Better to invest in taxable and not deferred?

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Elysium
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Better to invest in taxable and not deferred?

Post by Elysium » Sat Oct 13, 2018 9:58 pm

Conventional wisdom prevailing on BH and elsewhere in financial media is you max out your tax deferred space (401(k), 403(b), TSP, etc) and then fund Roth followed by any excess in taxable accounts. Especially if your investment choices are really good then no reason not to max out tax deferred space. Recently I heard an argument from a coworker that was never heard before with an interesting angle to it. It goes like this:

You invest up to getting max employer matching contributions in tax deferred, and after that take the rest as taxable income and invest in taxable accounts. Logic: capital gains taxes are lower than ordinary income taxes and expectation is ordinary income taxes will remain high in retirement especially with looming debt obligations. Capital gains taxes will remain lower because it is mainly for the benefit of the super rich, and since super rich controls how tax laws are passed it is best to side with them.

I couldn't think of an immediate reason as to why this could be flawed, other than taxes could be lower in retirement while they are higher now, so why pay more taxes now thinking to benefit from lower capital gains in future which isn't guaranteed.

This sounds clever? but something tells me it isn't, what is the flaw in this line of thinking.

onourway
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Re: Better to invest in taxable and not deferred?

Post by onourway » Sat Oct 13, 2018 10:07 pm

Even if you believe this, you should be maxing all Roth accounts now. Then you pay income tax but no capital gains. In that case you should be maxing both your Roth 401k and your Roth IRA before investing in taxable.

Soon2BXProgrammer
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Re: Better to invest in taxable and not deferred?

Post by Soon2BXProgrammer » Sat Oct 13, 2018 10:13 pm

also, it is reasonable to have enough deferred (pretax) assets to fill the 0 and 10% brackets for the rest of your life.

KlangFool
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Re: Better to invest in taxable and not deferred?

Post by KlangFool » Sat Oct 13, 2018 10:22 pm

OP,

Please check out this thread first.

viewtopic.php?t=87471
<<How to pay ZERO taxes in retirement with 6-figure expenses>>

KlangFool

retiredjg
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Re: Better to invest in taxable and not deferred?

Post by retiredjg » Sun Oct 14, 2018 9:13 am

There are two arguments against this that I know of.

1) If you put money into taxable now, you pay taxes on it now so less actually gets into the taxable account. If you put $10k into a tax deferred account, you have $10k in there - to be taxed at a later time when you hope your tax rate will be lower than now (for example 25% now or 15% later). You end up with more money by deferring taxes.

But if you have the same $10k to invest and put it in a taxable account, you only get $7.5k in there (assuming a 25% rate now for this example). Yes, the taxes on this money will be less because capital gains taxes are always less, but it is less money to start with so what has been accomplished?

2) In addition to putting a smaller amount into taxable, $7.5k in this example, there is a little tax drag on it every year because of dividends and taxable gains distributions which you have to pay tax on. I doubt this amounts to much, but compounded year after year, it might amount to something.

There is no tax drag in the tax-deferred account.


I think your friend, without realizing it, is comparing putting $10k into tax deferred to $10k in taxable. This is not the right comparison.

jj45
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Re: Better to invest in taxable and not deferred?

Post by jj45 » Sun Oct 14, 2018 10:41 am

Elysium wrote:
Sat Oct 13, 2018 9:58 pm
expectation is ordinary income taxes will remain high in retirement
If you retire wealthy, then yes, ordinary income taxes will be high and you might have done better investing in taxable. If you do not retire wealthy, then taxes will be low and you will have done better investing in tax-deferred. Of course we all hope to retire wealthy but sometimes life intervenes. Illness can cause earlier retirement than planned, you or a loved one might need expensive ongoing medical care, the list is long.

So you can invest in taxable and end up with more money when you are already rich and it doesn't matter much, or invest in tax-deferred and end up with more money when you are not rich and every penny counts. I chose tax-deferred.

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raven15
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Re: Better to invest in taxable and not deferred?

Post by raven15 » Sun Oct 14, 2018 11:10 am

Nope, it is never Better. If you think your income tax rate will be higher now than retirement, then defer taxes. If you think your income tax rate will be higher in retirement, then use Roth-type shelters. Either way an HSA is your friend. Else you will pay taxes on ordinary dividends and other people’s gains and come out behind in addition to whatever tax rate difference you get.
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JBTX
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Re: Better to invest in taxable and not deferred?

