Is Tax Diversification Overrated?

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iceport
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Re: Is Tax Diversification Overrated?

Post by iceport »

FiveK wrote: Mon Sep 13, 2021 10:48 pm A recent article, Tax Diversification Limits And Roth Optimization Benefits goes into some detail on this. E.g.,
...the reality is that splitting dollars between traditional and Roth retirement accounts isn’t just a form of diversification; because the outcomes are correlated to each other (as a change in tax rates that benefits one type of account adversely impacts the other type by the same amount), the net result is that tax diversification doesn’t actually diversify the risk, it simply neutralizes the opportunity altogether.
The article goes on to acknowledge that some guesswork is needed, but suggests
the better approach is to try to Roth-optimize by timing when to shift between traditional and Roth accounts. Which, in practice, is easier than most realize, as while a household’s future is never certain, the Roth-vs-traditional decision has the most impact in years that are especially high or low in income… which are actually the years that are most easy to identify in the moment for a Roth optimization timing decision!
This is pretty much the primary philosophy in the Traditional versus Roth - Bogleheads wiki: take a back-of-the-envelope guess at your retirement marginal tax rate, compare to your current rate, and choose Roth vs. traditional accordingly.
FiveK,

Thank you for posting this article! I really like Kitces' analyses. And I love his highly detailed and unique illustration of the equivalency of Roth vs. traditional, assuming constant tax rates.

I'll have to spend some quality time studying it, but something bugs me right off the bat...

He belabors the point that investment diversification is not like tax diversification. Yet in the nice graphic he uses to show how diversifying away from traditional only "narrows the range" of outcomes, reducing the upside potential benefit and the downside potential detriment of tax risk simultaneously. Well... isn't that exactly the same effect diversifying away from equities only with the addition of fixed income has?

I don't care what term it goes by, having more than only traditional pre-tax accounts does, indeed, seem to reduce the magnitude of the worst effects of tax risk.

Am I missing something? Is this just semantics, a case of Kitces using the term "diversification" in the strictest sense instead of a looser, more general sense?
"Discipline matters more than allocation.” ─William Bernstein
tibbitts
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

willthrill81 wrote: Tue Sep 14, 2021 11:16 am
tibbitts wrote: Tue Sep 14, 2021 11:14 am
GoneOnTilt wrote: Tue Sep 14, 2021 10:57 am I think tax diversification is underrated. I don't put all my money in tax free or tax deferred. I like having a percentage in taxable accounts, so I can do what I want/need, when I want/need to. I can't imagine it won't help me control taxes when I retire as well. We'll see I suppose.
Historically there's seemed to be an over-emphasis on maximizing deferred accounts and not much discussion of the potential downsides. I think that's because for many years contributions to tax-deferred were much more limited than now, so only now are larger numbers of people facing substantial RMDs. The increase in contribution limits, combined with an increasing emphasis on defined contribution vs. defined benefit employer plans, plus strong investment market performance over the last decade or so have created somewhat of a perfect storm for RMDs.
If tax-deferred balances are so large that RMDs will create a genuine tax issue, then the individuals in question can retire earlier than they had originally planned, perhaps much earlier.
Sometimes there are mitigating factors to encourage working longer, such as vesting in employer benefits (healthcare, pension, etc.) that might be essentially all-or-nothing. So without them there might not be as much of an RMD issue but with them their might be a "genuine" one, of course with "genuine" being subject to interpretation. For me personally for "genuine" I'd start paying attention somewhere between RMDs plus other taxable income passing maybe the third IRMAA tier, maybe triggering NIIT, or venturing too far into the 32+% marginal brackets.
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

willthrill81 wrote: Tue Sep 14, 2021 12:40 pm
ThankYouJack wrote: Tue Sep 14, 2021 12:27 pm
willthrill81 wrote: Tue Sep 14, 2021 11:36 am
IowaFarmBoy wrote: Tue Sep 14, 2021 11:30 am If your assumption is that you are 24% now and will only be 12% in retirement is correct, you strategy is sound.

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

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

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

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

Consequently, unless one is planning on retiring early enough to convert tax-deferred assets into Roth using the standard deduction, there isn't much reason not to do Roth contributions and conversions in the 12% bracket.
Thanks, much appreciated.
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

FiveK wrote: Mon Sep 13, 2021 10:48 pm A recent article, Tax Diversification Limits And Roth Optimization Benefits goes into some detail on this. E.g.,
...the reality is that splitting dollars between traditional and Roth retirement accounts isn’t just a form of diversification; because the outcomes are correlated to each other (as a change in tax rates that benefits one type of account adversely impacts the other type by the same amount), the net result is that tax diversification doesn’t actually diversify the risk, it simply neutralizes the opportunity altogether.
The article goes on to acknowledge that some guesswork is needed, but suggests
the better approach is to try to Roth-optimize by timing when to shift between traditional and Roth accounts. Which, in practice, is easier than most realize, as while a household’s future is never certain, the Roth-vs-traditional decision has the most impact in years that are especially high or low in income… which are actually the years that are most easy to identify in the moment for a Roth optimization timing decision!
This is pretty much the primary philosophy in the Traditional versus Roth - Bogleheads wiki: take a back-of-the-envelope guess at your retirement marginal tax rate, compare to your current rate, and choose Roth vs. traditional accordingly.
Thanks for posting this. Roth-optimizing makes sense to me and after getting all the feedback from this thread, I have a better feel for when to optimize.
an_asker
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Re: Is Tax Diversification Overrated?

Post by an_asker »

ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
I think what you're missing is an analysis of what your most likely tax bracket would likely be at retirement. If you go along with the 12% happy path, I can raise you one and say that I expect 0% tax at retirement (and most likely neither of us would be right in our assumptions).

If you are in the 24% marginal tax bracket and have been saving to the max, I bet* your marginal tax rate at retirement would be quite close (if not higher than) that 24% which you are trying to escape from! :oops:

* unless you are loaded on bonds in your tax deferred accounts in which case it won't be growing as much as it should be!
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

iceport wrote: Mon Sep 13, 2021 1:31 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
I think what you are missing is the element of uncertainty, or risk.

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

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

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

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

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

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

There is a direct analogy between tax risk and investment risk. Investors may believe that common stocks are likely to generate a substantial equity risk premium. Yet they also recognize that higher equity returns are not guaranteed, and so diversify against that risk by holding other assets such as fixed income securities. In the case of taxes, participants may expect taxes to be lower (suggesting pre-tax savings) or higher (Roth savings) in retirement. But in pursuing a strategy of tax diversification, they will acknowledge the inherent uncertainty of forecasting any future tax rates, including their own, and so hold both types of savings.
"...acknowledge the inherent uncertainty of forecasting any future tax rates, including their own..."
Thanks for posting this. I think I'm less concerned about my tax rate going up significantly than many on here. If I was in the top 1-10% I may feel differently.
Will tax rates go up drastically?
Seems unlikely, especially after reading the Kitces article.

