Author Topic: Max out IRA or invest in brokerage account?  (Read 23680 times)

$_gone_amok

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Max out IRA or invest in brokerage account?
« on: June 20, 2012, 12:24:16 PM »
My wife and I are in our early 30's. We are both maxing out our Roth 401K at work with approximately 300K vested.  We also have around 50K in traditional IRAs.  We stopped contribution to our IRAs when we started paying for daycare tuition.  But in a year our oldest will start school and we will once again have some positive cash flow every month.

We want to retire in our mid 40's with a 40K annual expenses limit. Which is still a long way before we could penalty free withdraw from IRA and 401K.  Should we we stop contributing to IRA and invest all the money in our brokerage accounts? I remember MMM wrote an article a while ago about having too much in 401K and IRA, I think that may be our case.

Looking forward to hear your thoughts.

JohnGalt

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Re: Max out IRA or invest in brokerage account?
« Reply #1 on: June 20, 2012, 12:31:30 PM »
Have you looked into 72t and Roth conversions?  72t lets you withdraw regularly from an IRA as long as you set it up to be substantially equal withdrawals - basically turning it into an annuity, I think.  Roth conversions are the method that I particularly like - you can convert IRA money to Roth IRA money by paying the income taxes due and then you can withdraw it (after it is there for 5 years) penalty and tax free.  This lets you set up a conversion every year for the amount you want to withdraw 5 years down the line, so you would just need enough money to get you through the first 5 years.

With those options in mind and my marginal tax bracket now vs what I expect it to be in retirement - I am maxing out my 401k (non roth) and Roth IRA (only because my income prevents traditional IRA) every year until retirement.  Depending on your taxes now vs expected tax rate in retirement, it may make more sense to go with the traditional 401k route rather than roth 401k, but, in either case, I don't think you should be afraid of putting the most you can into retirement vehicles to take advantage of the tax benefits just because you are planning on retiring before the penalty free withdrawal age.

trammatic

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Re: Max out IRA or invest in brokerage account?
« Reply #2 on: June 20, 2012, 12:40:09 PM »
If you're planning on retiring in the next 10 or 15 years, I bet your income now is much higher than it will be in retirement.  If so, the tax benefits of a deductible IRA coupled with a 72t might be helpful.

grantmeaname

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Re: Max out IRA or invest in brokerage account?
« Reply #3 on: June 20, 2012, 12:55:24 PM »
Roth 401k? That's great! That means all 300k of your 401k money is accessible 5 years after you retire, because you can move it over to a Roth IRA, tax-free, penalty free. You should open and max out a Roth IRA before you so much as think about contributing to a brokerage account. The Roth IRA money that's there natively can be withdrawn the second it goes in, tax and penalty free (except investment earnings, but those are withdrawn last). That means your Roth IRA holdings are your key to funding the intermediate 5 years while your Roth 401k is sitting and seasoning in the IRA account. Make sense?

gestalt162

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Re: Max out IRA or invest in brokerage account?
« Reply #4 on: June 20, 2012, 01:05:16 PM »
Roth 401k? That's great! That means all 300k of your 401k money is accessible 5 years after you retire, because you can move it over to a Roth IRA, tax-free, penalty free. You should open and max out a Roth IRA before you so much as think about contributing to a brokerage account. The Roth IRA money that's there natively can be withdrawn the second it goes in, tax and penalty free (except investment earnings, but those are withdrawn last). That means your Roth IRA holdings are your key to funding the intermediate 5 years while your Roth 401k is sitting and seasoning in the IRA account. Make sense?

Even better. As long as the Roth IRA has been open at least 5 years, rollover contributions can be tapped immediately. So the 5 year waiting period may be 0 years! http://www.investopedia.com/articles/retirement/09/roth-401k-rollover.asp#axzz1yMSOaL8U

With that in mind, the OPs should open a Roth IRA right now, provided that their income doesn't put them over the contribution limit. Then when they retire, they already have a base of retirement money in the Roth IRA, and have instant access to all the money they roll over from their Roth 401(k). They should set up a taxable investment account to capture any money left over after their 401(k) and Roth IRAs have been funded to the max.

