Financial Samurai

@BG

That 93% came from where? If that’s your own probability, that’s great. And that also suggests a bell curve, 7% chance of less. Let’s assume you are 100% confident of replacing exactly 100% of your income at retirement, no more no less. Ideally, only some small fraction would be in Roth, maybe 20%. Regardless of the exact numbers, you’d first want to fill the brackets below the one you are currently in, no?

28%/9% ? I understand those numbers, but here’s what’s missing. Your pretax deposits now are all at 28% (unless you are right on the edge and really at 25%), but at retirement, the first X dollars are taxed at “zero”, next Y$ at 10%, next Z$ at 15%. The average rate is meaningless for your analysis, you need to understand that to find your ideal mix. The mix is different for every person, and is only 0% Roth for those who are blessed with a pension and Social Security that come close to 80-85% replacement rate. Those people are few and far between.

From what you’ve said, you should do the math and save enough pre-tax so withdrawals fill the 15% bracket. This make sense?
JoeTaxpayer´s last blog ..Martin Luther King Jr. Day 2010

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@JoeTaxpayer
Hi JoeTaxpayer!

The 93% number comes from FinancialEngines’ analysis of my portfolios, based on my expected retirement age, savings rates, investments, etc. I believe they use Monte Carlo simulations for various variables like inflation rates and growth rates to determine the probability of me meeting my retirement objectives. Their services are free to me as a benefit of my employer.

Anyhow, assume I make $100k a year today, and it is predicted I will earn $100k a year off of my investments during retirement. If we assume that tax rates don’t change between now and then, most people will just claim that there is really no difference between Traditional or Roth investment accounts. Neither one has a dollar advantage over the other (if the tax rates stay the same). Do you agree with this? Practically everyone will agree with this given assumption.

However, I disagree with that assumption — the _one_ difference is that I have child tax credits and mortgage interest deductions _today_ that I guarantee you I will not have in retirement.

So, in this sense, it pays for me to pay income taxes today (and invest in the Roth) since my tax rate is most-likely lower now than it will be in retirement. If congress increases taxes, then even more so.

For my future retirement effective tax rate to break-even with my current effective tax-rate, congress would have lower taxes by about 5%, to balance out my loss of the child credit and mortgage interest deduction.

Anyhow, I can’t go completely Roth, since my employer’s 401k contributions are considered part of the traditional 401k, so there is some hedging going on whether I like it or not.

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@BG

Nope. I disagree. You are correct in your observation. Which is why it makes more sense to talk about your taxable income.

If that $100K at retirement is gross, you have (if single) $3650 exemption and $5700 std deduction, $9350 at zero rate. Next $8375 at 10%, Next $25,625 at 15%. This totals $43,350 that of the $100,000 would benefit you if it were pretax. You say you are in the 28% bracket. This 43K would come out at 15% tops. Total tax $4681.

These number inflate over time of course. You can see I straddle the line. Maybe to you, paying tax at 28% instead of hoping for 25% years hence is not worth it. No push back from me.

Look at my numbers carefully, from listening to you just this bit, your ideal mix is likely 40-45% pretax money. I’d like to hear your thoughts on that back of envelope assessment.
JoeTaxpayer´s last blog ..Martin Luther King Jr. Day 2010

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@JoeTaxpayer
Hi Joe — thanks for trying to explain all this to me. I think I am starting to wrap my head around this.

I believe you are saying to not purchase 100% Roth (and pay taxes at today’s highest marginal tax bracket — 25% for married on $100k gross), on money that could grow tax-deferred and would actually be taxed at a much lower marginal tax bracket in retirement (the 10% and 15% brackets — there is no zero bracket).

If you fill the lowest brackets with tax-deferred money in retirement — you are coming out ahead (25% marginal tax today -vs- 10% or 15% marginal tax in retirement). The bracket at the same rate (25%) is a wash between Roth and Traditional, and anything over the 25% bracket is best served by a Roth account.

This makes perfect sense and sorry it took me so long to get this straight. You really gave me something to think about!

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@BG

Yes – you got it. I often struggle to get a thought into words, and appreciate your patience.

“there is no zero bracket”

Indeed. I use that expression to describe the sum of the Standard deduction and exemption. It’s a misnomer but does acknowledge $9350 (single) or $18,700 (couple) that one can have as income, not subject to tax.