Will the rule for Roth IRAs be revised?
My guess would be no, but who knows.
Will you need to make an enormous portfolio withdrawal to address a family emergency?
What sort of emergency and how much $ are we talking? As of now I do have a brokerage account. I also have Roth contributions. Even if I didn't have those, there would be other options and I might have a traditional emergency fund. And even if I didn't have an emergency fund, paying a 10% early withdrawal penalty on traditional wouldn't be horrible if I saved 24% going in, and was taxed at 12%+10% (penalty) coming out.
an_asker
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Re: Is Tax Diversification Overrated?

Post by an_asker »

ThankYouJack wrote: Tue Sep 14, 2021 1:26 pm
willthrill81 wrote: Tue Sep 14, 2021 12:40 pm [...]
Once SS benefits begin, it can be very difficult to remain in the 12% bracket. As noted on this Wiki page, $30k of SS benefits and $24k of other taxable income is enough to put a MFJ couple into a 15% marginal tax rate. For a single filer, $30k of SS benefits and $14k of other taxable income is enough to move into the 15% marginal tax rate. Note that these marginal rates can be as high as 40.7%, and the thresholds for increasing marginal rates go up every year because this is not all adjusted for inflation.

Consequently, unless one is planning on retiring early enough to convert tax-deferred assets into Roth using the standard deduction, there isn't much reason not to do Roth contributions and conversions in the 12% bracket.
Thanks, much appreciated.
Looks like i got beat to my answer :-)
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Re: Is Tax Diversification Overrated?

Post by JayDee37 »

Someone mentioned this upthread, but the reason I try to have dollars earmarked for retirement in accounts with various tax treatments (I have a pretax 457, Roth IRA, and taxable) is to be able to handle large lumpy expenses in retirement without complicating my ability to plan around things like ACA subsidy cutoffs, SS tax humps, and IRMAA cliffs (in addition to marginal tax rates). I have seen this bite my parents during their retirement. They only have pensions/SS/tax deferred, and in the few years that they had larger-than-anticipated lumpy expenses (home maintenance/remodeling, health issues, surprise international trips for family weddings/funerals) those larger tax deferred withdrawals had knock-on effects that kind of shocked them. I have been fortunate to be able to max out my 457 and Roth IRA contributions over the past several years while also creating a substantial taxable account due to some financial windfalls, and I know that many people don't have those opportunities. But for me the Roth is an important part of my "sleep well at night" security blanket. I like having some dollars socked away that I will be able access without having to worry about all the weird cliffs and cutoffs and rules about "substantially equal" withdrawals, etc.
Tell me, what do you plan to do with your one wild and precious life? | ~Mary Oliver
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willthrill81
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

tibbitts wrote: Tue Sep 14, 2021 1:25 pm
willthrill81 wrote: Tue Sep 14, 2021 11:16 am
tibbitts wrote: Tue Sep 14, 2021 11:14 am
GoneOnTilt wrote: Tue Sep 14, 2021 10:57 am I think tax diversification is underrated. I don't put all my money in tax free or tax deferred. I like having a percentage in taxable accounts, so I can do what I want/need, when I want/need to. I can't imagine it won't help me control taxes when I retire as well. We'll see I suppose.
Historically there's seemed to be an over-emphasis on maximizing deferred accounts and not much discussion of the potential downsides. I think that's because for many years contributions to tax-deferred were much more limited than now, so only now are larger numbers of people facing substantial RMDs. The increase in contribution limits, combined with an increasing emphasis on defined contribution vs. defined benefit employer plans, plus strong investment market performance over the last decade or so have created somewhat of a perfect storm for RMDs.
If tax-deferred balances are so large that RMDs will create a genuine tax issue, then the individuals in question can retire earlier than they had originally planned, perhaps much earlier.
Sometimes there are mitigating factors to encourage working longer, such as vesting in employer benefits (healthcare, pension, etc.) that might be essentially all-or-nothing. So without them there might not be as much of an RMD issue but with them their might be a "genuine" one, of course with "genuine" being subject to interpretation. For me personally for "genuine" I'd start paying attention somewhere between RMDs plus other taxable income passing maybe the third IRMAA tier, maybe triggering NIIT, or venturing too far into the 32+% marginal brackets.
Yes, there can be such mitigating factors. But more often than not, it seems to me at least that those complaining about RMDs creating a 'tax bomb' for them simply worked significantly longer than they really needed to.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

an_asker wrote: Tue Sep 14, 2021 1:57 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
I think what you're missing is an analysis of what your most likely tax bracket would likely be at retirement. If you go along with the 12% happy path, I can raise you one and say that I expect 0% tax at retirement (and most likely neither of us would be right in our assumptions).

If you are in the 24% marginal tax bracket and have been saving to the max, I bet* your marginal tax rate at retirement would be quite close (if not higher than) that 24% which you are trying to escape from! :oops:

* unless you are loaded on bonds in your tax deferred accounts in which case it won't be growing as much as it should be!
It seems like a lot depends on if we FIRE or semi-FIRE. If that's the case, I don't think our AGI (with expenses far less than $100k) would put us in that high of a tax bracket and we would be on the "happy path" :wink:
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Re: Is Tax Diversification Overrated?

Post by randomguy »

an_asker wrote: Tue Sep 14, 2021 1:57 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm I often see on here that people feel better having tax diversification - one's portfolio spread out between traditional, roth and taxable accounts. I've always figured I'd rather save about 24% in taxes today and pay about 12% in taxes later so I've always preferred pre-tax accounts, and my portfolio is very pre-tax heavy (about 80%). To maximize tax savings, since my current tax rate is greater than my expected future tax rate, it seems to make sense to keep loading up on pre-tax accounts whenever possible. Isn't this strategy minimizing taxes over the long haul or am I missing something?
I think what you're missing is an analysis of what your most likely tax bracket would likely be at retirement. If you go along with the 12% happy path, I can raise you one and say that I expect 0% tax at retirement (and most likely neither of us would be right in our assumptions).

If you are in the 24% marginal tax bracket and have been saving to the max, I bet* your marginal tax rate at retirement would be quite close (if not higher than) that 24% which you are trying to escape from! :oops:

* unless you are loaded on bonds in your tax deferred accounts in which case it won't be growing as much as it should be!
I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

randomguy wrote: Tue Sep 14, 2021 2:58 pm I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
But you don't have to have anywhere near 4-8M to generate RMDs that will put you in a 24% or higher bracket. Remember you likely also have taxable social security and maybe other investment income. It's the RMDs that are the problem, and you can get there without ever having been at that tax bracket level during your working career.
wrongfunds
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Re: Is Tax Diversification Overrated?