$_gone_amok

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Re: Max out IRA or invest in brokerage account?
« Reply #5 on: June 20, 2012, 01:11:04 PM »
Thanks for the info guys! I had no idea that Roth 401K and Roth IRA conversion can be accessed in 5 years.

However, due to our income we are not allowed to a Roth IRA and we receive no tax deduction for putting money into a traditional IRA either.

What I think I will do is:

1. Contribute to a traditional IRA and do a Roth conversion immediately.  No tax paid because no capital gains. This money should grow tax free and eligible for withdrawal as long as long as it has been there for seasoned for 5 years. Is this correct?

2. Any money left over will go into brokerage accounts.

grantmeaname

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Re: Max out IRA or invest in brokerage account?
« Reply #6 on: June 20, 2012, 01:30:42 PM »
Yeah, that looks right.

JohnGalt

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Re: Max out IRA or invest in brokerage account?
« Reply #7 on: June 20, 2012, 01:30:57 PM »
Thanks for the info guys! I had no idea that Roth 401K and Roth IRA conversion can be accessed in 5 years.

However, due to our income we are not allowed to a Roth IRA and we receive no tax deduction for putting money into a traditional IRA either.

What I think I will do is:

1. Contribute to a traditional IRA and do a Roth conversion immediately.  No tax paid because no capital gains. This money should grow tax free and eligible for withdrawal as long as long as it has been there for seasoned for 5 years. Is this correct?

2. Any money left over will go into brokerage accounts.
I believe that is correct.  My understanding is that, with the current lack of an income based limit on conversions to Roth IRA, any one can back into contributing to a Roth regardless of their income.

JR

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Re: Max out IRA or invest in brokerage account?
« Reply #8 on: June 20, 2012, 01:44:05 PM »
Roth 401k? That's great! That means all 300k of your 401k money is accessible 5 years after you retire, because you can move it over to a Roth IRA, tax-free, penalty free. You should open and max out a Roth IRA before you so much as think about contributing to a brokerage account. The Roth IRA money that's there natively can be withdrawn the second it goes in, tax and penalty free (except investment earnings, but those are withdrawn last). That means your Roth IRA holdings are your key to funding the intermediate 5 years while your Roth 401k is sitting and seasoning in the IRA account. Make sense?

Am I correct in saying that only their contributions are accessible before 59.5?  Employer match and non elective employer contributions are considered pretax contributions and can not be removed penalty free before 59.5.  Please correct me if I am wrong.

skyrefuge

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Re: Max out IRA or invest in brokerage account?
« Reply #9 on: June 20, 2012, 01:54:42 PM »
Alright, now that that's out of the way, I have to ask, why the Roth 401(k)s?  At your income level, I'm guessing that puts you in the 28% bracket, so you'd save $9520/year in federal income tax if you made $34k worth of traditional 401(k) contributions instead of Roth 401(k).  Upon withdrawal, when you'd be taxed on less than $40k of income, you'd pay only $1503 in federal taxes on that $34k, assuming the other $6k for expenses came from your Roth IRA.  Even if tax rates for the poor go up by the time you're withdrawing, it's hard to imagine a situation where they'd go up enough to wipe out that $8k/year savings.  Or are you prevented from making deductible 401(k) contributions too?

$_gone_amok

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Re: Max out IRA or invest in brokerage account?
« Reply #10 on: June 20, 2012, 03:08:50 PM »
Alright, now that that's out of the way, I have to ask, why the Roth 401(k)s?  At your income level, I'm guessing that puts you in the 28% bracket, so you'd save $9520/year in federal income tax if you made $34k worth of traditional 401(k) contributions instead of Roth 401(k).  Upon withdrawal, when you'd be taxed on less than $40k of income, you'd pay only $1503 in federal taxes on that $34k, assuming the other $6k for expenses came from your Roth IRA.  Even if tax rates for the poor go up by the time you're withdrawing, it's hard to imagine a situation where they'd go up enough to wipe out that $8k/year savings.  Or are you prevented from making deductible 401(k) contributions too?

I think we made the decision to use Roth 401k after calculating that we will come ahead at the end even if we reinvest the savings from a traditional 401K.  I double checked again just now using this calculator (http://scrs.schwab.com/tools/schwab_roth_401k_calc.htm) and it is still true for us.