Post by JBTX » Sun Oct 14, 2018 11:24 am

The argument presented to OP generally doesn't work because a Roth IRA has zero taxes, vs taxable has capital gains taxes. One could argue that in specific (and rare) circumstances a taxable may beat a traditional tax deferred 401k, but it almost never would beat a Roth, except

- You are somehow able to very efficiently tax lost harvest to offset $3000 or more ordinary income most years with capital losses, and then somewhere in the future realize accumulated taxable gains while in a zero tax rate. I'm not sure if this is practically achievable.

- You end up in a net loss situation - capital losses can offset taxable income to a degree

retiredjg
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Re: Better to invest in taxable and not deferred?

Post by retiredjg » Sun Oct 14, 2018 11:31 am

jj45 wrote:
Sun Oct 14, 2018 10:41 am
Elysium wrote:
Sat Oct 13, 2018 9:58 pm
expectation is ordinary income taxes will remain high in retirement
If you retire wealthy with a high income, then yes, ordinary income taxes will be high and you might have done better investing in taxable. If you do not retire wealthy, then taxes will be low and you will have done better investing in tax-deferred. Of course we all hope to retire wealthy but sometimes life intervenes. Illness can cause earlier retirement than planned, you or a loved one might need expensive ongoing medical care, the list is long.

So you can invest in taxable and end up with more money when you are already rich and it doesn't matter much, or invest in tax-deferred and end up with more money when you are not rich and every penny counts. I chose tax-deferred.
I'll take the liberty to do a slight edit on your comment. :happy I think you are headed in the right direction except for one thing.

Retiring wealthy is not the same thing as retiring in a high income bracket. It is certainly possible to retire very wealthy and still be in a lower income bracket.

Here are a couple of old threads discussing this idea. I've not read them lately, but think much of the thinking should still be current.

viewtopic.php?f=2&t=87471

viewtopic.php?t=79510

TravelforFun
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Re: Better to invest in taxable and not deferred?

Post by TravelforFun » Sun Oct 14, 2018 11:41 am

Besides the lower long-term capital gain tax rates the OP mentioned, don't forget when you pass your taxable accounts to your heirs after you pass, they pay nothing on the gains because of the step-up.

Pass your IRA accounts to your heirs and here come RMD and the tax man.

On the verge of retirment now and facing no lower tax rates in retirement, I wish I had invested more in taxable and less on 401K.

TravelforFun

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willthrill81
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Re: Better to invest in taxable and not deferred?

Post by willthrill81 » Sun Oct 14, 2018 11:57 am

TravelforFun wrote:
Sun Oct 14, 2018 11:41 am
Besides the lower long-term capital gain tax rates the OP mentioned, don't forget when you pass your taxable accounts to your heirs after you pass, they pay nothing on the gains because of the step-up.

Pass your IRA accounts to your heirs and here come RMD and the tax man.
Like the OP, you're forgetting that taxes have already been paid on the funds going into a taxable account, plus tax drag along the way. No federal income tax has been paid on the traditional IRA and 401k accounts, and you're given the use of the money that would have been paid in taxes to make more money.

I've not seen a realistic scenario where taxable beat tax deferred when all was said and done.
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UpsetRaptor
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Re: Better to invest in taxable and not deferred?

Post by UpsetRaptor » Sun Oct 14, 2018 12:06 pm

Elysium wrote:
Sat Oct 13, 2018 9:58 pm
what is the flaw in this line of thinking.
A few, but the main thing this argument misses is the taxes saved now. $10K invested in tax deferred now will be ~$6K-$8K in taxable, depending on your tax rate. Even IF the taxable comes out at a lower rate in the future, it's not going to catch up to all those extra savings/investments each year.

JustinR
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Re: Better to invest in taxable and not deferred?

Post by JustinR » Sun Oct 14, 2018 12:27 pm

Your coworker is wrong.

You already paid taxes on the income you're investing for taxable, and are going to be taxed even more with capital gains tax. So you earned $100, after tax it's now $70, you invest $70 and any gains are taxed.

Meanwhile deferred funds like a 401k, you may never pay taxes on if you control your income in retirement right. So you earned $100, invest the whole $100, and you may never be taxed (or be taxed very little) on the $100 or any gains.

That's the benefit of deferred. You worry about the tax situation later. You should always defer as much as you possibly can.

The order is:
- 401k/Traditional IRA/HSA
- Roth IRA
- Taxable
Last edited by JustinR on Sun Oct 14, 2018 1:06 pm, edited 1 time in total.