Post by wrongfunds »

I have never rejected any raise because it might have put me in a higher tax bracket in my entire working career. I don't think I will be changing my attitude when I retire.
Silk McCue
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Re: Is Tax Diversification Overrated?

Post by Silk McCue »

wrongfunds wrote: Tue Sep 14, 2021 6:41 pm I have never rejected any raise because it might have put me in a higher tax bracket in my entire working career. I don't think I will be changing my attitude when I retire.
What does that have to do with making decisions about how your excess funds are invested for retirement?

Cheers
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FiveK
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Re: Is Tax Diversification Overrated?

Post by FiveK »

iceport wrote: Tue Sep 14, 2021 1:14 pm He belabors the point that investment diversification is not like tax diversification. Yet in the nice graphic he uses to show how diversifying away from traditional only "narrows the range" of outcomes, reducing the upside potential benefit and the downside potential detriment of tax risk simultaneously. Well... isn't that exactly the same effect diversifying away from equities only with the addition of fixed income has?

I don't care what term it goes by, having more than only traditional pre-tax accounts does, indeed, seem to reduce the magnitude of the worst effects of tax risk.

Am I missing something? Is this just semantics, a case of Kitces using the term "diversification" in the strictest sense instead of a looser, more general sense?
Your interpretation seems reasonable.

The article says
Or viewed another way, splitting dollars between traditional and Roth accounts is not akin to ‘investment diversification’ (e.g., between large- and small-cap stocks); instead, it’s more analogous to taking money out of the markets altogether (eliminating both the downside and upside opportunity) and just holding zero-risk-zero-opportunity cash instead.
Analogies are sometimes in the eye of the beholder. ;)
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Re: Is Tax Diversification Overrated?

Post by smitcat »

tibbitts wrote: Tue Sep 14, 2021 6:14 pm
randomguy wrote: Tue Sep 14, 2021 2:58 pm I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
But you don't have to have anywhere near 4-8M to generate RMDs that will put you in a 24% or higher bracket. Remember you likely also have taxable social security and maybe other investment income. It's the RMDs that are the problem, and you can get there without ever having been at that tax bracket level during your working career.
A wise observation that many do not realize untill its too late.
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

smitcat wrote: Wed Sep 15, 2021 6:33 am
tibbitts wrote: Tue Sep 14, 2021 6:14 pm
randomguy wrote: Tue Sep 14, 2021 2:58 pm I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
But you don't have to have anywhere near 4-8M to generate RMDs that will put you in a 24% or higher bracket. Remember you likely also have taxable social security and maybe other investment income. It's the RMDs that are the problem, and you can get there without ever having been at that tax bracket level during your working career.
A wise observation that many do not realize untill its too late.
Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
Last edited by ThankYouJack on Wed Sep 15, 2021 7:03 am, edited 1 time in total.
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

wrongfunds wrote: Tue Sep 14, 2021 6:41 pm I have never rejected any raise because it might have put me in a higher tax bracket in my entire working career. I don't think I will be changing my attitude when I retire.
I'm not sure the point you're making related to tax diversification. Care to explain?
smitcat
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Re: Is Tax Diversification Overrated?

Post by smitcat »

ThankYouJack wrote: Wed Sep 15, 2021 7:01 am
smitcat wrote: Wed Sep 15, 2021 6:33 am
tibbitts wrote: Tue Sep 14, 2021 6:14 pm
randomguy wrote: Tue Sep 14, 2021 2:58 pm I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
But you don't have to have anywhere near 4-8M to generate RMDs that will put you in a 24% or higher bracket. Remember you likely also have taxable social security and maybe other investment income. It's the RMDs that are the problem, and you can get there without ever having been at that tax bracket level during your working career.
A wise observation that many do not realize untill its too late.
Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
If you want to play with various numbers and ages to look for potential problems and opportunities they can easily show up well below the 4/8 million as Tibbits has indicated. If you choose to use a couple and only assume incomes at 71 from SS, after tax accounts and pretax accounts you get something like this....
$198K - number at which 24% rate begins

$51K - effective SS income for a couple with $60K SS at 71
$94K - RMD's at 71 on $2.5 million
$45K - residual incomes from $2 million after tax account with no sales
$190K total - so at this time with this example you remain under the $198K 24% limit.

Your options/challenges with this example when playing with the numbers in only these three areas include....
Pre tax accounts - if you do not take more than the RMD are these accounts gojng to grow over time? If yes then both the RMD and the account balance are going to go up each year. Example of what happens if the pre tax accounts remain exactly the same each year (withdrawals equal earnings) and are subject to increasing RMD %'s.
$114K - RMD's at 76 on 2.5 million
$140K - RMD's at 81 on 2.5 million
This is all while married , if one spouse passes the math changes.

After tax accounts - They may be larger, they may generate more divs. If there is any activity that generates gains they are also to be considered in the income calcs.

SS - the combined couples elected SS at 71 may be higher than $60K.

The variations are endless and the only thing that matters is your best guess at projected numbers for your own situation.
wrongfunds
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Re: Is Tax Diversification Overrated?

Post by wrongfunds »

ThankYouJack wrote: Wed Sep 15, 2021 7:02 am
wrongfunds wrote: Tue Sep 14, 2021 6:41 pm I have never rejected any raise because it might have put me in a higher tax bracket in my entire working career. I don't think I will be changing my attitude when I retire.
I'm not sure the point you're making related to tax diversification. Care to explain?
In my (not so) humble opinion the fear of having to pay higher taxes is overblown. Do the best that you can to minimize the taxes but understand that there are lots of moving parts and true optimization only exist after the fact. Having to pay too much taxes just means you had too much income!

Believe me, there have been many instances where I had greedily paid in advance but then ended up losing all that money down the drain (aka pre-buying startup shares to save on the taxes if the startup makes it big). Being out of job when the startup went bust, the lost prepaid money hurt a lot both psychologically and financially. In my then life, those thousands of dollars meant quite a lot to me. Even though this particular case was very asymmetrical in the sense that the tax savings would have been multiples of the prepaid money, the loss, when realized, still stung. Logically and mathematically, it made perfect sense to take that chance. Probabilistically? Not so much, given very few startups make it.

Being wrong and NOT doing perfect tax diversification will NOT hurt you much if you end up having too much money and paying taxes on it. Just to follow the example above, it would have been much better if the start up had made big BUT I had not pre-bought the pre-IPO shares even though I would be cursing my decision and lamenting about at every chance I got (similar to the RMD tax bomb discussions!). But I realize that those are two different types of hurt.