Chris

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Re: Max out IRA or invest in brokerage account?
« Reply #11 on: June 20, 2012, 03:13:27 PM »
However, due to our income we are not allowed to a Roth IRA and we receive no tax deduction for putting money into a traditional IRA either.

Does your employer also offer a standard 401k plan? Roth IRAs offer more investment choices than Roth 401k plans.

My employer allows splitting: it's possible to contribute to both a Roth 401k and a standard 401k in the same year (subject to the limit). You might consider making enough 401k contributions to the point where you're eligible to make Roth IRA contributions.

$_gone_amok

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Re: Max out IRA or invest in brokerage account?
« Reply #12 on: June 20, 2012, 03:28:16 PM »
Chris,
that's a good idea. I'll look into this.

Lars

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Re: Max out IRA or invest in brokerage account?
« Reply #13 on: June 20, 2012, 09:56:05 PM »
I'd second the idea of putting some money into a standard 401k. Since the first 20k you take each year from pre-tax accounts in retirement is tax free due to the standard deduction and personal exemptions, I recommend contributing such that you calculate you'll have least 500k in pre-tax accounts at retirement.

As I learned the hard way, when using those traditional and roth calculators remember to use the average tax rate for both your contribution and your future withdrawals - not your marginal tax rates. It doesn't help that their default withdrawal tax rates are often far too high for muchachian incomes or the average american for that matter.

grantmeaname

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Re: Max out IRA or invest in brokerage account?
« Reply #14 on: June 21, 2012, 08:26:01 AM »
Math and taxes time, everybody!
Even better. As long as the Roth IRA has been open at least 5 years, rollover contributions can be tapped immediately. So the 5 year waiting period may be 0 years! http://www.investopedia.com/articles/retirement/09/roth-401k-rollover.asp#axzz1yMSOaL8U
That article refers only to post-59.5 distributions, not to any-age withdrawal of principal. I believe that rule doesn't apply to conversions, based on this bogleheads thread. For sure, you need to wait five years for a traditional 401k, so I assumed a Roth works the same way. The thread appears to support that.

Am I correct in saying that only their contributions are accessible before 59.5?  Employer match and non elective employer contributions are considered pretax contributions and can not be removed penalty free before 59.5.  Please correct me if I am wrong.
I had always assumed that anything that got moved from a 401k account would be a contribution, but it makes more sense that the nature of each dollar in the account (i.e., earnings or contribution) is preserved, which turns out to be the case. The same vanguard thread explains that pretty nicely:
Quote
Your Roth 401k balance must be CHARACTERIZED as a certain type of Roth IRA balance. The [401k contributions are] treated as additional Roth IRA contributions bringing your total balance of these regular contributions up to 37k. The [earnings are] added to your Roth IRA earnings bringing that total up to 7k. Your total Roth IRA balance is 44k. You can take out up to 37k tax and penalty free.
So yes, you are correct. Next: employer contributions go into a regular 401k type account, yes. To convert them to a Roth IRA you would need to pay income tax on the entire value of employer match that's being converted (you get a 1099 from the brokerage); alternately, you could convert them to a traditional IRA, but then you'd need to be 59.5 to tap them.

Alright, now that that's out of the way, I have to ask, why the Roth 401(k)s?
This is yet another example of the Roth being worse for taxes but better because it allows contribution withdrawal penalty-free. The whole "retire in our mid 40s" component of the plan ruins the traditional 401(k) for this. In a minute, after I've thought about something other than 401(k)s for a second, I'll explain the tax-efficient alternative option to the OP, but in a nutshell you want to contribute to a traditional 401(k) and then convert one year of expenses each year and use them each converted chunk of money five years after the conversion.

You might consider making enough 401k contributions to the point where you're eligible to make Roth IRA contributions.
Their isn't an income limit, so much as a range, for contributing to a Roth IRA. If you make just slightly too much and you manage to reduce your MAGI to just under the top of the range, you'll only be able to contribute $200. To get low enough to contribute fully, you'd have to generate a full $10k in deductions.

