Is seeking tax shelter always right?

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jdsmith
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Is seeking tax shelter always right?

Post by jdsmith » Mon Apr 15, 2019 3:45 pm

Wife and I are 15-20 years from retirement. We are currently tax-sheltering at the highest possible rate: each maxing out our 403b's, 457's, Roth IRA's, plus a family HSA, not to mention the mandatory state retirement contributions from us+employer. This practice will soon require taking some funds from our taxable portfolio for living expenses. We maintain a 70/25/5 Stocks/Bonds/Real Estate portfolio, and rebalance with new inflow.

Right now 72% of our portfolio is in taxable accounts (at VG), and the other 28% is sheltered (mostly tax-deferred at TIAA/CREF + State Retirement System + IRAs at VG). Interestingly, our tax-sheltered fraction has actually dropped a few percent over the past few years, despite these heroic sheltering efforts. The reason for this is that we (approximately) follow the tax-efficiency principle of placing bond funds in sheltered accounts, stock index funds in taxable. So while we continue to sock money away into sheltered bonds, the stocks funds keep growing even faster. Obviously in a future downturn the sheltered fraction would increase rapidly as stocks fall.

My question is: theoretically, is there such a thing as an ideal tax-sheltered percentage? Assuming you don't need to spend anything until retirement, is it 100%? We are in the 22% tax bracket now (mostly due to all that sheltering). So we are saving taxes now, but may increase taxes on ourself in retirement with mandatory withdrawals.

As a general principle, is there such a thing as too much tax sheltering?

Lou354
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Re: Is seeking tax shelter always right?

Post by Lou354 » Mon Apr 15, 2019 3:56 pm

If your tax rate in retirement will be higher than now you may be overdoing it. Also taking funds from your taxable account for current living expenses is a taxable event that will cut into the tax savings you’re getting from some of the other things you’re doing.

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Re: Is seeking tax shelter always right?

Post by grabiner » Mon Apr 15, 2019 7:40 pm

Lou354 wrote:
Mon Apr 15, 2019 3:56 pm
If your tax rate in retirement will be higher than now you may be overdoing it.
But in that case, you can use a Roth account instead; convert traditional IRAs to Roth IRAs now, or after you retire. A Roth account clearly dominates a taxable account, since the tax on a Roth account is zero.

The one occasional situation in which a taxable account is better than a tax-sheltered account is when the tax-sheltered account has high expenses which outweigh the tax benefit. This can happen with some 403(b)s, as it is common for a teacher to spend 20 years stuck with the same plan, and if the expenses are over 1.5% for 20 years, a taxable account might be better. It's not an issue for the OP, who has TIAA-CREF.
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Re: Is seeking tax shelter always right?

Post by JBTX » Mon Apr 15, 2019 7:50 pm

In our case in our 50s approx 90% is in tax advantaged, maybe 60% traditional and 40% Roth. In almost all cases Roth will be as good or likely better than a taxable account.

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jdsmith
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Re: Is seeking tax shelter always right?

Post by jdsmith » Mon Apr 15, 2019 10:25 pm

Good thoughts, thanks all. Roths are obviously ideal but right now they represent only ~8% of our tax-advantaged contributions; the 403b/457/HSA tax-deferred vehicles are the bulk. So I should re-phrase the question: is seeking to maximize tax-deferred tax shelter always the best approach?

I do like the idea of converting IRAs or rollover IRAs to Roths tax-free in the low income years after retirement and before RMD's set in. Honestly it's a good argument to retire early by a few years and take advantage of those low-income years.

I agree that taking capital gains on appreciated taxable holdings for living expenses just to permit high levels of sheltering could be counter-productive, but of course you can minimize those gains and there is still a modest tax savings.

One simple thought experiment: hold the same bond fund for 20 years in a tax-deferred vs. taxable account. E.g. for a 3% yield, and a marginal tax rate of 24%, the principal grows by (1 + 3% * (1-24%))^20=1.57x, whereas the tax-deferred account grows to (1 + 3%)^20=1.81x, and is subsequently taxed at an effective tax rate of say, 15%, yielding 1.54x the starting balance. Repeat the experiment at 4% yield, however, and the tax-deferred strategy prevails.

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Re: Is seeking tax shelter always right?