Now, you have the facts you need to make an informed decision. Future marginal rates? Still unknown. But from Sam’s efforts and mine, you understand the process better. You have time to change your target as time passes to optimize your wealth.
I will have a beverage in your honor.

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admin Reply:
January 20th, 2010 at 12:31 pm

JoeTP – Phew, thanks for being so patient in explaining to the community. Very helpful! I’ll buy you a beer next time we meet up! Takes a lot of patience and explaining to do.

In fact, you may want to encapsulate your very helpful comments from here into a new post. Join forces!

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@Admin & @JoeTaxpayer:

And I too shall drink a beer in your honor, and tell my friends about this as well. If either of you are going to do another post on this, perhaps you could also share a public Google Docs Spreadsheet so all the math is right there.

Thanks again!

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I agree this move doesn’t make sense for everyone. But I’ll take issue with a couple of your points. First, your point #1 about how smart the government is (as well as your complete non-sequitur about Obama– the 2010 conversion rule pre-dates Obama by years. I read about it at least as early as 2006). Yes, the government likes the idea of getting tax revenues now rather than later. But their logic is akin to the pre-1789 French government’s selling future exemption from taxes: from the government’s perspective, the upside is all now and the downside is all later– and maybe WAY later. Especially because the people for whom it makes most sense to convert are the people who are 20-30 years away from retirement; if I convert $140k this year, at age 35, then they’re getting tax revenues NOW that they wouldn’t have gotten for 30 years. Even if I ultimately “win” by making this move, the people who make up the current government also win, because most of them weren’t going to be running things in 30 years anyway. So: they get the money now; the resulting shortfall comes after they’re retired, voted out, or even dead. So in one sense they’re “smart”; in another sense, they’re very short-sighted.

And secondly, though your point is well taken that the government can change the rules in the future, I have a hard time believing that the Roth-holding lobby is going to be powerless to get certain things “grandfathered” in. And the Roth has advantages like no minimum distributions. The biggest threat to the Roth is probably not that the government would nakedly violate the terms of the contract; it’s that taxes might be introduced on consumption so that avoiding the income tax on Roth withholdings would be useless unless you could actually avoid spending the money.

Which is to say, the best candidates for conversion are those who are 3-4 decades away from needing the money or even better, who plan never to need the money but to pass it on to heirs; those who can pay the tax from outside the account itself; and those who are savvy enough to lower their taxable income in the year they do the conversion. Note: you don’t have to pay tax on the IRA that you convert; you have to pay tax on your total taxable income of which the converted amount makes up a part. If you can reduce your taxable income for 2010 as I am, by such moves as living in a foreign country (that’s like $90k of earned income sheltered right there) and owning rental real estate, plus who among us doesn’t have some stock losses from early 2009 to carry forward?, then you can avoid paying very much tax now for the privilege of avoiding tax in the future.

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Thought about this some more (don’t cringe yet).

I’m going back to my original argument that we should only be looking at effective tax rates — the effective tax rate is the percentage of taxes actually paid compared to gross income. That one number encompasses all the brackets, credits, deductions, and all the other crap that affects your federal tax bill.

Using the calculator at:
http://www.1040.com/site/taxtools/federaltaxestimator/tabid/227/default.aspx

Plugging in $100k gross income (married), and nothing else: the effective tax rate is 12.2% — this would represent the tax-rate applicable in retirement (such as from tax-deferred savings).

On that same calculator, add two dependents, with both qualifying for the Child Tax Credit. The effective rate is 8.2%. This represent my effective tax rate today.

The difference here is 4%. I save 4% by paying taxes today (at 8.2%), investing in a Roth, to avoid the 12.2% future effective tax (when I will not have the Child-tax-credit). This is assuming that the tax codes do not change in the future, and everything remains constant. If congress raises rates, then I come out even more ahead. Congress would need to lower taxes by 4% (effective) for me to even break even with the traditional plan. So, I’m sticking with my original hypothesis, that at least for me, the Roth is a much better deal.

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admin Reply:
January 21st, 2010 at 11:45 am

Mike / BG – It’s important to believe in what you believe. If your ROTH contribution makes you happy, then that’s all that matters. Better than not contributing at all.