Since the first 20k you take each year from pre-tax accounts in retirement is tax free due to the standard deduction and personal exemptions, I recommend contributing such that you calculate you'll have least 500k in pre-tax accounts at retirement.
The pre-tax accounts sadly don't allow withdrawals in the mid-40s, when the OP will be retiring. As a side note, social security counts as taxable income, so the actual amount of tax-deferred income that doesn't get taxed is even lower.

$_gone_amok

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Re: Max out IRA or invest in brokerage account?
« Reply #15 on: June 21, 2012, 05:33:43 PM »

You might consider making enough 401k contributions to the point where you're eligible to make Roth IRA contributions.
Their isn't an income limit, so much as a range, for contributing to a Roth IRA. If you make just slightly too much and you manage to reduce your MAGI to just under the top of the range, you'll only be able to contribute $200. To get low enough to contribute fully, you'd have to generate a full $10k in deductions.


Grant, you are right about that. There's a phased out limit for Roth IRA contribution and it doesn't make sense to me after I run the numbers.


Since the first 20k you take each year from pre-tax accounts in retirement is tax free due to the standard deduction and personal exemptions, I recommend contributing such that you calculate you'll have least 500k in pre-tax accounts at retirement.
The pre-tax accounts sadly don't allow withdrawals in the mid-40s, when the OP will be retiring. As a side note, social security counts as taxable income, so the actual amount of tax-deferred income that doesn't get taxed is even lower.

Thanks this this info!

Lars

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Re: Max out IRA or invest in brokerage account?
« Reply #16 on: June 22, 2012, 01:12:41 AM »
Since the first 20k you take each year from pre-tax accounts in retirement is tax free due to the standard deduction and personal exemptions, I recommend contributing such that you calculate you'll have least 500k in pre-tax accounts at retirement.
The pre-tax accounts sadly don't allow withdrawals in the mid-40s, when the OP will be retiring. As a side note, social security counts as taxable income, so the actual amount of tax-deferred income that doesn't get taxed is even lower.

Withdrawals in your mid-40s won't be a problem if you do a 72t distribution. Also social security can be counted as income but this happens gradually as your income considered taxable (wages, IRA, pension) increases - at a taxable income of 20k and social security benefits of 20k for a married couple no social security benefits are taxable as I read IRS rules. Grumble, grumble ... complex tax code. 

grantmeaname

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Re: Max out IRA or invest in brokerage account?
« Reply #17 on: June 22, 2012, 09:35:00 AM »
The problem with 72t distributions is that they're unbelievably conservative with distribution size. To support a $25k lifestyle and retirement at 42, you need $850k in the account according to this calculator (and that's an amount not adjusted to inflation, so at 3% inflation a year you'd be getting only $14k dollars of buying power in the last year you were eligible for regular retirement).

skyrefuge

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Re: Max out IRA or invest in brokerage account?
« Reply #18 on: June 23, 2012, 11:38:23 AM »
I think we made the decision to use Roth 401k after calculating that we will come ahead at the end even if we reinvest the savings from a traditional 401K.  I double checked again just now using this calculator (http://scrs.schwab.com/tools/schwab_roth_401k_calc.htm) and it is still true for us.

What are the two tax rates that you're using?  I think your Before Retirement rate should be your marginal rate (28%?) and your After Retirement rate should be your average rate (10-11% with a $40,000 IRA/401(k) income under current law, according to TaxCaster)  With those rates Traditional 401(k) is pretty clearly the winner.

This is yet another example of the Roth being worse for taxes but better because it allows contribution withdrawal penalty-free. The whole "retire in our mid 40s" component of the plan ruins the traditional 401(k) for this. In a minute, after I've thought about something other than 401(k)s for a second, I'll explain the tax-efficient alternative option to the OP, but in a nutshell you want to contribute to a traditional 401(k) and then convert one year of expenses each year and use them each converted chunk of money five years after the conversion.

I'm not quite sure what your advice is here.  Initially it sounds like you're saying that you believe traditional 401(k)s/IRAs are a bad idea for anyone who wants to retire in their mid 40s?  Or are you only saying that it would be a bad idea if the Traditional 401(k)->Roth IRA rollover loophole wasn't available?