I feel that BH places too much emphasis on how not to pay big taxes while losing the fact that the big taxes would be result of the bigger income.
Silk McCue
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Re: Is Tax Diversification Overrated?

Post by Silk McCue »

:greedy
wrongfunds wrote: Wed Sep 15, 2021 7:34 am I feel that BH places too much emphasis on how not to pay big taxes while losing the fact that the big taxes would be result of the bigger income.
I’m quite certain that most Bogleheads fully understand the relationship between income and taxes. It’s that very reason that many seek to make prudent investment location decisions that will allow them, an eventual surviving spouse, or possibly legacy beneficiaries to not have to fork over more in taxes than is necessary.

I actually expect that to the contrary many folks fail to properly consider the tax consequence of their investments and withdrawals and pay an unnecessary tax burden out of a lack of knowledge.

Ignorance isn’t bliss although it feels like it if you are ignorant.

It took very little effort over the past 5 years prior to my wife joining me in retirement this year to perform Roth conversions in a very tax efficient manner. Based upon our unique financial situation that was a solid strategic decision. As was funding a DAF last year to support our giving until we utilize QCDs starting in 8 years. We are 60/62

Cheers
cas
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Re: Is Tax Diversification Overrated?

Post by cas »

ThankYouJack wrote: Wed Sep 15, 2021 7:01 am Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
Not an answer to the "24% bracket" question you asked, but ... given the "12% bracket" you keep mentioning you think you will be in for RMDs ... note that, at 50K SS (MJF), the "12% bracket" is almost non-existent.

See the SS tax hump heat map for MJF (2021 version) here. Find the 50K column and read upward to see what marginal rates will be as withdrawals from the pre-tax account increase. Note that the SS tax hump has almost completely overlaid all the 10% nominal tax bracket and almost all the nominal 12% tax bracket.

Note 1: Other sizes of the heat map, as well as the Filing Single heat map are available in the Taxation of Social Security Benefits wiki article.)

Note 2: It is a bit more complicated that just looking at the 2021 heat map, because the shape of the heat map in future years will gradually morph, because part of the "taxation of SS" calculation is inflation adjusted and part is not.
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

ThankYouJack wrote: Wed Sep 15, 2021 7:01 am
smitcat wrote: Wed Sep 15, 2021 6:33 am
tibbitts wrote: Tue Sep 14, 2021 6:14 pm
randomguy wrote: Tue Sep 14, 2021 2:58 pm I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
But you don't have to have anywhere near 4-8M to generate RMDs that will put you in a 24% or higher bracket. Remember you likely also have taxable social security and maybe other investment income. It's the RMDs that are the problem, and you can get there without ever having been at that tax bracket level during your working career.
A wise observation that many do not realize until its too late.
Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
If you assume low enough rates of return, no other taxable accounts or income besides taxable social security, two people who will always have MFJ status, and some bracket inflation going forward, then yes the amount to get to 24% may be closer to $4M. But the way the post was phrased ("4/8"), I believe the intent was to say $4M for single and $8M for MFJ, and you definitely don't need that much in deferred to reach 24% or even higher with current brackets.
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Re: Is Tax Diversification Overrated?

Post by whodidntante »

While it's fine to seek opinions, I do not trust the conclusions of bloggers and others who may have significantly different situations and assumptions than myself. So years ago I ran a few simulations to attempt to predict my lifelong real spending power over my lifetime with different tax-advantaged account contribution strategies.

I had to make some extremely dark assumptions about future tax rates for current tax-deferred contributions to be worse for my future self. Though I did assume that all current-year tax savings are invested in the most tax-efficient vehicle remaining because that's what I actually do. But I think that is often left out of consideration.

Another consideration is that not all of us will have a long successful career and retire with a multimillion-dollar portfolio or whatever one was planning on. I'm pretty sure that no one predicts they will have a stroke, a disabling car accident, go to prison for 10 years, lose a lawsuit and pay a big judgment, or have their professional reputation ruined and their earning power greatly reduced. But those things do happen to successful people. Using tax-deferred accounts before things went to heck mean you'll be able to spend more over your life because you saved tax and invested the tax savings when your marginal rate was higher. You also get creditor and judgment protection that taxable accounts will not enjoy.
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

wrongfunds wrote: Wed Sep 15, 2021 7:34 am
I feel that BH places too much emphasis on how not to pay big taxes while losing the fact that the big taxes would be result of the bigger income.
As someone who has never had a "big" income by Boglehead standards, I know that sometimes high marginal rates are entirely a result of poor tax planning for a given income level. And once you've made mistakes (for example deferring too much at very low marginal rates), even years before, you often can't compensate or correct for those mistakes later on. Actually, all of the posts in this thread are concerned with bigger taxes not being the result of bigger income.
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Re: Is Tax Diversification Overrated?

Post by wrongfunds »

tibbitts wrote: Wed Sep 15, 2021 10:00 am
wrongfunds wrote: Wed Sep 15, 2021 7:34 am
I feel that BH places too much emphasis on how not to pay big taxes while losing the fact that the big taxes would be result of the bigger income.
As someone who has never had a "big" income by Boglehead standards, I know that sometimes high marginal rates are entirely a result of poor tax planning for a given income level. And once you've made mistakes (for example deferring too much at very low marginal rates), even years before, you often can't compensate or correct for those mistakes later on. Actually, all of the posts in this thread are concerned with bigger taxes not being the result of bigger income.
Only when all of the favorable assumptions come to fruition and NOT otherwise. This is important point which is often lost.
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

whodidntante wrote: Wed Sep 15, 2021 9:58 am Using tax-deferred accounts before things went to heck mean you'll be able to spend more over your life because you saved tax and invested the tax savings when your marginal rate was higher.
For many years during my working career, when I always maximized contributions to deferred accounts, my marginal rates without making any deferred contributions would have been lower than my now-essentially-fixed marginal rates will be going forward, based almost entirely on social security and RMDs. It would take some dire assumptions to materialize (very large medical expenses, for example) for that not to be the case.
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

cas wrote: Wed Sep 15, 2021 8:37 am
ThankYouJack wrote: Wed Sep 15, 2021 7:01 am Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
Not an answer to the "24% bracket" question you asked, but ... given the "12% bracket" you keep mentioning you think you will be in for RMDs ... note that, at 50K SS (MJF), the "12% bracket" is almost non-existent.