Post by grabiner » Mon Apr 15, 2019 10:39 pm

jdsmith wrote:
Mon Apr 15, 2019 10:25 pm
One simple thought experiment: hold the same bond fund for 20 years in a tax-deferred vs. taxable account. E.g. for a 3% yield, and a marginal tax rate of 24%, the principal grows by (1 + 3% * (1-24%))^20=1.57x, whereas the tax-deferred account grows to (1 + 3%)^20=1.81x, and is subsequently taxed at an effective tax rate of say, 15%, yielding 1.54x the starting balance. Repeat the experiment at 4% yield, however, and the tax-deferred strategy prevails.
What you miss here is that you can't hold the same investment in both accounts. If you put $10,000 in a tax-deferred account, you only spent $7600 out of pocket, so your alternative is holding $7600 in a taxable account. Now the tax-deferred account comes out ahead regardless of interest rates.

It does sometimes happen that a taxable account is better than a non-deductible IRA. Here, you have to pay the full amount to invest in either one. Gains in the non-deductible IRA are tax-deferred, but if you hold stock in the taxable account, gains are mostly deferred there as well, and are taxed at lower rates. Therefore, stock in a taxable account is usually better than stock in a non-deductible IRA, but bonds in a non-deductible IRA are better than bonds in a taxable account.
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Re: Is seeking tax shelter always right?

Post by FiveK » Mon Apr 15, 2019 10:51 pm

jdsmith wrote:
Mon Apr 15, 2019 10:25 pm
One simple thought experiment: hold the same bond fund for 20 years in a tax-deferred vs. taxable account. E.g. for a 3% yield, and a marginal tax rate of 24%, the principal grows by (1 + 3% * (1-24%))^20=1.57x, whereas the tax-deferred account grows to (1 + 3%)^20=1.81x, and is subsequently taxed at an effective tax rate of say, 15%....
Did all other income cease when the bond fund was withdrawn? If not, the marginal rate applies there also.

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Re: Is seeking tax shelter always right?

Post by Beliavsky » Tue Apr 16, 2019 6:25 am

grabiner wrote:
Mon Apr 15, 2019 10:39 pm
bonds in a non-deductible IRA are better than bonds in a taxable account.
One should also compare taxable bonds in a non-deductible IRA to municipal bonds in a taxable account. I think the latter will often do better, but it depends on the investor's tax bracket, the time horizon, and the ratio of muncipal to taxable bond yields. As I wrote before, Muni bonds have done well even pre-tax.

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Re: Is seeking tax shelter always right?

Post by jdsmith » Tue Apr 16, 2019 11:20 pm

I think it's fair to compare an effective rate to a marginal rate as in retirement our incomes will have ceased, and we do not have SS (state employees). Ongoing dividends obviously complicate this. Very interesting points on municipals; we do hold some but I've been eager to shift all our bond portfolio to tax sheltered accounts; this reduces the urgency somewhat. In our case all the sheltering is deductible.

Grabiner, I agree that in the normal situation comparing pre- and post-tax holdings is apples to oranges, but in this case, we have two options:
  • Leave taxable investments where they are, using tax-exempt bonds as needed for the taxable portion to maintain AA.
  • By increasing tax-deferred sheltering to the maximum amount and living off of taxable sales, transfer investments from taxable to tax-deferred.
So in our case it seems to be more apples to apples, with the first approach leading to additional (e.g. dividend) income and associated taxes, and the 2nd approach leading to additional capital gains and associated taxes.

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Re: Is seeking tax shelter always right?

Post by FiveK » Tue Apr 16, 2019 11:34 pm

jdsmith wrote:
Tue Apr 16, 2019 11:20 pm
I think it's fair to compare an effective rate to a marginal rate as in retirement our incomes will have ceased, and we do not have SS (state employees).
That might be fair for your very first investment. Subsequent investments, however, are withdrawn in addition to what you could withdraw based on the first investment, so you will pay marginal rates for those.

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Re: Is seeking tax shelter always right?

Post by jdsmith » Wed Apr 17, 2019 7:51 am

FiveK wrote:
Tue Apr 16, 2019 11:34 pm
That might be fair for your very first investment. Subsequent investments, however, are withdrawn in addition to what you could withdraw based on the first investment, so you will pay marginal rates for those.
I suppose it depends on whether income in retirement is below or matches pre-retirement earnings. See, e.g., https://www.forbes.com/sites/financialf ... you-think/

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Re: Is seeking tax shelter always right?