I agree that it's possible in some situations to have too much money socked away in relatively-inaccessible tax-deferred vehicles, but those situations are relatively rare, and I don't think this is one of them.  Or at least not one that would be helped by continuing to make Roth 401(k) contributions vs. Traditional.  The OP will presumably be living past 59.5, so having some savings that's only accessible at that point isn't a bad thing, especially since he currently has only $50k in tax-deferred savings.  Maybe it did make sense to make those Roth 401(k) contributions earlier in his career if his income/tax-rate was lower then, but now, in light of the fact that he already has $300k in Roth 401(k) savings, and is currently in a much higher tax bracket than he will be in retirement, I think making Traditional 401(k) contributions going forward would be a good idea.  Especially since IRA contributions going forward will continue to be non-deductible/Roth-style.

As a side note, social security counts as taxable income, so the actual amount of tax-deferred income that doesn't get taxed is even lower.

Just to echo Lars, playing with TaxCaster, it shows that if you enter Social Security income of $20k, and IRA income of $20k, total tax is $0 (0% of that $40k income).  With $40k SS and $40k IRA income, total tax is $4899 (6.1% of that $80k income)

velocistar237

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Re: Max out IRA or invest in brokerage account?
« Reply #19 on: June 23, 2012, 06:13:53 PM »
I think we made the decision to use Roth 401k after calculating that we will come ahead at the end even if we reinvest the savings from a traditional 401K.  I double checked again just now using this calculator (http://scrs.schwab.com/tools/schwab_roth_401k_calc.htm) and it is still true for us.

What are the two tax rates that you're using?  I think your Before Retirement rate should be your marginal rate (28%?) and your After Retirement rate should be your average rate (10-11% with a $40,000 IRA/401(k) income under current law, according to TaxCaster)  With those rates Traditional 401(k) is pretty clearly the winner.

I'm curious about this, too. According to the calculator, for a pre-retirement marginal tax rate of 28%, your total retirement tax rate would have to be 20% or greater for the Roth to come out ahead.

$_gone_amok

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Re: Max out IRA or invest in brokerage account?
« Reply #20 on: June 25, 2012, 03:15:36 PM »
I used 33% as my current tax rate and 25% as my retirement tax rate. The reason I did that is that is because I estimate at our retirement we will have a few income producing rental properties and thus it will bump us up to the 25% bracket.

arebelspy

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Re: Max out IRA or invest in brokerage account?
« Reply #21 on: June 25, 2012, 07:18:20 PM »
I used 33% as my current tax rate and 25% as my retirement tax rate. The reason I did that is that is because I estimate at our retirement we will have a few income producing rental properties and thus it will bump us up to the 25% bracket.

Wouldn't rentals lower your tax bracket?
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tannybrown

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Re: Max out IRA or invest in brokerage account?
« Reply #22 on: June 25, 2012, 07:25:53 PM »
I used 33% as my current tax rate and 25% as my retirement tax rate. The reason I did that is that is because I estimate at our retirement we will have a few income producing rental properties and thus it will bump us up to the 25% bracket.

Wouldn't rentals lower your tax bracket?

I'd assume the rent itself would increase one's taxable income...and that the deductible interest/expenses would likely be a smaller figure than the rent itself in a typical year.  Maybe I'm missing something.

arebelspy

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Re: Max out IRA or invest in brokerage account?
« Reply #23 on: June 25, 2012, 08:44:36 PM »
I used 33% as my current tax rate and 25% as my retirement tax rate. The reason I did that is that is because I estimate at our retirement we will have a few income producing rental properties and thus it will bump us up to the 25% bracket.

Wouldn't rentals lower your tax bracket?

I'd assume the rent itself would increase one's taxable income...and that the deductible interest/expenses would likely be a smaller figure than the rent itself in a typical year.  Maybe I'm missing something.