MotoTrojan
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Re: Better to invest in taxable and not deferred?

Post by MotoTrojan » Sun Oct 14, 2018 12:30 pm

UpsetRaptor wrote:
Sun Oct 14, 2018 12:06 pm
Elysium wrote:
Sat Oct 13, 2018 9:58 pm
what is the flaw in this line of thinking.
A few, but the main thing this argument misses is the taxes saved now. $10K invested in tax deferred now will be ~$6K-$8K in taxable, depending on your tax rate. Even IF the taxable comes out at a lower rate in the future, it's not going to catch up to all those extra savings/investments each year.
This is the key. Nowhere near equivalent.

KJVanguard
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Re: Better to invest in taxable and not deferred?

Post by KJVanguard » Sun Oct 14, 2018 12:39 pm

TravelforFun wrote:
Sun Oct 14, 2018 11:41 am
Besides the lower long-term capital gain tax rates the OP mentioned, don't forget when you pass your taxable accounts to your heirs after you pass, they pay nothing on the gains because of the step-up.
My mother avoided tax on about $200,000 of cap gains upon her death. Then I sold her (then my inherited) Tax-Managed Small Cap to harvest a $12,000 cap loss, even though it had made quite a lot of money over the last 16 years of life she held it. That fund never distributed a single gain ever, so never was a cent of cap gains tax paid upon it. Overall, NEGATIVE taxes over 20 years!
TravelforFun wrote:
Sun Oct 14, 2018 11:41 am
Pass your IRA accounts to your heirs and here come RMD and the tax man.
Yes, and the really sad part is that most people have no clue how to handle an inherited IRA. I would recommend looking into books on the subject by Ed Slott, the nation's leading expert on IRAs. I have multiple inherited IRAs (including one that's been inherited twice as the first beneficiary died). I'm honoring my ancestors by taking only the RMD (down to the cent -- I will not round up to the next dollar!), such that IRAs can live on up to 50 years after their death. One can get inherited IRAs to live on till they are about age 83.

Also no taxes on Roth IRAs.

I have a charity as the beneficiary of my traditional IRAs, so the IRS will get nothing as a charity is not taxable.

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iceport
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Re: Better to invest in taxable and not deferred?

Post by iceport » Sun Oct 14, 2018 1:06 pm

Elysium wrote:
Sat Oct 13, 2018 9:58 pm
Recently I heard an argument from a coworker that was never heard before with an interesting angle to it. It goes like this:

You invest up to getting max employer matching contributions in tax deferred, and after that take the rest as taxable income and invest in taxable accounts. Logic: capital gains taxes are lower than ordinary income taxes and expectation is ordinary income taxes will remain high in retirement especially with looming debt obligations. Capital gains taxes will remain lower because it is mainly for the benefit of the super rich, and since super rich controls how tax laws are passed it is best to side with them.

<snip>

This sounds clever? but something tells me it isn't, what is the flaw in this line of thinking.
You are correct; this line of thinking is flawed. It's understandable (at least to me, as someone who once held a similar flawed view), but it's flawed nonetheless.

Possibly the major flaw, in a broad sense, is focusing on the absolute value of the taxes paid, rather than focusing on the absolute value of the dollars the investor gets to keep and/or spend after taxes. Investors should always be focused on the latter.

To begin with, the argument is enormously flawed from the start because it ignores Roth contributions completely. Even if an investor applies flawed logic to the "tax-deferred" vs. taxable choice, it should be a no-brainer that a Roth account is better than a taxable account. Quite obviously, all growth in a Roth account is tax-free. It shouldn't matter what assumptions you entertain about capital gains taxes in the future, avoiding all future taxes altogether is clearly better. (Some folks might argue that the rules on Roth accounts could be changed to include some future taxation, but I consider applying that scenario retroactively to past contributions to be unrealistic.)

Okay, so let's assume maximizing the use of Roth accounts is inserted before any taxable investing in the order of things. The proposed use of taxable accounts instead of before-tax tax-advantaged accounts (aka "tax-deferred" accounts) is also flawed.

At this point, it might be best to first get a handle on how after-tax (Roth) accounts and before-tax (traditional or "tax-deferred") tax-advantaged accounts compare. It should be self-evident that a Roth account offers tax-free growth. What's less understood is that, assuming a constant tax rate before and after retirement, the traditional account offers exactly the same tax-free growth.