Post by learning_head » Wed Apr 17, 2019 8:56 am

jdsmith wrote:
Tue Apr 16, 2019 11:20 pm
Grabiner, I agree that in the normal situation comparing pre- and post-tax holdings is apples to oranges, but in this case, we have two options:
  • Leave taxable investments where they are, using tax-exempt bonds as needed for the taxable portion to maintain AA.
  • By increasing tax-deferred sheltering to the maximum amount and living off of taxable sales, transfer investments from taxable to tax-deferred.
When you talk about maintaining AA, how do you compute it? For example, if you have $100k in 403b in bonds and $100k in taxable in stocks, is that 50/50 AA? Well, it depends on how these amounts will be taxed. Assuming you 403b will be taxed at 25% and taxable at say 3% (because only gains are taxed and you may have few gains relative to principal), then your real (after-tax) AA is quite far from 50/50. I know we have to guesstimate ultimate rates we will pay, but a guesstimate is better than effectively assuming your 403b account will be taxed at 0% or same as taxable.

When I compute my asset allocation (or net worth for that matter), I normally reduce tax-deferred balances by 25%, taxable by 10% (probably an overshot) and Roth is at 0%. That gives me a better view of my real AA.

Similarly 100k in muni-bonds is likely going to be greater than 100k in 403b taxable bonds if you plan to pay taxes on 403b money upon withdrawals.

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Re: Is seeking tax shelter always right?

Post by FiveK » Wed Apr 17, 2019 10:05 am

jdsmith wrote:
Wed Apr 17, 2019 7:51 am
FiveK wrote:
Tue Apr 16, 2019 11:34 pm
That might be fair for your very first investment. Subsequent investments, however, are withdrawn in addition to what you could withdraw based on the first investment, so you will pay marginal rates for those.
I suppose it depends on whether income in retirement is below or matches pre-retirement earnings. See, e.g., https://www.forbes.com/sites/financialf ... you-think/
Pretty much, and for many the marginal rate on withdrawals will be less than on contributions, favoring traditional in a traditional vs. Roth decision.

The Forbes article is, however, not correct when it suggests using effective rate on withdrawals for the trad vs. Roth choice. That makes traditional look better than it is. See Traditional versus Roth - Bogleheads for more.

The Forbes article is correct about using effective tax rate to estimate total retirement expenses.

See Marginal Vs Effective Tax Rates And When To Use Each.

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Re: Is seeking tax shelter always right?

Post by jdsmith » Wed Apr 17, 2019 10:46 am

learning_head wrote:
Wed Apr 17, 2019 8:56 am
When you talk about maintaining AA, how do you compute it? For example, if you have $100k in 403b in bonds and $100k in taxable in stocks, is that 50/50 AA? Well, it depends on how these amounts will be taxed. Assuming you 403b will be taxed at 25% and taxable at say 3% (because only gains are taxed and you may have few gains relative to principal), then your real (after-tax) AA is quite far from 50/50. I know we have to guesstimate ultimate rates we will pay, but a guesstimate is better than effectively assuming your 403b account will be taxed at 0% or same as taxable.

When I compute my asset allocation (or net worth for that matter), I normally reduce tax-deferred balances by 25%, taxable by 10% (probably an overshot) and Roth is at 0%. That gives me a better view of my real AA.

Similarly 100k in muni-bonds is likely going to be greater than 100k in 403b taxable bonds if you plan to pay taxes on 403b money upon withdrawals.
That's a good point. Right now I compute AA without any estimate of the eventual impact of taxes. Of course any dividend-yielding asset will grow faster in tax-deferred than taxable accounts due to the tax drag. But your point is good that for computing present AA, holding bonds mostly in tax-deferred space (as we do) over-estimates the bond allocation. Then again, after 20 years the value of many stock funds will be predominantly gains, so again that reduces the tax impact on current vs. expected future (post-tax, in retirement) AA.

And if you compare bonds held in tax-deferred space with stocks that are nearly all gains, you have to read the tea leaves on whether the effective income tax rate or the capital gains rate will be higher 20 years down the road in retirement... which is not straightforward. I suppose a conservative approach for a tax-aware AA calculation is to "penalize" bonds held in tax-deferred space by the present difference between the marginal rate and capital gains rate (7% for us).

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Re: Is seeking tax shelter always right?

Post by jdsmith » Wed Apr 17, 2019 10:58 am

FiveK wrote:
Wed Apr 17, 2019 10:05 am

The Forbes article is, however, not correct when it suggests using effective rate on withdrawals for the trad vs. Roth choice. That makes traditional look better than it is. See Traditional versus Roth - Bogleheads for more.

Interesting. The relevant bit from that wiki page:
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

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Re: Is seeking tax shelter always right?