See the SS tax hump heat map for MJF (2021 version) here. Find the 50K column and read upward to see what marginal rates will be as withdrawals from the pre-tax account increase. Note that the SS tax hump has almost completely overlaid all the 10% nominal tax bracket and almost all the nominal 12% tax bracket.

Note 1: Other sizes of the heat map, as well as the Filing Single heat map are available in the Taxation of Social Security Benefits wiki article.)

Note 2: It is a bit more complicated that just looking at the 2021 heat map, because the shape of the heat map in future years will gradually morph, because part of the "taxation of SS" calculation is inflation adjusted and part is not.
That's a great map. A lot depends on how much and how long my spouse and I work, when we take SS, etc. I signed into the SS website and seems like our SS will be closer to $40k or lower than $50k.

If we're earning $40k in SS, (based on the map) other income could be $58k - $78k to put us at 12%. Also for many years prior to RMDs kicking in, we may be able to do Roth conversions to fill the lower bracket.

And if we decide to work longer, and are in the 22% bracket during retirement it won't be the end of the world :)
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

wrongfunds wrote: Wed Sep 15, 2021 10:05 am
tibbitts wrote: Wed Sep 15, 2021 10:00 am
wrongfunds wrote: Wed Sep 15, 2021 7:34 am
I feel that BH places too much emphasis on how not to pay big taxes while losing the fact that the big taxes would be result of the bigger income.
As someone who has never had a "big" income by Boglehead standards, I know that sometimes high marginal rates are entirely a result of poor tax planning for a given income level. And once you've made mistakes (for example deferring too much at very low marginal rates), even years before, you often can't compensate or correct for those mistakes later on. Actually, all of the posts in this thread are concerned with bigger taxes not being the result of bigger income.
Only when all of the favorable assumptions come to fruition and NOT otherwise. This is important point which is often lost.
I'm not sure what "all the favorable assumptions" are. With what seems like an average mix of positive and negative outcomes, and sufficient tax deferral opportunities, you can still defer income to the point where you end up paying more taxes than you needed to.
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Re: Is Tax Diversification Overrated?

Post by wrongfunds »

Do you agree that the stock market can go down and stay down for *long* time? Is it possible that long term return on stock could be negative? Is it probable? NO, but is it possible? YES!

We have had lots of discussion on this aspect of tax diversification could turn out to be a mistake when things go wrong, albeit the probability of that is quite low and I understand that.
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

ThankYouJack wrote: Wed Sep 15, 2021 10:11 am
cas wrote: Wed Sep 15, 2021 8:37 am
ThankYouJack wrote: Wed Sep 15, 2021 7:01 am Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
Not an answer to the "24% bracket" question you asked, but ... given the "12% bracket" you keep mentioning you think you will be in for RMDs ... note that, at 50K SS (MJF), the "12% bracket" is almost non-existent.

See the SS tax hump heat map for MJF (2021 version) here. Find the 50K column and read upward to see what marginal rates will be as withdrawals from the pre-tax account increase. Note that the SS tax hump has almost completely overlaid all the 10% nominal tax bracket and almost all the nominal 12% tax bracket.

Note 1: Other sizes of the heat map, as well as the Filing Single heat map are available in the Taxation of Social Security Benefits wiki article.)

Note 2: It is a bit more complicated that just looking at the 2021 heat map, because the shape of the heat map in future years will gradually morph, because part of the "taxation of SS" calculation is inflation adjusted and part is not.
That's a great map. A lot depends on how much and how long my spouse and I work, when we take SS, etc. I signed into the SS website and seems like our SS will be closer to $40k or lower than $50k.

If we're earning $40k in SS, (based on the map) other income could be $58k - $78k to put us at 12%. Also for many years prior to RMDs kicking in, we may be able to do Roth conversions to fill the lower bracket.

And if we decide to work longer, and are in the 22% bracket during retirement it won't be the end of the world :)
As you get closer to claiming SS benefits and have more precise information (e.g., portfolio balances, SS benefit amount), you can make better estimates of how much should be Roth converted. But in general, Roth conversions in the 12% bracket or lower are a slam dunk.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Is Tax Diversification Overrated?

Post by randomguy »

tibbitts wrote: Tue Sep 14, 2021 6:14 pm
randomguy wrote: Tue Sep 14, 2021 2:58 pm I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
But you don't have to have anywhere near 4-8M to generate RMDs that will put you in a 24% or higher bracket. Remember you likely also have taxable social security and maybe other investment income. It's the RMDs that are the problem, and you can get there without ever having been at that tax bracket level during your working career.
Yes if when you retire your income is higher than when your are working, you can end up in a higher tax bracket. I doubt that applies too many people. I do bet that group is vastly overrepresented on bogleheads:)
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Re: Is Tax Diversification Overrated?

Post by smitcat »

willthrill81 wrote: Tue Sep 14, 2021 2:10 pm
tibbitts wrote: Tue Sep 14, 2021 1:25 pm
willthrill81 wrote: Tue Sep 14, 2021 11:16 am
tibbitts wrote: Tue Sep 14, 2021 11:14 am
GoneOnTilt wrote: Tue Sep 14, 2021 10:57 am I think tax diversification is underrated. I don't put all my money in tax free or tax deferred. I like having a percentage in taxable accounts, so I can do what I want/need, when I want/need to. I can't imagine it won't help me control taxes when I retire as well. We'll see I suppose.
Historically there's seemed to be an over-emphasis on maximizing deferred accounts and not much discussion of the potential downsides. I think that's because for many years contributions to tax-deferred were much more limited than now, so only now are larger numbers of people facing substantial RMDs. The increase in contribution limits, combined with an increasing emphasis on defined contribution vs. defined benefit employer plans, plus strong investment market performance over the last decade or so have created somewhat of a perfect storm for RMDs.
If tax-deferred balances are so large that RMDs will create a genuine tax issue, then the individuals in question can retire earlier than they had originally planned, perhaps much earlier.
Sometimes there are mitigating factors to encourage working longer, such as vesting in employer benefits (healthcare, pension, etc.) that might be essentially all-or-nothing. So without them there might not be as much of an RMD issue but with them their might be a "genuine" one, of course with "genuine" being subject to interpretation. For me personally for "genuine" I'd start paying attention somewhere between RMDs plus other taxable income passing maybe the third IRMAA tier, maybe triggering NIIT, or venturing too far into the 32+% marginal brackets.
Yes, there can be such mitigating factors. But more often than not, it seems to me at least that those complaining about RMDs creating a 'tax bomb' for them simply worked significantly longer than they really needed to.
Work is not always a 'bad' word. It can involve activities that are mostly fun and not take up so much time as to limit other desires. In those cases working can also allow one to help out family, heirs and desired charities.
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Re: Is Tax Diversification Overrated?

