Simple rule for allocation between Traditional vs Roth

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acegolfer
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Simple rule for allocation between Traditional vs Roth

Post by acegolfer » Wed Feb 12, 2020 1:12 pm

From Brown, David C. & Cederburg, Scott & O’Doherty, Michael S., 2017. "Tax uncertainty and retirement savings diversification," Journal of Financial Economics, 126(3), pages 689-712.
Based on these results, we propose a rule that calls for investors to allocate all of their savings to Roth accounts if current taxable income corresponds to the lowest tax bracket and otherwise invest (Age + 20)% of their savings in traditional accounts with the remainder in Roth accounts.

The paper has a more complex problem but argues this simple rule is good enough.

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Watty
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Re: Simple rule for allocation between Traditional vs Roth

Post by Watty » Wed Feb 12, 2020 1:18 pm

Some things do not fit simple general rules since you also need to consider your marital status, your state income taxes, your income level, if you are likely to retire in a different area, if you live in a low, medium, high, or very high cost of living area, and you have high, medium, or low income.

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FiveK
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Re: Simple rule for allocation between Traditional vs Roth

Post by FiveK » Wed Feb 12, 2020 5:32 pm

Didn't see anything blatantly incorrect (and that shouldn't be taken as faint praise), and it correctly indicates that the higher one's "unavoidable income" in retirement, the more likely it is that Roth contributions will work best.

But it still required significant simplifying assumptions to reduce the article to 22 pages of dense prose and figures.

The observation "whereas conventional wisdom largely supports choosing between traditional and Roth accounts by comparing current tax rates with expected future tax rates, the hedging benefits of traditional accounts and the usefulness of Roth accounts in managing tax-schedule uncertainty are important considerations in the optimal savings decision" is apropos. In other words, you pays your money and you takes your chances.

Lee_WSP
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Re: Simple rule for allocation between Traditional vs Roth

Post by Lee_WSP » Wed Feb 12, 2020 6:12 pm

I propose this simple rule:

Allocate 100% of bonds to Trad. 100% of stocks to Roth.

I'm assuming AA glides down towards retirement.

DoctorPhysics
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Re: Simple rule for allocation between Traditional vs Roth

Post by DoctorPhysics » Wed Feb 12, 2020 6:20 pm

Not for me.

Like diversification with index funds, I choose to fund all of my tax deferred and post tax accounts to the max financially possible. Generally in that order.

No one knows what the future tax landscape will look like.
Just as much as we can’t predict the future of the market.

Triple digit golfer
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Re: Simple rule for allocation between Traditional vs Roth

Post by Triple digit golfer » Wed Feb 12, 2020 6:28 pm

This is very unclear from the quote. I'm 35. That means 55% to traditional and 45% to Roth. My wife and I save more than $26,667 (12,000 divided by 45%). So what do we do?

The quote says nothing about how to choose, Roth or Traditional.

We're in the 22% bracket, have access to a 401k, two IRAs, and invest another $20k or so outside of those. I don't see a clear answer on how to allocate.

CryingHawaiian
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Re: Simple rule for allocation between Traditional vs Roth

Post by CryingHawaiian » Wed Feb 12, 2020 6:36 pm

Triple digit golfer wrote:
Wed Feb 12, 2020 6:28 pm
This is very unclear from the quote. I'm 35. That means 55% to traditional and 45% to Roth. My wife and I save more than $26,667 (12,000 divided by 45%). So what do we do?

The quote says nothing about how to choose, Roth or Traditional.

We're in the 22% bracket, have access to a 401k, two IRAs, and invest another $20k or so outside of those. I don't see a clear answer on how to allocate.
I don't think this post/paper apply to you as it's suggesting what % of your total savings should be allocated between a traditional vs Roth retirement account.