Who knows what the future tax rate will be, but I’m sure as heck not giving the gov’t MORE of my money now. America commends you guys for supporting our spending.

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@BG

I pride myself on being able to explain things in more than one way.

See that 8.2% you cite? It’s a number that answers a particular question, I know you didn’t pull it out of thin air. No dollar was taxed at 8.2%, even though they all were.
When it comes to putting money into a pretax account (or converting, for that matter) the question is: what is the tax on those last X$? Since I am not at a whiteboard with you in front of me, I need to keep the numbers easy to read. You already said you are in the 28% marginal bracket. I’ll assume this to mean the last $1000 you earned was taxed at 28%. Right?
Now, I don’t really have a clue where the 12% future rate comes from and honestly, it doesn’t matter. When you go back to my post above, you have that ‘zero rate’. You married? I forget. If so, that $18,700 is tax free, zero. If you add enough 10% money, you’ll approach an average 5%. Call it quits there if you want.
We did this already, and I concluded that 40-45% in pretax accounts appear ideal for you. So why did you plug in $100K for retirement? Use $45K and then tell me your average rate. It’s not all or none. Both are less than optimal.

But remember the tale of the statistician who drowned in a pond whose average depth was 12 inches. In my approach, I dare say nothing happens at the average, it’s all at the margin.
JoeTaxpayer´s last blog ..The Roth IRA Conversion – Unintended Consequences

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@admin
Now you’re just being dogmatic.

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JoeTaxpayer :
…..I’ll assume this to mean the last $1000 you earned was taxed at 28%. Right?….

Don’t think so. You are not taking into the massive effect that having two dependent children, plus claiming the Child-Tax-Credit gives me in my working years (currently). That amount is $3,917 right off of today’s tax bill. That amount off of the tax bill effectively knocks me out of the 28% (or 25%) marginal bracket, and actually puts me in the 15% marginal bracket today — down to an 8.2% effective tax rate.

This is an important point: Earning $100k a year, with two kids, is the tax equivalent of a couple with no kids earning $64k.

You can’t ask what the tax rate was on the last XX dollars, if you can’t yourself answer the question on which dollars are saving the $3,917 via the deductions/credits. The only solution is to work with the average / effective tax rates.

I do admit an error in my earlier post. If I invest $15k into a tax-deferred account today, then that would lower my taxes down to an effective rate of 5.3% right now (taxes on $85k gross income). That immediate savings in taxes would free up an extra $2,900 we could invest. I’ll need to run the numbers to see if that extra money, if invested, would cancel (or beat) the higher effective tax rate in retirement. You might be right about traditional -over- Roth, but for the wrong reasons…

I’ll work on those calculations this weekend and get back to you.

Thanks for the great discussions!

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Sam, please pass me the lectern. (Thanks, I was falling off the soap box and dropping my notes.)

BG – there are two things at play. Your marginal tax rate (15%/25%) and the “phantom rate” you might experience due to phaseouts. Phantom Rate is what I call the dollars paid in federal tax on the last $100 you are taxed on. I have no trademark on it, others call it something else.

“You can’t ask what the tax rate was on the last XX dollars”

Of course I can. Really. I go into TurboTax (where I am a guest blogger. I think they owe me lunch) and just before I print my tax return, I increase/decrease my income by $100. The degree to which my tax goes up or down answers that question.

I am sorry, I thought earlier on you stated you were in the 28% bracket. If your taxable income puts you in the 15% bracket, I’d suggest you use Roth and Roth conversion to the extent that it fills the 15% bracket, but doesn’t make you pay 25% on any income.

As you get to the point where you are in the 25% bracket, I’d use pretax accounts to keep you down to 15% with an eye on enough pre-tax money to fill the 15% bucket at retirement.

My understanding of your situation has changed. My view that average/effective rate as a red herring has not. It only serves to inject a data point useless for this analysis. If it gets you the right answer, it will have been for the wrong reason. Try to digest this, unfortunately, Vulcan mind meld not an option.
JoeTaxpayer´s last blog ..Frugal Friday Week 31

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@JoeTaxpayer
Thanks Joe. I think there was a mis-communication. I’ve been talking about $100k gross income (line 7 of the 1040), not $100k taxable income (line 43 of the 1040) — I wish though :)

What you are calling the ‘phantom rate’, is what I’ve been calling the ‘effective rate’.

http://en.wikipedia.org/wiki/Tax_rate#Effective

“The effective rate of tax can often be discussed in terms of the effective marginal rate of tax – namely the amount of effective tax paid as a percentage of the last dollar earned or spent.”