A wiki article shows the simple algebra supporting this fact:
The simplest equations for the spendable amount one gets, after growth and taxes are considered:

Traditional = Original_amount * Growth * (1 - withdrawal_tax_rate)
Roth = Original_amount * (1 - contribution_tax_rate) * Growth

When the tax rates are equal, thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the Traditional and Roth results are equal.

For example, if your marginal tax rate is 25% (which does not currently exist as a federal rate, but could be your rate including state tax), you can contribute $3000 to a Roth account, or $4000 to a traditional account for the same $3000 out of pocket. If the account doubles in value, then you could have $6000 in the Roth account, or $8000 in the traditional account. Thus, if you retire at a 25% marginal tax rate, you will pay $2000 in tax when you withdraw the $8000 and wind up with the same $6000.

Traditional = $4000 * 2 * (1 - 0.25) = $6000
Roth = $4000 * (1 - 0.25) * 2 = $6000

If you retire at a 15% marginal tax rate, you will pay only $1200 in tax when you withdraw the $8000 and wind up with $6800.

Note: If you can maximize your IRA contribution, see below.
The above example shows that even though the traditional account requires far higher tax payments than the Roth account in absolute terms, the amount the investor has left to spend is the same!

So if the traditional and Roth tax-advantaged accounts offer the same tax break (under a constant tax rate assumption), namely tax-free growth, it should now be evident that both are preferable to a taxable account.

Taxable accounts, unlike Roth accounts, generate dividends — and capital gains distributions, typically, in the case of actively managed mutual funds — that are taxed each year, and capital gains taxes when investments are sold to spend. These taxes clearly tip the balance towards the better tax-advantaged options.

Even if income tax rates go up in the future, they're unlikely to go up high enough to overcome the significant tax advantages of a before-tax (traditional) tax-advantaged account.
"Discipline matters more than allocation.” ─William Bernstein

cherijoh
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Re: Better to invest in taxable and not deferred?

Post by cherijoh » Sun Oct 14, 2018 1:58 pm

retiredjg wrote:
Sun Oct 14, 2018 9:13 am
There are two arguments against this that I know of.

1) If you put money into taxable now, you pay taxes on it now so less actually gets into the taxable account. If you put $10k into a tax deferred account, you have $10k in there - to be taxed at a later time when you hope your tax rate will be lower than now (for example 25% now or 15% later). You end up with more money by deferring taxes.

But if you have the same $10k to invest and put it in a taxable account, you only get $7.5k in there (assuming a 25% rate now for this example). Yes, the taxes on this money will be less because capital gains taxes are always less, but it is less money to start with so what has been accomplished?

2) In addition to putting a smaller amount into taxable, $7.5k in this example, there is a little tax drag on it every year because of dividends and taxable gains distributions which you have to pay tax on. I doubt this amounts to much, but compounded year after year, it might amount to something.

There is no tax drag in the tax-deferred account.


I think your friend, without realizing it, is comparing putting $10k into tax deferred to $10k in taxable. This is not the right comparison.
+1
That is usually the issue - the person arguing against tax-deferred is usually ignoring the taxes paid on the initial after-tax contribution and the ongoing tax drag from dividends.

A related issue is that as you get older and reduce your AA to stocks, the person who only used tax-deferred up to their company match may find that they have insufficient tax-deferred space to hold their bond allocation. Bond interest payments are taxed at ordinary tax rates when held in taxable accounts and therefore have even more tax drag than stocks.

IMO, it is possible to end up with too much in tax-deferred if, for instance, your company offers a super generous voluntary contribution to your 401k or a couple maxes out both their 401Ks on modest income (i.e., super savers). But most people will end up needing to max out tax-deferred AND make after-tax investments - unless you are one of the lucky few still covered by a pension.

From a practical standpoint, if you are planning to retire early (under 59.5) it is helpful to have some after-tax investments. In practice, the exception that allows you penalty-free access to your 401k when retiring at or over 55 only works if your 401k has flexible terms of disbursal. Since I didn't meet the company definition of "retired" (in terms of age and years of service), my former employer only allows me to leave my money in the 401k plan, roll it over to an IRA, or take a 100% withdrawal. Unlike IRAs, 401Ks don't have to allow on-demand withdrawals until you hit RMDs at 70.5. This often comes as a surprise to participants who hadn't bothered to read the rules of their 401k plan documents.