Since you're already maxing your 401k and roth you can ignore this entire thread.
You get what you get and you don’t get upset

Triple digit golfer
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Re: Simple rule for allocation between Traditional vs Roth

Post by Triple digit golfer » Wed Feb 12, 2020 6:37 pm

CryingHawaiian wrote:
Wed Feb 12, 2020 6:36 pm
Triple digit golfer wrote:
Wed Feb 12, 2020 6:28 pm
This is very unclear from the quote. I'm 35. That means 55% to traditional and 45% to Roth. My wife and I save more than $26,667 (12,000 divided by 45%). So what do we do?

The quote says nothing about how to choose, Roth or Traditional.

We're in the 22% bracket, have access to a 401k, two IRAs, and invest another $20k or so outside of those. I don't see a clear answer on how to allocate.
I don't think this post/paper apply to you as it's suggesting what % of your total savings should be allocated between a traditional vs Roth retirement account.

Since you're already maxing your 401k and roth you can ignore this entire thread.
But, we use a traditional for my wife. I also can use a Roth 401k option, but don't. So how to allocate?

CryingHawaiian
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Re: Simple rule for allocation between Traditional vs Roth

Post by CryingHawaiian » Wed Feb 12, 2020 6:47 pm

Triple digit golfer wrote:
Wed Feb 12, 2020 6:37 pm
CryingHawaiian wrote:
Wed Feb 12, 2020 6:36 pm
Triple digit golfer wrote:
Wed Feb 12, 2020 6:28 pm
This is very unclear from the quote. I'm 35. That means 55% to traditional and 45% to Roth. My wife and I save more than $26,667 (12,000 divided by 45%). So what do we do?

The quote says nothing about how to choose, Roth or Traditional.

We're in the 22% bracket, have access to a 401k, two IRAs, and invest another $20k or so outside of those. I don't see a clear answer on how to allocate.
I don't think this post/paper apply to you as it's suggesting what % of your total savings should be allocated between a traditional vs Roth retirement account.

Since you're already maxing your 401k and roth you can ignore this entire thread.
But, we use a traditional for my wife. I also can use a Roth 401k option, but don't. So how to allocate?
Could be interpreting this wrong but here's how I'm viewing the formula. (btw it says if you're in the lowest tax bracket, which you and your wife are not):

Example:

$30,000 in savings per year
35 years old
55% of those savings should go to traditional
45% of those should go to Roth.

Since 45% of $30K is $13.5K and the maximum Roth contribution for you and yoyur wife would be $12K, you would both max your Roths, and then put the remaining $18,000 in your traditional accounts.

The % of your total savings in traditional accounts would be 60% ($18K / $30K), but you're already contributing the max to your Roth. It's a fancy formula to say max your Roth space if you can afford to do so.
You get what you get and you don’t get upset

Triple digit golfer
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Re: Simple rule for allocation between Traditional vs Roth

Post by Triple digit golfer » Wed Feb 12, 2020 6:49 pm

CryingHawaiian wrote:
Wed Feb 12, 2020 6:47 pm
Triple digit golfer wrote:
Wed Feb 12, 2020 6:37 pm
CryingHawaiian wrote:
Wed Feb 12, 2020 6:36 pm
Triple digit golfer wrote:
Wed Feb 12, 2020 6:28 pm
This is very unclear from the quote. I'm 35. That means 55% to traditional and 45% to Roth. My wife and I save more than $26,667 (12,000 divided by 45%). So what do we do?

The quote says nothing about how to choose, Roth or Traditional.

We're in the 22% bracket, have access to a 401k, two IRAs, and invest another $20k or so outside of those. I don't see a clear answer on how to allocate.
I don't think this post/paper apply to you as it's suggesting what % of your total savings should be allocated between a traditional vs Roth retirement account.

Since you're already maxing your 401k and roth you can ignore this entire thread.
But, we use a traditional for my wife. I also can use a Roth 401k option, but don't. So how to allocate?
Could be interpreting this wrong but here's how I'm viewing the formula. (btw it says if you're in the lowest tax bracket, which you and your wife are not):

Example:

$30,000 in savings per year
35 years old
55% of those savings should go to traditional
45% of those should go to Roth.