I’ve been calculating the effective rate as: ER=TaxPaid/GrossIncome. Gross income being line 7 of the 1040. Looking at my 2009 filings, this equals 8.92%. If you are calculating it as ER=TaxPaid/TaxableIncome, where TaxableIncome is line 43 of the 1040, then the rate is 12.32% for me in 2009.

I think we are mind melding now.

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We are fogetting one very important point in all these arguements.

RMD’s

To some people, this is what they are most afraid of in traditional qualified retirement plans. All of these types of savings vehicles have required minimum distributions. They must occur between 59 1\2 and 70 1\2.

Let’s say we have another recession when some poor schmuck reaches 70 and he is REQUIRED by the IRS to pull money out of his IRA, and then pay tax on it. He would effectively lock in huge losses, pay taxes on the reduced amount, and his retirement funds would be depleted even faster.

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You are calculating effective average, not effective marginal, which is what I call Phantom Rate.
You want to understand the impact of just the last dollar added or taken away, as this would drive your choice between tax status of retirement accounts.
This can’t be gotten just by glancing at the tax form and dividing. You’d need to “what-if” by adding a dollar or really $100.
You may be in the lucky situation to be able to be in the 15% exactly over the next 10 or more years choosing between the two.
JoeTaxpayer´s last blog ..Frugal Friday Week 31

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@Benjamin Bloom

From 59-1/2-70-1/2 withdrawals are optional, not RMD.

RMDs are one factor. It starts at 3.6% and doesn’t get larger than 5% until age 79.

The ‘poor schmuck’ would be worse off had he paid the taxes on the larger, pre-recession value, no? Now his taxes due are less, not more. BTW, he ‘locks in’ nothing. You can take a distribution in kind, i.e. withdraw the stock not sell it and remove cash. The withdrawn stock takes on basis as of the date of transfer out of the IRA.

By the way, late 50′s is a great time to consider all this. Close enough to retirement to really have a grip on your pretax wealth numbers. I have an 80 year old. 15% bracket with some room to spare. For 5 years, now, we’ve been converting just enough to Roth each year to ‘fill the bracket.’ As her RMDs grow, that amount may be less each year, depending. For 2009, with no RMD we had a nice conversion number. I hope this exemplifies both my strategic use of Roth and my not ignoring RMDs.
JoeTaxpayer´s last blog ..Frugal Friday Week 31

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Ooh, ooh pick me! I disgree! :) As I commented over on GoodFinancialCents:

I’d like to point out my favorite feature of all Roth vehicles: they reduce the number of variables affecting your buying power in retirement. Yes, tax-deferred *may* prove superior to tax-free for some people if you are looking at it purely from a dollars standpoint. But you don’t find out until you retire; in fact you only find out year-by-year *during* retirement. In addition to your buying power depending upon returns and inflation, it also depends on tax rates if it’s coming from a traditional account.

Imagine yourself at age 75. If your tax bracket increases that year, *even if the new rate is still lower than what you would have paid when you were making contributions*, the buying power generated by your traditional 401k distributions will decrease. Not so with distributions from a Roth vehicle. So it’s not just about which gives you more bang for your buck over the total time period, it is about whether or not you can count on your buying power once you no longer have the ability to alter it through earned income.

So maybe I pay 25% tax on Roth contributions this year, but this is my earning phase. I can handle it. I can pay more now, not to increase my total nest egg later, but to reduce the risks to my buying power later. The alternative is to *increase* the risks to my buying power in retirement, in return for saving money today. Does that sound like a good idea? Not to me. Inflation, returns and taxation are all significant variables which most of your retirement planning efforts will revolve around diminishing as far as possible. The opportunity to remove taxation from that list completely is too good to pass up.

(Note that it is only Federal income tax that Roth distributions avoid… they can still be subject to state income tax. But in many states no taxes would apply anyway, and at least it gives you the option of moving.)