Post by serbeer » Wed Apr 17, 2019 11:52 am

learning_head wrote:
Wed Apr 17, 2019 8:56 am

When I compute my asset allocation (or net worth for that matter), I normally reduce tax-deferred balances by 25%, taxable by 10% (probably an overshot) and Roth is at 0%. That gives me a better view of my real AA.
So learning_head, you think that tax adjustment for taxable should be lower than that for IRA? And use 10% while thinking it to be an overshot? I am sorry to have to deliver bad news to you, but for long-term planning you better change you taxable tax-adjustment factor to somewhere between 25% and 40% range, depending on how soon you plan to use the money!

I know, it does not seem to make sense, I was totally shocked myself, but the numbers don't lie, and I ran my numbers in front of some pretty smart people on this board yet 10+ years ago. They eventually had to agree, though it took them awhile to do so since the numbers initially seem to defy common sense:
viewtopic.php?f=10&t=12720

Of course, as I said, the exact percentage depends on the time left till money are used. In my AA spreasheet I estimate the percentage based on number of years left left till mid-point of projected retirement (using formulas in the link above) -- that seems to make the most sense while not complicating it too much. The percentage used to be well over 30% for me in the past, but now, thanks to closer retirement date and recent changes in tax laws, it dropped to... 29%. Which is still more than 25% tax adjustment on my tax-deferred accounts. After all, there is a reason why tax-deferred accounts are considered more advantageous for wealth accumulation than taxable, even though few people bother to figure out why it is so exactly.

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Re: Is seeking tax shelter always right?

Post by Thesaints » Wed Apr 17, 2019 12:15 pm

jdsmith wrote:
Mon Apr 15, 2019 3:45 pm
As a general principle, is there such a thing as too much tax sheltering?
If the tax-sheltered assets are eventually taxed as income rather than as long-term capital gains/QDI one may want to consider carefully.

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Re: Is seeking tax shelter always right?

Post by jdsmith » Wed Apr 17, 2019 12:21 pm

jdsmith wrote:
Wed Apr 17, 2019 10:58 am
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.
(Following my own post). But the piece of analysis missing here is that in retirement you will have no regular income to fill up the first few tax brackets. So perhaps a reasonable answer to the question of "how much should I defer" when there is flexibility to do so is to ensure that RMD's keep you in the same tax bracket you are in now (assuming your standard of living does not rise in retirement).

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Re: Is seeking tax shelter always right?

Post by FiveK » Wed Apr 17, 2019 12:58 pm

jdsmith wrote:
Wed Apr 17, 2019 12:21 pm
jdsmith wrote:
Wed Apr 17, 2019 10:58 am
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.
(Following my own post). But the piece of analysis missing here is that in retirement you will have no regular income to fill up the first few tax brackets.
There's actually nothing missing in the analysis. "Withdrawals based on previous contributions" wlll fill lower brackets exactly the same as pensions and other "regular income" fill lower brackets. Thus any new contributions should, at a minimum, be evaluated using expected marginal rates based on withdrawals due to prior contributions.

In extreme situations (doctors in residency is a common example), it can be reasonable to estimate withdrawal marginal rates based on expected future contributions (presumably made at much higher marginal rates) as well. Of course, if future circumstances don't match expectations, then....
So perhaps a reasonable answer to the question of "how much should I defer" when there is flexibility to do so is to ensure that RMD's keep you in the same tax bracket you are in now (assuming your standard of living does not rise in retirement).
That is indeed a reasonable guess, because it delivers consistent marginal rates throughout retirement. Time available for trad->Roth conversions before RMDs start is also a factor.

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Re: Is seeking tax shelter always right?

Post by grabiner » Wed Apr 17, 2019 9:02 pm

FiveK wrote:
Wed Apr 17, 2019 12:58 pm
In extreme situations (doctors in residency is a common example), it can be reasonable to estimate withdrawal marginal rates based on expected future contributions (presumably made at much higher marginal rates) as well.
It isn't necessary for situations to be extreme. If you are in a lower tax bracket this year than you expect to be in for most of your career, then you can assume that your future contributions will all be traditional, and decide whether to use traditional or Roth this year accordingly. The low tax rate may be the result of large deductions, business losses, being unemployed part of the year, taking a temporary assignment in a no-tax state (or a state which doesn't allow a deduction for your retirement contributions), or just being early in a career.
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Re: Is seeking tax shelter always right?

Post by jdsmith » Wed Apr 17, 2019 9:41 pm

I'm thinking of trying to calculate this. Here are my notes to set this up. I'd be grateful for any feedback/corrections/suggestions:

Consider a ~$10k yearly investment made every year for 20 years. Two options:

Option A: Sheltermax

Elect pre-tax withholding of $10k/year, into a tax-deferred account, holding traditional bond funds. Offset this loss of pre-tax income with the sales of taxable holdings to maintain living expenses.