Since 45% of $30K is $13.5K and the maximum Roth contribution for you and yoyur wife would be $12K, you would both max your Roths, and then put the remaining $18,000 in your traditional accounts.

The % of your total savings in traditional accounts would be 60% ($18K / $30K), but you're already contributing the max to your Roth. It's a fancy formula to say max your Roth space if you can afford to do so.
Interesting. We are not doing that. We elected to go traditional for my wife's account.

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teen persuasion
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Re: Simple rule for allocation between Traditional vs Roth

Post by teen persuasion » Wed Feb 12, 2020 10:15 pm

acegolfer wrote:
Wed Feb 12, 2020 1:12 pm
From Brown, David C. & Cederburg, Scott & O’Doherty, Michael S., 2017. "Tax uncertainty and retirement savings diversification," Journal of Financial Economics, 126(3), pages 689-712.
Based on these results, we propose a rule that calls for investors to allocate all of their savings to Roth accounts if current taxable income corresponds to the lowest tax bracket and otherwise invest (Age + 20)% of their savings in traditional accounts with the remainder in Roth accounts.

The paper has a more complex problem but argues this simple rule is good enough.
Just based on the quote, this isn't very useful. It's based on "lowest tax bracket", not marginal rate.

With lower incomes (where you would be in the lowest tax bracket) you often also are eligible for refundable credits like EITC. The 21% phaseout rate on EITC acts like an additional tax rate. Matching or partially matching state credits increase this additional tax rate (NY matches at 30%, so an additional 6.3% phaseout rate). Contributions to employer traditional retirement accounts (but not tIRA contributions) can reverse these phaseouts. Thus even in a low (or zero) tax bracket there's a strong incentive to contribute as much as possible to traditional 401k/etc. accounts, to increase the refundable credits.

There's little incentive to contribute to tIRAs, though - so contributions here should be all Roth.

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acegolfer
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Re: Simple rule for allocation between Traditional vs Roth

Post by acegolfer » Wed Feb 12, 2020 11:23 pm

teen persuasion wrote:
Wed Feb 12, 2020 10:15 pm
acegolfer wrote:
Wed Feb 12, 2020 1:12 pm
From Brown, David C. & Cederburg, Scott & O’Doherty, Michael S., 2017. "Tax uncertainty and retirement savings diversification," Journal of Financial Economics, 126(3), pages 689-712.
Based on these results, we propose a rule that calls for investors to allocate all of their savings to Roth accounts if current taxable income corresponds to the lowest tax bracket and otherwise invest (Age + 20)% of their savings in traditional accounts with the remainder in Roth accounts.

The paper has a more complex problem but argues this simple rule is good enough.
Just based on the quote, this isn't very useful. It's based on "lowest tax bracket", not marginal rate.

With lower incomes (where you would be in the lowest tax bracket) you often also are eligible for refundable credits like EITC. The 21% phaseout rate on EITC acts like an additional tax rate. Matching or partially matching state credits increase this additional tax rate (NY matches at 30%, so an additional 6.3% phaseout rate). Contributions to employer traditional retirement accounts (but not tIRA contributions) can reverse these phaseouts. Thus even in a low (or zero) tax bracket there's a strong incentive to contribute as much as possible to traditional 401k/etc. accounts, to increase the refundable credits.

There's little incentive to contribute to tIRAs, though - so contributions here should be all Roth.
The way I read the quote is,

If you are in the lowest tax bracket, then 100% Roth, 0% Traditional (because of low benefit of deferring tax)
If not, then age+20% in Traditional, rest in Roth (as you get older and closer to retirement, you have better expectation of the tax code at retirement, more savings towards traditional)

As a rule of thumb, it makes perfect sense for me.