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But Ethan – the dollars used to pay the tax at retirement are also inflated, so to that point, it’s a wash.
The pro-Rothers keep referencing a mythical tax increase. Yet, to be in the 25% bracket today at retirement, one would need over $2M in today’s dollars.
So while you might be right about that 75 yr old you chose, he is in the top 5% of retirees. I can contrive a dozen scenarios where the traditional is better, but likewise a dozen where conversion is best. If in fact conversion is best for few than 10%, than why is 90% of the dialog promoting it? Why no warning about how few would benefit?
JoeTaxpayer´s last blog ..A Roth Roundup

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@Joe

I wasn’t trying to make an argument about inflation – I must have been unclear there. I was just referencing that your buying power in retirement depends on 1) contributions, 2) returns, 3) inflation and 4) taxation. And that you can largely remove one of those (taxation) from the equation with a Roth vehicle.

With my 75-year-old example, I was not referring to the situation in which a 75-year-old switches brackets, but the situation in which tax rates are increased by the government. In fact, the 75-year-old switching brackets is almost a non-issue by default. They obviously have other things going their way if they are moving *up* the bracket range. Even it means that their Roth/traditional decision wasn’t in retrospect quite as good/bad as they thought, they are obviously not hurting for it.

No, I meant to refer to taxes simply increasing while income does not. For myself, age 75 is 43 years away. That’s a long time to predict anything about taxation. But let’s say that today I pay 25% on my Roth contribution dollars, and at 65 I find myself only in the 15% tax bracket. This would be a classic example where people would say that I should have gone traditional. Fast-forward 10 years: everyone got a 3% tax hike. The traditional is still a net gain over a Roth, but when would I have realized that gain? During my working years. When would I have payed the price? During retirement. My buying power would have just dropped (by something less than 3% due to deductions, but not 0%) and I wouldn’t have been able to do anything about it. As a Roth user I am unaffected. And I’m unaffected by taxation changes at 85, 53 years from today. And I’m unaffected by taxation changes at 95, 63 years from today, if I happen to live that long.

I’m not saying you should pay 35% tax on Roth contributions today. Personally I usually fit into the 15% bracket, and I consider Roth’s a no-brainer at that level. But even at 25% I would recommend hedging your bets and putting half in a Roth and half in a traditional account.

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@Ethan

If by ‘remove’, you mean as a variable, yes, this is true. Removing the variable doesn’t make it a good decision though.

You say “usually” 15%. If you use pretax to stay right at 15%, and Roth for any more savings, I’d not say it was a bad decision. But – the chance of you becoming disabled or unable to work for a time is real, greater than ‘zero.’ Your standard deduction and exemption would cover a nice annual tax free withdrawal were that the case. And that 15% tax you paid would be an error, in hindsight. At 25%, I’d not recommend converting to all but a select few.
JoeTaxpayer´s last blog ..A Roth Roundup

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JoeTaxpayer) I understanding the math behind this better and agree with you (again) — for me, I appear to be better off with the majority of my investments in the traditional side. But what I don’t understand is the Roth IRA income caps & phaseouts.

Roths are great for people who save a ton of money, and expect to have very large incomes in retirement. But to be able to save enough to guarantee the large retirement, you have to have a large income today — which precludes you from being able to invest in the Roth (a catch-22).

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Joe – I didn’t read through all the comments, but hopefully someone pointed out some flaws in your logic. A ROTH conversion isn’t for everyone – no doubt about it. If someone can’t afford to do without taking money from their IRA – don’t do it!

Conversions are reversible for those that change their mind. Taxes can be opted to be split over 2 years.

The loophole that allows this conversion due to no limits in 2010 was prior to Obama’s administration. Don’t get me wrong – I think he’s a financial nightmare for this country.

In our example -

1. We have large tax deductions in the form of mortgage interest and dependents with child tax credits. When we are in retirement, we will not have any of those “write-offs” (if they even exist at that point.)

2. Most all of our other retirement is pre-tax deductions through current employers. So it’s good to be diverse.

3. ROTH Ira give additional flexibility with regard to withdrawals and payouts – for example: no RMD at age 70. So, we aren’t required to take the money if we don’t need it in any particular retirement year. Or, we can use some to help one kid through medical school, so he can support us down the road. (humor)….That alone is worth alot.

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