (according to Schwab's calculator). By age 80, your RMD would be $57k, but if inflation was 2% over the prior ten years, the inflation-adjusted value of that RMD would be just $47.5k. By the time you reached age 90, your RMD would be $79k nominal or $53k inflation-adjusted. And that's assuming a lower than historical inflation rate. Your inflation-adjusted RMD if inflation averaged 3% would be just $44k at age 90. Even with additional income coming from other sources like Social Security, you'd likely need close to $2 million in tax-deferred accounts before RMDs alone might put you just into the 22% bracket in your late 80s. That's not much of a problem in my view.

What is generally the easiest and most effective means of dealing with this issue is to make Roth conversions before RMDs begin to reduce the size of your tax-deferred accounts. I will be doing this in a couple of years with a significant rollover traditional IRA and won't finish that one until I'm close to retirement. And I hope to have around 15 years to make additional Roth conversions to the top of the 12% bracket.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

not4me
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Re: Hedging tomorrow's tax rates

Post by not4me » Tue Oct 23, 2018 2:00 pm

There have been several threads around lately that (to me) get back to the same point & I think different folks have different circumstances. I do think that for some people bringing along taxable accounts makes sense. Is it 50/50? Well, for starters, I'd say look at employer match. That isn't always 50/50. But anything you are putting in that isn't matched may deserve looking at.

One of the main reasons I ever diversify is my inability to accurately predict the future. I don't know future tax policy, what life will throw at me, etc. But having some money in taxable also gives more flexibility in investment choices, tax management, liquidity, etc

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ray.james
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Re: Hedging tomorrow's tax rates

Post by ray.james » Tue Oct 23, 2018 2:15 pm

willthrill81 wrote:
Tue Oct 23, 2018 12:20 pm

On an inflation-adjusted basis, this is unlikely unless you were a 'super saver' with tax-deferred accounts. Yes, the percentage of the your tax-deferred assets that must be withdrawn increases over time, but since this cuts into the growth of your account and inflation reduces the value of those withdrawals, the inflation-adjusted value of RMDs doesn't necessarily increase much over time.

For instance, if you started with $1 million in a traditional IRA and experienced 5% average nominal growth, at 70.5 your RMD would be ~$36k (according to Schwab's calculator). By age 80, your RMD would be $57k, but if inflation was 2% over the prior ten years, the inflation-adjusted value of that RMD would be just $47.5k. By the time you reached age 90, your RMD would be $79k nominal or $53k inflation-adjusted. And that's assuming a lower than historical inflation rate. Your inflation-adjusted RMD if inflation averaged 3% would be just $44k at age 90. Even with additional income coming from other sources like Social Security, you'd likely need close to $2 million in tax-deferred accounts before RMDs alone might put you just into the 22% bracket in your late 80s. That's not much of a problem in my view.

What is generally the easiest and most effective means of dealing with this issue is to make Roth conversions before RMDs begin to reduce the size of your tax-deferred accounts. I will be doing this in a couple of years with a significant rollover traditional IRA and won't finish that one until I'm close to retirement. And I hope to have around 15 years to make additional Roth conversions to the top of the 12% bracket.
1 million is too low balance target for current 30 year old couple. 401k limits are almost 19K this year. Someone maxing 401k at current 19K limits with another 5 employer match . 25K contributions compounded at 7% over 25 years is 1.7 million.