Post by tibbitts »

randomguy wrote: Wed Sep 15, 2021 11:00 am
tibbitts wrote: Tue Sep 14, 2021 6:14 pm
randomguy wrote: Tue Sep 14, 2021 2:58 pm I am not trying to escape from the 24% bracket. I am just trying to make sure I have 10/22% income. Sure if I end up with some 24% income that income could have gone to the roth but given the uncertainity and the fact it is a wash, it isnt something to lose sleep over.

As far as being over, if your tax deferred is generating 164k/329k of income (portfolio balance of ~ 4/8 million when you retire), you were probably in that tax bracket to start with. Not many people retire on a lot more money than they had when they were working.
But you don't have to have anywhere near 4-8M to generate RMDs that will put you in a 24% or higher bracket. Remember you likely also have taxable social security and maybe other investment income. It's th RMDs that are the problem, and you can get there without ever having been at that tax bracket level during your working career.
Yes if when you retire your income is higher than when your are working, you can end up in a higher tax bracket. I doubt that applies too many people. I do bet that group is vastly overrepresented on bogleheads:)
That's been my own experience, but I agree that the higher-tax-in-retirement group is overrepresented on Bogleheads.
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

smitcat wrote: Wed Sep 15, 2021 11:01 am
willthrill81 wrote: Tue Sep 14, 2021 2:10 pm
tibbitts wrote: Tue Sep 14, 2021 1:25 pm
willthrill81 wrote: Tue Sep 14, 2021 11:16 am
tibbitts wrote: Tue Sep 14, 2021 11:14 am
Historically there's seemed to be an over-emphasis on maximizing deferred accounts and not much discussion of the potential downsides. I think that's because for many years contributions to tax-deferred were much more limited than now, so only now are larger numbers of people facing substantial RMDs. The increase in contribution limits, combined with an increasing emphasis on defined contribution vs. defined benefit employer plans, plus strong investment market performance over the last decade or so have created somewhat of a perfect storm for RMDs.
If tax-deferred balances are so large that RMDs will create a genuine tax issue, then the individuals in question can retire earlier than they had originally planned, perhaps much earlier.
Sometimes there are mitigating factors to encourage working longer, such as vesting in employer benefits (healthcare, pension, etc.) that might be essentially all-or-nothing. So without them there might not be as much of an RMD issue but with them their might be a "genuine" one, of course with "genuine" being subject to interpretation. For me personally for "genuine" I'd start paying attention somewhere between RMDs plus other taxable income passing maybe the third IRMAA tier, maybe triggering NIIT, or venturing too far into the 32+% marginal brackets.
Yes, there can be such mitigating factors. But more often than not, it seems to me at least that those complaining about RMDs creating a 'tax bomb' for them simply worked significantly longer than they really needed to.
Work is not always a 'bad' word. It can involve activities that are mostly fun and not take up so much time as to limit other desires. In those cases working can also allow one to help out family, heirs and desired charities.
True, but that's aside from the point I was making.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

willthrill81 wrote: Wed Sep 15, 2021 10:42 am
ThankYouJack wrote: Wed Sep 15, 2021 10:11 am
cas wrote: Wed Sep 15, 2021 8:37 am
ThankYouJack wrote: Wed Sep 15, 2021 7:01 am Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
Not an answer to the "24% bracket" question you asked, but ... given the "12% bracket" you keep mentioning you think you will be in for RMDs ... note that, at 50K SS (MJF), the "12% bracket" is almost non-existent.

See the SS tax hump heat map for MJF (2021 version) here. Find the 50K column and read upward to see what marginal rates will be as withdrawals from the pre-tax account increase. Note that the SS tax hump has almost completely overlaid all the 10% nominal tax bracket and almost all the nominal 12% tax bracket.

Note 1: Other sizes of the heat map, as well as the Filing Single heat map are available in the Taxation of Social Security Benefits wiki article.)

Note 2: It is a bit more complicated that just looking at the 2021 heat map, because the shape of the heat map in future years will gradually morph, because part of the "taxation of SS" calculation is inflation adjusted and part is not.
That's a great map. A lot depends on how much and how long my spouse and I work, when we take SS, etc. I signed into the SS website and seems like our SS will be closer to $40k or lower than $50k.

If we're earning $40k in SS, (based on the map) other income could be $58k - $78k to put us at 12%. Also for many years prior to RMDs kicking in, we may be able to do Roth conversions to fill the lower bracket.

And if we decide to work longer, and are in the 22% bracket during retirement it won't be the end of the world :)
As you get closer to claiming SS benefits and have more precise information (e.g., portfolio balances, SS benefit amount), you can make better estimates of how much should be Roth converted. But in general, Roth conversions in the 12% bracket or lower are a slam dunk.
Thanks to your posts and others in this thread, this is now clear to me.
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

ThankYouJack wrote: Wed Sep 15, 2021 11:17 am
willthrill81 wrote: Wed Sep 15, 2021 10:42 am
ThankYouJack wrote: Wed Sep 15, 2021 10:11 am
cas wrote: Wed Sep 15, 2021 8:37 am
ThankYouJack wrote: Wed Sep 15, 2021 7:01 am Let's say social security is $50k, the standard deduction is $25k, a couple is married filing jointly, and there's no other income (no pension, no taxable account). Doesn't the pre-tax account need to be close to $4M (at least over $3.5M) to get pushed into the 24% bracket?
Not an answer to the "24% bracket" question you asked, but ... given the "12% bracket" you keep mentioning you think you will be in for RMDs ... note that, at 50K SS (MJF), the "12% bracket" is almost non-existent.

See the SS tax hump heat map for MJF (2021 version) here. Find the 50K column and read upward to see what marginal rates will be as withdrawals from the pre-tax account increase. Note that the SS tax hump has almost completely overlaid all the 10% nominal tax bracket and almost all the nominal 12% tax bracket.

Note 1: Other sizes of the heat map, as well as the Filing Single heat map are available in the Taxation of Social Security Benefits wiki article.)

Note 2: It is a bit more complicated that just looking at the 2021 heat map, because the shape of the heat map in future years will gradually morph, because part of the "taxation of SS" calculation is inflation adjusted and part is not.
That's a great map. A lot depends on how much and how long my spouse and I work, when we take SS, etc. I signed into the SS website and seems like our SS will be closer to $40k or lower than $50k.

If we're earning $40k in SS, (based on the map) other income could be $58k - $78k to put us at 12%. Also for many years prior to RMDs kicking in, we may be able to do Roth conversions to fill the lower bracket.