The other exception to early withdrawal penalties, a Substantially Equal Payment Plan (SEPP), is fairly rigid in the amount you can withdraw and the period of time the plan must stay in place. If you mess up on sticking to the rules, the 10% penalty will be due retroactively.

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Re: Better to invest in taxable and not deferred?

Post by willthrill81 » Sun Oct 14, 2018 2:22 pm

iceport wrote:
Sun Oct 14, 2018 1:06 pm
Elysium wrote:
Sat Oct 13, 2018 9:58 pm
Recently I heard an argument from a coworker that was never heard before with an interesting angle to it. It goes like this:

You invest up to getting max employer matching contributions in tax deferred, and after that take the rest as taxable income and invest in taxable accounts. Logic: capital gains taxes are lower than ordinary income taxes and expectation is ordinary income taxes will remain high in retirement especially with looming debt obligations. Capital gains taxes will remain lower because it is mainly for the benefit of the super rich, and since super rich controls how tax laws are passed it is best to side with them.

<snip>

This sounds clever? but something tells me it isn't, what is the flaw in this line of thinking.
You are correct; this line of thinking is flawed. It's understandable (at least to me, as someone who once held a similar flawed view), but it's flawed nonetheless.

Possibly the major flaw, in a broad sense, is focusing on the absolute value of the taxes paid, rather than focusing on the absolute value of the dollars the investor gets to keep and/or spend after taxes. Investors should always be focused on the latter.

To begin with, the argument is enormously flawed from the start because it ignores Roth contributions completely. Even if an investor applies flawed logic to the "tax-deferred" vs. taxable choice, it should be a no-brainer that a Roth account is better than a taxable account. Quite obviously, all growth in a Roth account is tax-free. It shouldn't matter what assumptions you entertain about capital gains taxes in the future, avoiding all future taxes altogether is clearly better. (Some folks might argue that the rules on Roth accounts could be changed to include some future taxation, but I consider applying that scenario retroactively to past contributions to be unrealistic.)

Okay, so let's assume maximizing the use of Roth accounts is inserted before any taxable investing in the order of things. The proposed use of taxable accounts instead of before-tax tax-advantaged accounts (aka "tax-deferred" accounts) is also flawed.

At this point, it might be best to first get a handle on how after-tax (Roth) accounts and before-tax (traditional or "tax-deferred") tax-advantaged accounts compare. It should be self-evident that a Roth account offers tax-free growth. What's less understood is that, assuming a constant tax rate before and after retirement, the traditional account offers exactly the same tax-free growth.

A wiki article shows the simple algebra supporting this fact:
The simplest equations for the spendable amount one gets, after growth and taxes are considered:

Traditional = Original_amount * Growth * (1 - withdrawal_tax_rate)
Roth = Original_amount * (1 - contribution_tax_rate) * Growth

When the tax rates are equal, thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the Traditional and Roth results are equal.

For example, if your marginal tax rate is 25% (which does not currently exist as a federal rate, but could be your rate including state tax), you can contribute $3000 to a Roth account, or $4000 to a traditional account for the same $3000 out of pocket. If the account doubles in value, then you could have $6000 in the Roth account, or $8000 in the traditional account. Thus, if you retire at a 25% marginal tax rate, you will pay $2000 in tax when you withdraw the $8000 and wind up with the same $6000.

Traditional = $4000 * 2 * (1 - 0.25) = $6000
Roth = $4000 * (1 - 0.25) * 2 = $6000

If you retire at a 15% marginal tax rate, you will pay only $1200 in tax when you withdraw the $8000 and wind up with $6800.

Note: If you can maximize your IRA contribution, see below.
The above example shows that even though the traditional account requires far higher tax payments than the Roth account in absolute terms, the amount the investor has left to spend is the same!

So if the traditional and Roth tax-advantaged accounts offer the same tax break (under a constant tax rate assumption), namely tax-free growth, it should now be evident that both are preferable to a taxable account.

Taxable accounts, unlike Roth accounts, generate dividends — and capital gains distributions, typically, in the case of actively managed mutual funds — that are taxed each year, and capital gains taxes when investments are sold to spend. These taxes clearly tip the balance towards the better tax-advantaged options.

Even if income tax rates go up in the future, they're unlikely to go up high enough to overcome the significant tax advantages of a before-tax (traditional) tax-advantaged account.
:sharebeer

Very well said! It's entirely true that if a Roth account is superior to a taxable account, which should be obvious, and a Roth is equivalent to a tax-deferred account if tax rates are the same for contributions and withdrawals, then a tax-deferred account is better than a taxable one.
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Re: Better to invest in taxable and not deferred?