The above assumes the person retires after 25 years, only one person contributes to 401k, inflation adjusted 7% return, 3% inflation which I think is the median case for most profession couples. For many, 2 million plus is easy to hit for dual income folks by the time they turn 60.
When in doubt, http://www.bogleheads.org/forum/viewtopic.php?f=1&t=79939

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Re: Hedging tomorrow's tax rates

Post by JackoC » Tue Oct 23, 2018 2:22 pm

Artsdoctor wrote:
Mon Oct 22, 2018 3:36 pm
I think that the general concept in investing would be to make the best decisions based on today's tax code and not to try and predict future tax law. That doesn't mean that you'd invest blindly without regard to taxes, but it's just too difficult to predict future taxes.
But 'today's tax code' is set to expire, many aspects, after 2027, and nominally go back to that it was before the recent tax bill. So for example people who aren't very old and considering the possibility of estate tax would use the old estate tax exemption (~5.5mi per person) for an expected date of death past 2027, not the new (interim) one (~11mil), according to 'today's tax code'. But I think it just points out though how difficult it is to predict. We basically agree on that. My only slight point of possible disagreement is whether current law (taken literally) is that much preferable a baseline to anything else. Without getting into the merits of any public policy, it would also be one thing if the issue were 'puppies are cute, yes or no?' Or seriously, public policies supported by a consensus, which there still are. And assuming those policies will remain as is, is more reasonable IMO than assuming high income people's taxes will stay at whatever they happen to be at a particular point along the political pendulum's swing.

On the comment about betting on higher tax rates being a losing bet for a century it was a bad bet for a long time but more like late WWII to the early 1990's. Betting in 1925 on a higher top marginal tax rate 20 years hence was a great bet. After a few years in early 90's with the lowest marginal rates since the 20's, when 'up' seemed the most likely direction, and turned out to be, it's been a mixed bet. Betting on sustained higher long term treasury rates was generally bad bet since the early 1980's, not that much shorter than betting on higher tax rates was after WWII, but that doesn't mean it always will be.

But as somebody else said, rates for lower incomes arguably have more natural stability. Although, there are also all kinds of quirky effective marginal rates further down. A remarkable one in a recent personal finance thread, the guy who makes $110-120 but has to a find a way to lower it to 64k with big retirement contributions to save 20k+ a year on health insurance cost. Without getting picky, legalistic or political about what's a 'tax' or not, that's a huge marginal increase in one's cost for income just above 64k due to a public policy one has essentially no control over (an umbrella category which includes taxes).

JackoC
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Re: Hedging tomorrow's tax rates

Post by JackoC » Tue Oct 23, 2018 2:27 pm

ray.james wrote:
Tue Oct 23, 2018 2:15 pm
willthrill81 wrote:
Tue Oct 23, 2018 12:20 pm

On an inflation-adjusted basis, this is unlikely unless you were a 'super saver' with tax-deferred accounts.

For instance, if you started with $1 million in a traditional IRA and experienced 5% average nominal growth, at 70.5 your RMD would be ~$36k (according to Schwab's calculator). By age 80, your RMD would be $57k, but if inflation was 2% over the prior ten years, the inflation-adjusted value of that RMD would be just $47.5k. By the time you reached age 90, your RMD would be $79k nominal or $53k inflation-adjusted. And that's assuming a lower than historical inflation rate. Your inflation-adjusted RMD if inflation averaged 3% would be just $44k at age 90. Even with additional income coming from other sources like Social Security, you'd likely need close to $2 million in tax-deferred accounts before RMDs alone might put you just into the 22% bracket in your late 80s. That's not much of a problem in my view.
1 million is too low balance target for current 30 year old couple. 401k limits are almost 19K this year. Someone maxing 401k at current 19K limits with another 5 employer match . 25K contributions compounded at 7% over 25 years is 1.7 million.
More pointless to actually argue about future returns than future tax rates, but 7% real return especially with any balance in bonds in the portfolio over time, good luck with that, IMO. :happy

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Re: Hedging tomorrow's tax rates

Post by willthrill81 » Tue Oct 23, 2018 4:13 pm

ray.james wrote:
Tue Oct 23, 2018 2:15 pm
willthrill81 wrote:
Tue Oct 23, 2018 12:20 pm

On an inflation-adjusted basis, this is unlikely unless you were a 'super saver' with tax-deferred accounts. Yes, the percentage of the your tax-deferred assets that must be withdrawn increases over time, but since this cuts into the growth of your account and inflation reduces the value of those withdrawals, the inflation-adjusted value of RMDs doesn't necessarily increase much over time.