Alaric
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Re: Simple rule for allocation between Traditional vs Roth

Post by Alaric » Thu Feb 13, 2020 7:56 am

I assume by "lowest tax bracket" they mean 10% rather than 0%, the actual lowest. The advice seems a bit arbitrary especially in today's environment where the second-lowest federal tax bracket is 12%. So if your top marginal rate is 10% you should go full Roth, but if you're in the very different 12% bracket, you should go 40% to 100% traditional depending on age.

Alaric
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Re: Simple rule for allocation between Traditional vs Roth

Post by Alaric » Thu Feb 13, 2020 7:56 am

I assume by "lowest tax bracket" they mean 10% rather than 0%, the actual lowest. The advice seems a bit arbitrary especially in today's environment where the second-lowest federal tax bracket is 12%. So if your top marginal rate is 10% you should go full Roth, but if you're in the very different 12% bracket, you should go 40% to 100% traditional depending on age.

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teen persuasion
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Re: Simple rule for allocation between Traditional vs Roth

Post by teen persuasion » Thu Feb 13, 2020 8:14 am

acegolfer wrote:
Wed Feb 12, 2020 11:23 pm
teen persuasion wrote:
Wed Feb 12, 2020 10:15 pm
acegolfer wrote:
Wed Feb 12, 2020 1:12 pm
From Brown, David C. & Cederburg, Scott & O’Doherty, Michael S., 2017. "Tax uncertainty and retirement savings diversification," Journal of Financial Economics, 126(3), pages 689-712.
Based on these results, we propose a rule that calls for investors to allocate all of their savings to Roth accounts if current taxable income corresponds to the lowest tax bracket and otherwise invest (Age + 20)% of their savings in traditional accounts with the remainder in Roth accounts.

The paper has a more complex problem but argues this simple rule is good enough.
Just based on the quote, this isn't very useful. It's based on "lowest tax bracket", not marginal rate.

With lower incomes (where you would be in the lowest tax bracket) you often also are eligible for refundable credits like EITC. The 21% phaseout rate on EITC acts like an additional tax rate. Matching or partially matching state credits increase this additional tax rate (NY matches at 30%, so an additional 6.3% phaseout rate). Contributions to employer traditional retirement accounts (but not tIRA contributions) can reverse these phaseouts. Thus even in a low (or zero) tax bracket there's a strong incentive to contribute as much as possible to traditional 401k/etc. accounts, to increase the refundable credits.

There's little incentive to contribute to tIRAs, though - so contributions here should be all Roth.
The way I read the quote is,

If you are in the lowest tax bracket, then 100% Roth, 0% Traditional (because of low benefit of deferring tax)
If not, then age+20% in Traditional, rest in Roth (as you get older and closer to retirement, you have better expectation of the tax code at retirement, more savings towards traditional)

As a rule of thumb, it makes perfect sense for me.
That's exactly the way I read it, too. But being in the 10% bracket could still mean having a 40+% marginal tax rate, due to phaseouts of refundable credits (and including state tax rates and credit phaseouts).

For me in NYS, 10% federal tax + 4% state tax + 21% EITC phaseout rate + 6.3% state EITC match (30% of federal) = 41.3% marginal rate on traditional vs Roth 401k contributions.

My objection - use of tax bracket as the yardstick, not marginal tax rate.

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acegolfer
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Re: Simple rule for allocation between Traditional vs Roth

Post by acegolfer » Thu Feb 13, 2020 8:44 am

teen persuasion wrote:
Thu Feb 13, 2020 8:14 am

For me in NYS, 10% federal tax + 4% state tax + 21% EITC phaseout rate + 6.3% state EITC match (30% of federal) = 41.3% marginal rate on traditional vs Roth 401k contributions.

My objection - use of tax bracket as the yardstick, not marginal tax rate.
If my marginal tax rate were 41.3%, I wouldn't call it lowest tax bracket. Following the paper, I would not 100% in Roth.