Post by aj76er » Sun Oct 14, 2018 6:14 pm

Aside from tax rates pre and post retirement, one must consider the time value of money, in which a dollar of tax savings today is worth more than a dollar of tax savings in the future. The reason for this is two-fold: inflation continually erodes the purchase power of a dollar, and long-term compounding will, over time, increase the value of investment dollars.
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Re: Better to invest in taxable and not deferred?

Post by willthrill81 » Sun Oct 14, 2018 6:17 pm

aj76er wrote:
Sun Oct 14, 2018 6:14 pm
Aside from tax rates pre and post retirement, one must consider the time value of money, in which a dollar of tax savings today is worth more than a dollar of tax savings in the future. The reason for this is two-fold: inflation continually erodes the purchase power of a dollar, and long-term compounding will, over time, increase the value of investment dollars.
How is that relevant in a discussion of taxable versus tax-deferred?
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Better to invest in taxable and not deferred?

Post by aj76er » Sun Oct 14, 2018 9:01 pm

willthrill81 wrote:
Sun Oct 14, 2018 6:17 pm
aj76er wrote:
Sun Oct 14, 2018 6:14 pm
Aside from tax rates pre and post retirement, one must consider the time value of money, in which a dollar of tax savings today is worth more than a dollar of tax savings in the future. The reason for this is two-fold: inflation continually erodes the purchase power of a dollar, and long-term compounding will, over time, increase the value of investment dollars.
How is that relevant in a discussion of taxable versus tax-deferred?
One of the OP's points was that it was optimal to pay more taxes now (ie favoring post-tax dollars vs tax-deferred dollars) in attempt to achieve lower taxes later (ie LTCG rates vs marginal income rates). My point is that the time-value of money over a long period of time is the more important thing to optimize. So any theoretical tax difference will pale in comparison to the opportunity cost of not fully utilizing tax-deferred space. That is, the tax savings that one achieves today by first filling up tax-deferred space, which then is compounded over time, will outweigh any theoretical tax savings one may get later on money that was already taxed. At any rate, I think it is the same argument to be made for 401k vs Roth. For most people in high marginal tax brackets in their working years, the 401k makes more sense.
"Buy-and-hold, long-term, all-market-index strategies, implemented at rock-bottom cost, are the surest of all routes to the accumulation of wealth" - John C. Bogle

Elysium
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Re: Better to invest in taxable and not deferred?

Post by Elysium » Sun Oct 14, 2018 9:29 pm

OP here. Glad to see many thoughtful responses. I knew it wouldn't pass the BH stress test, and that's why I posted it since I have never found a solid reason myself. Anytime I ran this calculation in excel over the years, every time tax deferred and Roth has come out ahead.

I must clarify one thing about the line of thinking from this individual, he believes the system is sort of rigged in favor of super rich. His rationale, we just passed an unfunded trillion dollar tax cut and debt obligations are high, not only is ordinary taxes likely to be high in future but there is also possibility of a wealth tax on assets accumulated. Capital gain taxes are what the super rich are favoring and since they influence the laws, it is likely safer to be on the investments favored by them.

I have a hard time with this logic as it isn't based on known rules and tax consequences we apply here on BH and elsewhere, but on conjecture. Although some of his points such as size of national debt are facts, the conclusions derived from it is pure speculation.

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Re: Better to invest in taxable and not deferred?

Post by willthrill81 » Sun Oct 14, 2018 9:45 pm

aj76er wrote:
Sun Oct 14, 2018 9:01 pm
willthrill81 wrote:
Sun Oct 14, 2018 6:17 pm
aj76er wrote:
Sun Oct 14, 2018 6:14 pm
Aside from tax rates pre and post retirement, one must consider the time value of money, in which a dollar of tax savings today is worth more than a dollar of tax savings in the future. The reason for this is two-fold: inflation continually erodes the purchase power of a dollar, and long-term compounding will, over time, increase the value of investment dollars.
How is that relevant in a discussion of taxable versus tax-deferred?
One of the OP's points was that it was optimal to pay more taxes now (ie favoring post-tax dollars vs tax-deferred dollars) in attempt to achieve lower taxes later (ie LTCG rates vs marginal income rates). My point is that the time-value of money over a long period of time is the more important thing to optimize. So any theoretical tax difference will pale in comparison to the opportunity cost of not fully utilizing tax-deferred space. That is, the tax savings that one achieves today by first filling up tax-deferred space, which then is compounded over time, will outweigh any theoretical tax savings one may get later on money that was already taxed. At any rate, I think it is the same argument to be made for 401k vs Roth. For most people in high marginal tax brackets in their working years, the 401k makes more sense.
Actually, the time value of money doesn't impact the situation here. The after-tax nominal dollars in the end will be exactly the same when comparing tax-deferred accounts to Roth accounts if the tax rate when contributions are made is the same tax rate when withdrawals are made.