For instance, if you started with $1 million in a traditional IRA and experienced 5% average nominal growth, at 70.5 your RMD would be ~$36k (according to Schwab's calculator). By age 80, your RMD would be $57k, but if inflation was 2% over the prior ten years, the inflation-adjusted value of that RMD would be just $47.5k. By the time you reached age 90, your RMD would be $79k nominal or $53k inflation-adjusted. And that's assuming a lower than historical inflation rate. Your inflation-adjusted RMD if inflation averaged 3% would be just $44k at age 90. Even with additional income coming from other sources like Social Security, you'd likely need close to $2 million in tax-deferred accounts before RMDs alone might put you just into the 22% bracket in your late 80s. That's not much of a problem in my view.

What is generally the easiest and most effective means of dealing with this issue is to make Roth conversions before RMDs begin to reduce the size of your tax-deferred accounts. I will be doing this in a couple of years with a significant rollover traditional IRA and won't finish that one until I'm close to retirement. And I hope to have around 15 years to make additional Roth conversions to the top of the 12% bracket.
1 million is too low balance target for current 30 year old couple. 401k limits are almost 19K this year. Someone maxing 401k at current 19K limits with another 5 employer match . 25K contributions compounded at 7% over 25 years is 1.7 million.

The above assumes the person retires after 25 years, only one person contributes to 401k, inflation adjusted 7% return, 3% inflation which I think is the median case for most profession couples. For many, 2 million plus is easy to hit for dual income folks by the time they turn 60.
My analysis was merely for illustrative purposes. Most people who are maxing out their 401k for most of their career are already in the 22% bracket, and RMDs from that 401k alone are very unlikely to every push them above that bracket.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

fctu
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Re: Hedging tomorrow's tax rates

Post by fctu » Tue Oct 23, 2018 5:11 pm

I have been considering this same issue, but in regard to tax loss harvesting.

If the capital gains tax rate unexpectedly increases significantly, you could be worse off from your tax loss harvesting compared to if you had just left it alone.

curmudgeon
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Re: Hedging tomorrow's tax rates

Post by curmudgeon » Tue Oct 23, 2018 7:23 pm

fctu wrote:
Tue Oct 23, 2018 5:11 pm
I have been considering this same issue, but in regard to tax loss harvesting.

If the capital gains tax rate unexpectedly increases significantly, you could be worse off from your tax loss harvesting compared to if you had just left it alone.
I agree that current capital gains treatment is by no means locked in for the foreseeable future. Same goes for tax brackets, marginal rates, treatment of home sales gains, etc. On the other hand, if you are using your losses ($3K/year) against current ordinary income in upper brackets I suspect you come out ahead in most plausible scenarios. I'm somewhat diversified in my investment placements which gives some tax flexibility, but that's not always easy or practical to achieve.

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Re: Hedging tomorrow's tax rates

Post by JBTX » Tue Oct 23, 2018 8:01 pm

samsdad wrote:
Mon Oct 22, 2018 3:30 pm
So I was doing online calculators figuring what our future marginal tax bracket would have to be for us to break even on using tax-deferred vehicles such as a tIRA or 401k vs. sticking it in a brokerage account and ponying up on taxes today.