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teen persuasion
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Re: Simple rule for allocation between Traditional vs Roth

Post by teen persuasion » Thu Feb 13, 2020 8:49 am

Exactly my point - tax bracket is not the same as marginal tax rate. One can have BOTH a low tax bracket AND a high marginal tax rate at the same time.

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jeffyscott
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Re: Simple rule for allocation between Traditional vs Roth

Post by jeffyscott » Thu Feb 13, 2020 10:24 am

teen persuasion wrote:
Thu Feb 13, 2020 8:49 am
Exactly my point - tax bracket is not the same as marginal tax rate. One can have BOTH a low tax bracket AND a high marginal tax rate at the same time.
Yes, my daughter is in a similar circumstance, where effective marginal rate is about 40% with income under $30,000.

Also the conclusion refers to the bottom two brackets, not just the lowest one:
1. Households that currently fall into a low tax bracket (e.g., the 10% or 15% brackets in the 2015 tax schedule)
should invest 100% of their savings in Roth accounts.


It does go on to say:
A careful analysis of household-specific information regarding current and future income levels, account access, and other considerations could allow investors to improve their outcomes by tailoring the rule-based policy to their specific circumstances.

I would think an important factor would be current and expected total retirement assets (and expected retirement income from pension and SS). For example, for someone with no other income and assuming they would be spending ~4% of assets, you can approximate what level of assets would push them to the 22% tax bracket (about $1.25 million, if single). So, in that simple case traditional would make sense at even a 10% or 12% tax rate, if total savings will not exceed $1.25 million. I suppose getting into that would make it not very simple, though. The authors also considered tax uncertainty, though, so that might mean some should go to Roth even in this case.
Time is your friend; impulse is your enemy. - John C. Bogle

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jjustice
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Re: Simple rule for allocation between Traditional vs Roth

Post by jjustice » Thu Feb 13, 2020 10:52 am

There are two reasons to contribute to a Traditional IRA that I haven't seen mentioned.

1) When you get to be 70.5 years old, you'll be very happy to be able to make qualified charitable distributions from your TIRA. In addition to gratifying your charitable inclinations, they lower AGI (by taking the place of your RMDs) when you no longer have that mortgage that now enables you to itemize charitable deductions.
2) If you have ACA (Obamacare) health insurance, the adjustment for a Traditional IRA contribution not only reduces taxable income, but it also raises the amount you get in premium tax credit.

Roth IRAs certainly have their advantages, but they are not best for every circumstance.

John

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teen persuasion
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Re: Simple rule for allocation between Traditional vs Roth

Post by teen persuasion » Thu Feb 13, 2020 1:37 pm

if current taxable income corresponds to the lowest tax bracket
. Households that currently fall into a low tax bracket (e.g., the 10% or 15% brackets in the 2015 tax schedule)
So, parsing the language more closely, and noting the 15% bracket in 2015 comment, I realized that the tax changes have altered the landscape since 2015, particularly by removing personal exemptions and inserting additional dependent credits to compensate. In 2015, with 3 dependents, our standard deduction of ~$12k MFJ + 5 personal exemptions of ~$4k each = $32k removed from AGI to reach taxable income. Currently our MFJ standard deduction is ~$24k, regardless of number of dependents, but we have partially refundable and nonrefundable credits to reduce the tax on the higher taxable income. So our bracket may appear higher, while tax burden is possibly reduced.

Not comparing apples to apples.

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Re: Simple rule for allocation between Traditional vs Roth

Post by jmk » Thu Feb 13, 2020 9:58 pm

Alaric wrote:
Thu Feb 13, 2020 7:56 am
I assume by "lowest tax bracket" they mean 10% rather than 0%, the actual lowest. The advice seems a bit arbitrary especially in today's environment where the second-lowest federal tax bracket is 12%. So if your top marginal rate is 10% you should go full Roth, but if you're in the very different 12% bracket, you should go 40% to 100% traditional depending on age.
They state lowest means 10% or 15%.

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