For instance, let's assume 25% taxes (not a real bracket, but this is just an illustration) and, as such, $1,000 would be contributed to a tax-deferred account while $750 would be contributed to a Roth. Both of the accounts then double in size due to growth. The tax-deferred account is worth $2,000 pre-tax, but after paying 25% taxes on the withdrawals, $1,500 would be left. This is exactly how much the Roth is worth since no taxes are due on it. Inflation is irrelevant because it has the same effect, reducing the real growth rate, on both account types, so neither gets an advantage over the other.

This is the same situation with taxable vs. tax-deferred vs. Roth.

Now in practice, the tax-deferred accounts often are preferable because they are used to 'fill up' the lower tax brackets first. For instance, a married filing jointly couple needs around $100k of taxable income to fill up the 0%, 10%, and 12% tax brackets. Assuming 4% withdrawals, a $2.5 million portfolio would be needed to do this. So if the couple is in a higher than 12% bracket when they are making contributions, the tax-deferred account will win out, everything else held equal.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

J295
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Re: Better to invest in taxable and not deferred?

Post by J295 » Mon Oct 15, 2018 10:14 am

In our case it seems to have worked out well to use up all the tax deferred space. I was in a relatively high income profession, so the tax rate was high and we put everything possible into tax deferred, including contributions by the firm. Retired at 53, and 2/3 of assets are tax deferred and 1/3 are taxable. Objective is to only take RMD from tax deferred when that time comes, and leave balance to family.

a couple of unanticipated benefits of our current mix … We are able to control modified adjusted gross income and qualify for premium tax credits under the affordable care act… And we can either do Roth conversions or take advantage of the 0% capital gains rates ( only modest space for this due to the affordable care act limitations )

FoolMeOnce
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Re: Better to invest in taxable and not deferred?

Post by FoolMeOnce » Mon Oct 15, 2018 10:35 am

TravelforFun wrote:
Sun Oct 14, 2018 11:41 am
Besides the lower long-term capital gain tax rates the OP mentioned, don't forget when you pass your taxable accounts to your heirs after you pass, they pay nothing on the gains because of the step-up.

Pass your IRA accounts to your heirs and here come RMD and the tax man.

On the verge of retirment now and facing no lower tax rates in retirement, I wish I had invested more in taxable and less on 401K.

TravelforFun
Curious: is your regret taking into account that the balance in taxable would be significantly lower?

KlangFool
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Re: Better to invest in taxable and not deferred?

Post by KlangFool » Mon Oct 15, 2018 11:06 am

Deleted.

Off topic.

KlangFool
Last edited by KlangFool on Mon Oct 15, 2018 12:59 pm, edited 2 times in total.

Minderbinder
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Re: Better to invest in taxable and not deferred?

Post by Minderbinder » Mon Oct 15, 2018 11:18 am

raven15 wrote:
Sun Oct 14, 2018 11:10 am
Nope, it is never Better. If you think your income tax rate will be higher now than retirement, then defer taxes. If you think your income tax rate will be higher in retirement, then use Roth-type shelters. Either way an HSA is your friend. Else you will pay taxes on ordinary dividends and other people’s gains and come out behind in addition to whatever tax rate difference you get.
Nailed it.

aristotelian
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Re: Better to invest in taxable and not deferred?

Post by aristotelian » Mon Oct 15, 2018 11:26 am

You would only not invest in 401k/deferred if you expected that deferred tax would be higher than your current tax. For the vast majority of people at the peak of their earning power, their retirement tax rate will be lower. Remember that we are talking about taxable income, not spending. Once you are retired, you lose the biggest source of taxable income. If you can manipulate your tax bracket in retirement, the huge upside of 401k is that you will be saving pretax at your current marginal rate, avoiding both state and federal tax on the front end, with the possibility of being able to cash out tax free in the future.