For our savings rate and assuming 20 years of savings, and assuming our current bracket at 22% MFJ, our future selves would have to be taxed at just over a 36% marginal bracket in order for to start losing money by using tax-deferred investing. So, I thought, "Huh! There's no way that I'd be taxed at a 36% marginal bracket MFJ. That's quite a jump in income and tax!" Then I remembered that people have said the tax brackets from 30-40 years ago were much higher, and they're not kidding. I never stopped to look, but I just did and it was quite eye-watering: https://files.taxfoundation.org/legacy/ ... ominal.pdf

Yes, I know that inflation, etc. needs to figure into going through backwards-looking charts like this. So, I used the CPI Inflation Calculator https://data.bls.gov/cgi-bin/cpicalc.pl ... ar2=201809, and after some fiddling, I found out that $20,000 in January 1964 dollars has the purchasing power of about $163,000 today. Today's MFJ couples can make up to $165k and still be in the 22% marginal tax bracket. In 1964, if you made up to that much in yesteryear's dollars ($20,000), you'd have been in the 30.5% marginal bracket. Jumping forward to the groovy year of 1974, earning $30,000 would get you approx. the equivalent of $162,500 in todays dollars, but unfortunately, you'd be paying 39% to THE MAN.

So, with this in mind, I started wondering if the mantra espoused around here about always stuffing tax-deferred accounts first and putting any money into taxable with you last dollars you found in the couch makes any sense.

The three-fund portfolio is championed around here as being a great long-term hedge what with its mix of US and international equities and a solid chunk of bonds. People who are 100% equities (or worse, 100% US equities such as yours truly) are considered to have a much riskier portfolio. Conversely, people who have 50% or greater in bonds are rarely chastised for being running the risk of not keeping up with the silent thief of inflation.

Yet I rarely see anyone advocate for a 50/50 mix of investing in tax-deferred/tax-advantaged and taxable. It seems the only drumbeat I hear is about filling traditional IRAs/401ks first, and perhaps, only. Given the historical tax rates, and the possibilities of going back to those levels in the future, my question is why? Wouldn't it make sense to hedge and do a 50/50 mix?
We will be in the ball park of 50/50 Roth/traditional. I did some Roth conversions decades ago and they have appreciated. Plus my Roths are more heavily weighted stocks vs traditional has relatively more bonds.

I'm not saying what I did was right or wrong, it is just what we did. The stock market was down, and it just seemed like tax rates would eventually go up (and they actually went down)

Overall I agree having some diversification between traditional and Roth is beneficial. Plus there are other benefits of Roth in terms of future flexibility.

While I don't know what percent of posters advocates what here, I agree the conventional wisdom here is for most to stuff as much as they can in traditional, and then Roth to the extent that is what you have left. It is a perfectly reasonable strategy, but it is based upon some assumptions. The assumptions are just assumed to be understood by all, but in reality they arent fully understood by everybody or arent applicable to everybody.

In general I see the assumptions as:

1. You will save a lot, and retire many years (10+) before drawing SS. For a married couple, either they both retire early, or the spouse was non working spouse in the first place.

2. You will have no or very little earned income in your pre ss retirement

3. You will do Roth conversions and recognize capital gains during those years.

4. You will have no pensions or other non retirement income, other than your investments.

5. You will be able to manage the Roth conversions and capital gains realization such that they don't increase your marginal rate and you are able to stack them efficiently

6. You will not rely on ACA subsidies, because their phase out increases your marginal rate significantly.

7. During your accumulation years, when you choose tax deferred, you ALWAYS put the tax savings either iadditional traditional, a Roth or a taxable account, and you keep those funds invested until retirement, and you invest them like retirement funds (ie you don't spend it, you don't buy a bigger house or cars or boats or planes, and you don't slug it into a big fat cash emergency reserve)

8. Once drawing SS, you wont be heavily impacted by "the hump" due to taxability of SS income.

9. Income taxes will not go up significantly in the future.

10. You don't get divorced and forced into higher single tax rates.


I am sure many here will navigate those assumptions efficiently. But it would only take a couple to go south and the traditional advantage may largely be lost.

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Re: Hedging tomorrow's tax rates

Post by FoolMeOnce » Tue Oct 23, 2018 8:13 pm

ralph124cf wrote:
Mon Oct 22, 2018 9:08 pm
When trying to analyze a question like this, I like to examine the margins.