Considerations for Option A:
  • Dividends generate tax-free growth, and are fully re-invested.
  • Tax savings at the marginal rate mean less offsetting taxable cash-out is needed from taxable accounts: $10k * (1-0.22) = $7800 (for a 22% marginal rate) to maintain living expenses.
  • But capital gains incurred by selling those taxable assets counteract this effect. These may be up to (but likely less than) 15% depending on asset appreciation.
  • Putting these together, the equivalent taxable cash-out needed to maintain the same living expenses and offset $10k sheltered is in the range $7800 to $7800/(1-0.15)=$9176.
  • In retirement, tax-deferred withdrawals are taxed at an effective tax rate, which may approach the marginal rate depending on other income sources.
  • In retirement, tax-deferred accounts are subject to RMDs.
  • Continuing dividends remain tax-free.
  • Sheltering reduces present AGI, which may enable certain tax credits, or make Roth IRA contributions possible that otherwise would not have been.
Option B: Invest in Place

Forgo tax-sheltering, and keep the $7800-$9176 equivalent in a taxable account in a municipal bond fund.

Considerations for Option B:
  • Dividends are tax-free, though possibly not state tax free, and are reinvested.
  • The yield is somewhat less than a normal bond fund of similar risk held in a tax-deferred account.
  • In retirement, no additional taxes are incurred beyond any yearly dividend-based income tax.
Question

Which Option, A or B, results in larger after-tax value, taken either as a lump sum at retirement (20 years), or at a 4% continuous draw-down rate starting then?

For simplicity assume the same marginal tax rate of 22% applies in retirement, and that all brackets below that are already filled by other sources. Presume a 5% yield for traditional bond, and 4.5% for municipal (guesses).
Last edited by jdsmith on Thu Apr 18, 2019 11:00 am, edited 1 time in total.

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Re: Is seeking tax shelter always right?

Post by grabiner » Wed Apr 17, 2019 10:50 pm

jdsmith wrote:
Wed Apr 17, 2019 9:41 pm
I'm thinking of trying to calculate this. Here are my notes to set this up. I'd be grateful for any feedback/corrections/suggestions:

Consider a ~$10k yearly investment made every year for 20 years. Two options:

Option A: Sheltermax

Elect pre-tax withholding of $10k/year, into a tax-deferred account, holding traditional bond funds. Offset this loss of pre-tax income with the sales of taxable holdings to maintain living expenses.

Option B: Invest in Place

Forgo tax-sheltering, and keep the $7800-$9176 equivalent in a taxable account in a municipal bond fund.

Which Option, A or B, results in larger after-tax value, taken either as a lump sum at retirement (20 years), or at a 4% continuous draw-down rate?

For simplicity assume the same marginal tax rate of 22% applies in retirement, and that all brackets below that are already filled by other sources. Presume a 5% yield for traditional bond, and 4.5% for municipal (guesses).
A good way to see why A beats B is to consider the equivalent Roth investment. Invest $7800 in a Roth account, instead of in a taxable account. This must beat option B as long as the taxable account has a positive tax cost (stocks gain value, and municipal bonds yield less than taxable bonds). But A is equivalent to B if you retire in the same tax bracket, $10,000 in a traditional account and $7800 in a Roth account will have the same after-tax value if invested the same way.

Even if you have to sell stock to fund the Roth, it is still a better deal, because you would be paying that tax anyway. If you sell $10,000 of stock with a $5000 basis to put $9250 in a Roth account, you get tax-free growth on $9250, so if the market grows X-fold, you get X*9250. If you keep the money in a taxable account, you have X*10000 before any tax cost. You lose at least $750 of the original basis, and at least 15% of the growth, so at best you have 9250+(X-1)*8500.
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Re: Is seeking tax shelter always right?

Post by jdsmith » Thu Apr 18, 2019 11:46 am

Great simplifying analysis. Thanks. The basis is the key in the Roth comparison. If in the worst case, you have no basis in the stock you sell, you have X*8500 in either scenario (10k in taxable grows to X*10k, loses 15% so 8500X, vs 10k is sold and 8500 invested in a Roth, which grows to 8500X). And of course in taxable any income generated reduces performance relative to the Roth, as does a lower-yielding muni bond (though I note that our taxable holding of Vanguard Ohio Long-Term Tax-Exempt Fund did better over the past 5 years (4.43%) than total bond, intermediate term tax exempt, and many others).

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