Some exceptions:
-You are a student or very early in your career
-You will get a huge inheritance that will give you a crazy high tax bracket in retirement
-You expect that tax brackets will be dramatically higher in the future

The last one is probably the biggest concern. Still I would stick with 401k up the limit in most situations, using Roth IRA and taxable as a hedge.

fulltilt
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Re: Better to invest in taxable and not deferred?

Post by fulltilt » Mon Oct 15, 2018 12:01 pm

KlangFool wrote:
Mon Oct 15, 2018 11:06 am

Elysium,

<< I must clarify one thing about the line of thinking from this individual, he believes the system is sort of rigged in favor of super rich.>>

This is a bunch of BS. The system punishes folks that spend most of their incomes. If you do not spend, you can save most of your money and you generate less taxable income.

<< His rationale, we just passed an unfunded trillion dollar tax cut and debt obligations are high, not only is ordinary taxes likely to be high in future but there is also possibility of a wealth tax on assets accumulated. >>

So, he chooses to spend most of his money and ended up pay a lot of taxes. It is not his fault. The savers should be punished instead.

It is an "income" tax system. If you do not spend, you do not need to generate the income. If you choose to spend more, you generate more income and pay more taxes. Your choice your life.

KlangFool
A person making the median individual income in the United States ($32k) doesn't have nearly the same amount of discretion and ability to choose how much of their income they spend each year compared to a high earning individual which makes your remark come across as insensitive. At the risk of going off topic into politics and violating the rules, i think it is important to realize that many individuals on this board are extraordinary and their experiences are *vastly* different than the majority of people.

TravelforFun
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Re: Better to invest in taxable and not deferred?

Post by TravelforFun » Mon Oct 15, 2018 6:29 pm

FoolMeOnce wrote:
Mon Oct 15, 2018 10:35 am
TravelforFun wrote:
Sun Oct 14, 2018 11:41 am
Besides the lower long-term capital gain tax rates the OP mentioned, don't forget when you pass your taxable accounts to your heirs after you pass, they pay nothing on the gains because of the step-up.

Pass your IRA accounts to your heirs and here come RMD and the tax man.

On the verge of retirment now and facing no lower tax rates in retirement, I wish I had invested more in taxable and less on 401K.

TravelforFun
Curious: is your regret taking into account that the balance in taxable would be significantly lower?
Yes of course I know the balance in taxable would be lower than my IRA balance by a a percentage equal to approximately my tax rate. However, when I withdraw from my IRA I would pay the marginal tax rate (22%) on the withdrawals but when I withdraw from my taxable, I would pay the long term capital gain rate (15%) on the gains and 0% on the principal. Plus, when I pass the taxable to my heirs, they would get a step up basis which is a huge deal to me.

TravelforFun

not4me
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Re: Better to invest in taxable and not deferred?

Post by not4me » Wed Oct 17, 2018 9:56 am

Elysium wrote:
Sat Oct 13, 2018 9:58 pm

This sounds clever? but something tells me it isn't, what is the flaw in this line of thinking.
I don't think this is a flaw in SOME cases. If the co-worker is saying this is always the best, I think they are as incorrect as saying it never is.

I skimmed other posts & think most points at least touched on, but would add that in taxable there is just more flexibility. That may not matter to some, but everyone's situation is different. The co-worker may also have talked with someone who has done this in the past & doesn't understand how things have changed over the years.

Cartographer
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Re: Better to invest in taxable and not deferred?

Post by Cartographer » Wed Oct 17, 2018 10:34 am

There can certainly be situations where tax-deferred is worse, but it seems very unlikely.

Keep in mind that your taxable account also gets taxes as income tax, and then ADDITIONALLY gets taxed on any gains. If investing for 30 years in stocks, you can expect something like 90% of the final account value to be gains. If we assume for the moment that taxes are flat and will be the same in retirement, this means the taxable account incurs an extra 13.5% tax over the tax-deferred.

Things usually get even more tilted toward tax-deferred once you consider our progressive income tax. You tax-deferred account allows you to defer taxes at the marginal rate. Assuming your tax-deferred is your primary source of income, your 401k will be taxed at your effective tax rate, which will be lower.

The only way for tax-deferred to be worse is if tax rates go up significantly in retirement. This can happen if the law changes, or if you end up in a higher tax bracket in retirement. But your tax rate will have to be something like 13.5% higher in retirement to overcome the loss to capital gains. In the vast majority of situations, this is unlikely.

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