SUPPOSE you have the earnings to contribute to either a tax deferred plan or a ROTH, BUT you do not have the cash to do so. Suppose you borrow $10,000 at 4% interest. You can use the money for ROTH, tax deferred, or a taxable account

You can invest the $10,000 in stock XYZ in ROTH, tax deferred, or in a taxable account. XYZ doubles in two years. You sell the stock for $20,000.

Assuming you are old enough, you can then pull the $20,000 out. For the ROTH, you would pay back the $10,000 loan, plus the $800 interest (ignoring compounding) and have $9,200 to spend. No taxes are due.

For the tax deferred, you would have to pay back the loan plus the interest, again leaving $9,200, but then you would owe taxes on the full $20,000 withdrawal. Assuming the 22% tax bracket, that would be $4,400. This $4,400 tax assumption needs to be reduced by the $2,200 tax savings for depositing the initial $10,000 into tax deferred (plus interest on the $2,200 for two years, which I choose not to include). This leaves $7,000 spendable. This clearly shows that the ROTH is superior to the tax deferred IF your time horizon is two years and you double your money in that time period.

If the return of the investment is negative, or below the prevailing interest rates, then tax deferred wins. Tax deferred generally wins if your tax rate in retirement is below your tax rate while working, something which is very hard to predict.

A taxable account is in the middle due to LTCG rates and the deductibility of investment interest (unless that changed this year?).

Ralph
The bolded part makes your analysis meaningless. You should also assume that extra $2,200 you saved by putting the $10K in tax-deferred is invested in taxable and doubles just like the other investments to compare apples to apples. You end up with equal amounts in the end regardless of whichever retirement account you used. (Then you can get more complex and add some tax drag into the taxable calculation)

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FiveK
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Re: Hedging tomorrow's tax rates

Post by FiveK » Tue Oct 23, 2018 8:33 pm

FoolMeOnce wrote:
Tue Oct 23, 2018 8:13 pm
The bolded part makes your analysis meaningless. You should also assume that extra $2,200 you saved by putting the $10K in tax-deferred is invested in taxable and doubles just like the other investments to compare apples to apples. You end up with equal amounts in the end regardless of whichever retirement account you used. (Then you can get more complex and add some tax drag into the taxable calculation)
+1

It's even worse than ignoring $2200: $10K after tax is the same as $10K/(1-0.22)=$12820.51 pre-tax. The "end up with equal amounts" is still correct.

One can review the commutative property of multiplication and Maxing out your retirement accounts for more on the simple and complex situations.

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Re: Hedging tomorrow's tax rates

Post by bmelikia » Tue Oct 23, 2018 8:35 pm

I like the "guarantee" that I have zero tax liability on the money I have placed in Roth IRA and Roth 401k accounts - it is worth the "guarantee" for me to not have to play the guessing game of "I wonder what tax rates are going to be in the future. . ."

At least it will minimize my concerns over what future tax rates will be. I put the word "guarantee" in quotes because since the future is unknown - who knows, maybe they will tax the Roth accounts either directly or indirectly once the time comes. . .

I'm about to turn 34 so I have about 25-26 years left until I find out - that's also me assuming I'll be alive to find out!
"I would rather die with money, than live without it...." - Bogleheads member Ron | | "The greatest enemy of a good plan, is the dream of a perfect plan." | -Bogle

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Re: Hedging tomorrow's tax rates

Post by Artsdoctor » Wed Oct 24, 2018 1:16 pm

There will always be a benefit of making investment portfolio moves when one is younger than when one is older; if you're younger, you have time on your side. All things being equal, a younger investor will most likely (not always) benefit from a Roth over a tax-deferred account. The older the investor is, the less clear-cut the advantage will be. There is really no possible way to anticipate tax rates in the future, even if there's a threat of everything reverting back in 2027 (that's an eternity in politics), so the best you can do is make decisions based on what's available now and in the short term.

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