And if we decide to work longer, and are in the 22% bracket during retirement it won't be the end of the world :)
As you get closer to claiming SS benefits and have more precise information (e.g., portfolio balances, SS benefit amount), you can make better estimates of how much should be Roth converted. But in general, Roth conversions in the 12% bracket or lower are a slam dunk.
Thanks to your posts and others in this thread, this is now clear to me.
No prob! Helping us all gain a better understanding of personal finance is the goal of this forum. :beer
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Is Tax Diversification Overrated?

Post by smitcat »

willthrill81 wrote: Wed Sep 15, 2021 11:13 am
smitcat wrote: Wed Sep 15, 2021 11:01 am
willthrill81 wrote: Tue Sep 14, 2021 2:10 pm
tibbitts wrote: Tue Sep 14, 2021 1:25 pm
willthrill81 wrote: Tue Sep 14, 2021 11:16 am

If tax-deferred balances are so large that RMDs will create a genuine tax issue, then the individuals in question can retire earlier than they had originally planned, perhaps much earlier.
Sometimes there are mitigating factors to encourage working longer, such as vesting in employer benefits (healthcare, pension, etc.) that might be essentially all-or-nothing. So without them there might not be as much of an RMD issue but with them their might be a "genuine" one, of course with "genuine" being subject to interpretation. For me personally for "genuine" I'd start paying attention somewhere between RMDs plus other taxable income passing maybe the third IRMAA tier, maybe triggering NIIT, or venturing too far into the 32+% marginal brackets.
Yes, there can be such mitigating factors. But more often than not, it seems to me at least that those complaining about RMDs creating a 'tax bomb' for them simply worked significantly longer than they really needed to.
Work is not always a 'bad' word. It can involve activities that are mostly fun and not take up so much time as to limit other desires. In those cases working can also allow one to help out family, heirs and desired charities.
True, but that's aside from the point I was making.
I am not sure what that point was then but we ended up with more in tax deferred then planned for a number of reasons - none of which we would change in the past if that were possible.
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Re: Is Tax Diversification Overrated?

Post by willthrill81 »

smitcat wrote: Wed Sep 15, 2021 11:38 am
willthrill81 wrote: Wed Sep 15, 2021 11:13 am
smitcat wrote: Wed Sep 15, 2021 11:01 am
willthrill81 wrote: Tue Sep 14, 2021 2:10 pm
tibbitts wrote: Tue Sep 14, 2021 1:25 pm
Sometimes there are mitigating factors to encourage working longer, such as vesting in employer benefits (healthcare, pension, etc.) that might be essentially all-or-nothing. So without them there might not be as much of an RMD issue but with them their might be a "genuine" one, of course with "genuine" being subject to interpretation. For me personally for "genuine" I'd start paying attention somewhere between RMDs plus other taxable income passing maybe the third IRMAA tier, maybe triggering NIIT, or venturing too far into the 32+% marginal brackets.
Yes, there can be such mitigating factors. But more often than not, it seems to me at least that those complaining about RMDs creating a 'tax bomb' for them simply worked significantly longer than they really needed to.
Work is not always a 'bad' word. It can involve activities that are mostly fun and not take up so much time as to limit other desires. In those cases working can also allow one to help out family, heirs and desired charities.
True, but that's aside from the point I was making.
I am not sure what that point was then but we ended up with more in tax deferred then planned for a number of reasons - none of which we would change in the past if that were possible.
My point was that I've seen many who were complaining about RMDs because they worked longer, often much longer, than was financially necessary. Retiring is not a purely financial decision, and some, like yourself, continue to work because they want to. But they should be aware that there can be consequences, like RMDs causing higher than expected taxes down the road.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
smitcat
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Re: Is Tax Diversification Overrated?

Post by smitcat »

willthrill81 wrote: Wed Sep 15, 2021 2:33 pm
smitcat wrote: Wed Sep 15, 2021 11:38 am
willthrill81 wrote: Wed Sep 15, 2021 11:13 am
smitcat wrote: Wed Sep 15, 2021 11:01 am
willthrill81 wrote: Tue Sep 14, 2021 2:10 pm

Yes, there can be such mitigating factors. But more often than not, it seems to me at least that those complaining about RMDs creating a 'tax bomb' for them simply worked significantly longer than they really needed to.
Work is not always a 'bad' word. It can involve activities that are mostly fun and not take up so much time as to limit other desires. In those cases working can also allow one to help out family, heirs and desired charities.
True, but that's aside from the point I was making.
I am not sure what that point was then but we ended up with more in tax deferred then planned for a number of reasons - none of which we would change in the past if that were possible.
My point was that I've seen many who were complaining about RMDs because they worked longer, often much longer, than was financially necessary. Retiring is not a purely financial decision, and some, like yourself, continue to work because they want to. But they should be aware that there can be consequences, like RMDs causing higher than expected taxes down the road.
Understood - we have been retired now for the most part. Some of our increase in pretax dollars came out of the desire to have a 401K plan for our staff. If it were not for them we might have passed on that program for a number of years.I have seen accounts end up the way they are for many reasons...
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iceport
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Re: Is Tax Diversification Overrated?

Post by iceport »

FiveK wrote: Tue Sep 14, 2021 10:38 pm
iceport wrote: Tue Sep 14, 2021 1:14 pm He belabors the point that investment diversification is not like tax diversification. Yet in the nice graphic he uses to show how diversifying away from traditional only "narrows the range" of outcomes, reducing the upside potential benefit and the downside potential detriment of tax risk simultaneously. Well... isn't that exactly the same effect diversifying away from equities only with the addition of fixed income has?

I don't care what term it goes by, having more than only traditional pre-tax accounts does, indeed, seem to reduce the magnitude of the worst effects of tax risk.

Am I missing something? Is this just semantics, a case of Kitces using the term "diversification" in the strictest sense instead of a looser, more general sense?
Your interpretation seems reasonable.

The article says
Or viewed another way, splitting dollars between traditional and Roth accounts is not akin to ‘investment diversification’ (e.g., between large- and small-cap stocks); instead, it’s more analogous to taking money out of the markets altogether (eliminating both the downside and upside opportunity) and just holding zero-risk-zero-opportunity cash instead.
Analogies are sometimes in the eye of the beholder. ;)
Yes, apparently...


Thanks for the confirmation (and for deciphering my awkward phrasing). I was starting to wonder if I've completely lost it. I always hate it when I don't agree with folks who are smarter than me!

And I was thinking about that very line by Kitces yesterday when I was out mowing the lawn. I thought, "Yeah, or choosing to hold, say, an allocation to intermediate-term bonds, maybe, instead of only equities? Like most of us do to varying degrees?"

I really do see an issue with different people using the term "diversification" differently, and thinking there's only one definition. Unless I'm mistaken, dbr likes to point to the definition that involves eliminating single-company risk by diversifying among, say 30 different companies or more. I guess that's the strict definition in the realm of modern portfolio theory? But from my completely unscientific, anecdotal experience, I see the term "diversification" being used very commonly — by laypeople and professionals alike — to describe simply allocating assets to more than one of the three main asset classes, traditionally being stocks, bonds, and cash. And under that latter definition, investment diversification has quite a bit in common with tax diversification.
"Discipline matters more than allocation.” ─William Bernstein
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iceport
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Re: Is Tax Diversification Overrated?

Post by iceport »

ThankYouJack wrote: Tue Sep 14, 2021 1:58 pm
iceport wrote: Mon Sep 13, 2021 1:31 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
I think what you are missing is the element of uncertainty, or risk.

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

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

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

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

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

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

There is a direct analogy between tax risk and investment risk. Investors may believe that common stocks are likely to generate a substantial equity risk premium. Yet they also recognize that higher equity returns are not guaranteed, and so diversify against that risk by holding other assets such as fixed income securities. In the case of taxes, participants may expect taxes to be lower (suggesting pre-tax savings) or higher (Roth savings) in retirement. But in pursuing a strategy of tax diversification, they will acknowledge the inherent uncertainty of forecasting any future tax rates, including their own, and so hold both types of savings.
"...acknowledge the inherent uncertainty of forecasting any future tax rates, including their own..."
Thanks for posting this. I think I'm less concerned about my tax rate going up significantly than many on here. If I was in the top 1-10% I may feel differently.
Will tax rates go up drastically?
Seems unlikely, especially after reading the Kitces article.

Will the rule for Roth IRAs be revised?
My guess would be no, but who knows.
Will you need to make an enormous portfolio withdrawal to address a family emergency?
What sort of emergency and how much $ are we talking? As of now I do have a brokerage account. I also have Roth contributions. Even if I didn't have those, there would be other options and I might have a traditional emergency fund. And even if I didn't have an emergency fund, paying a 10% early withdrawal penalty on traditional wouldn't be horrible if I saved 24% going in, and was taxed at 12%+10% (penalty) coming out.
I don't know, TYJ. I guess the classic example would be a serious medical emergency that generates a huge bill, even after insurance payments. By this, I guess I mean the kind of bill that sends lots of folks into bankruptcy. And though you are focused on the 10% penalty, what about the possibility of the withdrawal bumping you up a couple of income tax brackets, too?

But really, anything can happen. With tax rates, also. What might be unlikely is not impossible.

The guy that wrote the Vanguard paper, Stephen Utkus, was quoted a long time ago in a Journal of Financial Planning article:
When you put $100 into your 401(k) plan, you have no idea at that moment what your ultimate tax savings from that contribution is going to be. That savings depends on future tax rates.

Just recognizing tax uncertainty is the beginning of wisdom.
That makes a whole lot of sense to me...
"Discipline matters more than allocation.” ─William Bernstein
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ThankYouJack
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Re: Is Tax Diversification Overrated?

Post by ThankYouJack »

iceport wrote: Wed Sep 15, 2021 3:34 pm
ThankYouJack wrote: Tue Sep 14, 2021 1:58 pm
iceport wrote: Mon Sep 13, 2021 1:31 pm
ThankYouJack wrote: Mon Sep 13, 2021 12:33 pm Isn't this strategy minimizing taxes over the long haul or am I missing something?
I think what you are missing is the element of uncertainty, or risk.

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

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

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

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

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

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

There is a direct analogy between tax risk and investment risk. Investors may believe that common stocks are likely to generate a substantial equity risk premium. Yet they also recognize that higher equity returns are not guaranteed, and so diversify against that risk by holding other assets such as fixed income securities. In the case of taxes, participants may expect taxes to be lower (suggesting pre-tax savings) or higher (Roth savings) in retirement. But in pursuing a strategy of tax diversification, they will acknowledge the inherent uncertainty of forecasting any future tax rates, including their own, and so hold both types of savings.
"...acknowledge the inherent uncertainty of forecasting any future tax rates, including their own..."
Thanks for posting this. I think I'm less concerned about my tax rate going up significantly than many on here. If I was in the top 1-10% I may feel differently.
Will tax rates go up drastically?
Seems unlikely, especially after reading the Kitces article.

Will the rule for Roth IRAs be revised?
My guess would be no, but who knows.
Will you need to make an enormous portfolio withdrawal to address a family emergency?
What sort of emergency and how much $ are we talking? As of now I do have a brokerage account. I also have Roth contributions. Even if I didn't have those, there would be other options and I might have a traditional emergency fund. And even if I didn't have an emergency fund, paying a 10% early withdrawal penalty on traditional wouldn't be horrible if I saved 24% going in, and was taxed at 12%+10% (penalty) coming out.
I don't know, TYJ. I guess the classic example would be a serious medical emergency that generates a huge bill, even after insurance payments. By this, I guess I mean the kind of bill that sends lots of folks into bankruptcy. And though you are focused on the 10% penalty, what about the possibility of the withdrawal bumping you up a couple of income tax brackets, too?

But really, anything can happen. With tax rates, also. What might be unlikely is not impossible.

The guy that wrote the Vanguard paper, Stephen Utkus, was quoted a long time ago in a Journal of Financial Planning article:
When you put $100 into your 401(k) plan, you have no idea at that moment what your ultimate tax savings from that contribution is going to be. That savings depends on future tax rates.

Just recognizing tax uncertainty is the beginning of wisdom.
That makes a whole lot of sense to me...
Isn't that what insurance is for? My max out of pocket expense isn't super expensive so a huge medical expense isn't a major concern for me. Dying or having a serious medical condition would be a greater concern than the financial one.

There is some uncertainty with future tax rates but I don't think it's cause for concern either.
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iceport
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Re: Is Tax Diversification Overrated?

Post by iceport »

We're all free to make our own assumptions.

It's not always wise to act on them.

I have assumed for longer than I can remember that federal taxes have only one direction to go: up! And I've been wrong the whole time. Thankfully, I had the wisdom not to act on that assumption. Instead, I kept maxing out the tax-deferred account. And then income taxes were lowered, just in time for some Roth conversions! Was I lucky? Sure. But I was also positioned to take advantage of the opportunity because I didn't act solely on my assumption, which was eventually proven wrong.

It's always wise to consider that you might be wrong.

We're talking about differences around the margins with this tax question. How much you save is far more important than where you put it. So I'm not trying to be alarmist, and you are not going to go too far wrong no matter what you do. It's just never a bad idea to acknowledge uncertainty when it exists.
"Discipline matters more than allocation.” ─William Bernstein
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