Yes.  Depreciation.  Should hopefully shelter all of the rental's cash flow and some of your other income as well.
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skyrefuge

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Re: Max out IRA or invest in brokerage account?
« Reply #24 on: June 25, 2012, 08:49:35 PM »
I don't know anything about tax treatment of rental income, though my short reading indicates it generally reduces your tax bill, or only increases it slightly.  But let's ignore that for now, and say that it dramatically increases your taxable income, to the point where you have dollars taxed at a marginal 25% rate.  That would require $90,000 in total gross income (under 2012 rates), yet you say that your expenses would max out at $40,000.  So you'd be making WAY more money than you need, which means that you either could have retired a lot earlier, or you have a goal to pass down a huge inheritance.  In that case of an ever-increasing snowball of wealth and estate-planning, maybe the Roth 401(k) does make more sense for you.  Though I still think that Schwab calculator doesn't quite handle the tax rate questions correctly (it doesn't understand "filling in from the bottom"), and the marginal tax rates have to be at least equal before the Roth starts looking better.  Either way, with that kind of cushion, it's probably not a terribly important decision for you!

tannybrown

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Re: Max out IRA or invest in brokerage account?
« Reply #25 on: June 25, 2012, 09:23:44 PM »
I used 33% as my current tax rate and 25% as my retirement tax rate. The reason I did that is that is because I estimate at our retirement we will have a few income producing rental properties and thus it will bump us up to the 25% bracket.

Wouldn't rentals lower your tax bracket?

I'd assume the rent itself would increase one's taxable income...and that the deductible interest/expenses would likely be a smaller figure than the rent itself in a typical year.  Maybe I'm missing something.

Yes.  Depreciation.  Should hopefully shelter all of the rental's cash flow and some of your other income as well.

At 1/27.5, I guess it depends on how expensive the property is.  As the depreciation is due back when you sell rental income, it seems like it's a net win if someone holds the property until they die.  But if one sold rental property, would it be a wash re: taxes?
« Last Edit: June 25, 2012, 09:25:49 PM by tannybrown »

arebelspy

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Re: Max out IRA or invest in brokerage account?
« Reply #26 on: June 25, 2012, 10:14:33 PM »
Yes, depreciation recapture will hit you if/when you sell, however due to the time value of money writing it off now to shelter taxes and paying it back with future dollars (profits) is much better.

Also there are ways to avoid having to repay the depreciation (or any capital gains).  Probate, as you note, is one way to reset the cost basis.  A 1031 will defer it.  A charitable trust will make it not ever paid.  Etc.

In any case, I'd be very surprised if rental properties took a Mustachian from 15% to a 25% tax bracket.
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$_gone_amok

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Re: Max out IRA or invest in brokerage account?
« Reply #27 on: June 27, 2012, 01:27:00 PM »
Yes, depreciation recapture will hit you if/when you sell, however due to the time value of money writing it off now to shelter taxes and paying it back with future dollars (profits) is much better.

Also there are ways to avoid having to repay the depreciation (or any capital gains).  Probate, as you note, is one way to reset the cost basis.  A 1031 will defer it.  A charitable trust will make it not ever paid.  Etc.

In any case, I'd be very surprised if rental properties took a Mustachian from 15% to a 25% tax bracket.

My understanding is that depreciation gets smaller the longer you own the property.  I'm concerned that I won't be able to deduce as much rent as I like in 15 years. Thanks for the tips on tax shelters!

arebelspy

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Re: Max out IRA or invest in brokerage account?
« Reply #28 on: June 27, 2012, 02:50:17 PM »

My understanding is that depreciation gets smaller the longer you own the property.  I'm concerned that I won't be able to deduce as much rent as I like in 15 years. Thanks for the tips on tax shelters!

Maybe in real dollars, but otherwise no, straight line depreciation means it should be the same year 1 and 15 (until year 28).
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Re: Max out IRA or invest in brokerage account?
« Reply #29 on: June 27, 2012, 11:54:51 PM »
I have a question about Roth IRA's. I understand that you can withdraw penalty free your principle contribution amount. I'm wondering if it works to withdraw the interest from the principal, as long as it does not exceed the principle amount? For example, say I contributed $5,000 to the Roth, and I have it all invested in dividend-paying stocks. Could I withdraw those dividends, as long as the total amount withdrawn does not exceed the $5,000 I contributed?

grantmeaname

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Re: Max out IRA or invest in brokerage account?
« Reply #30 on: June 28, 2012, 06:03:32 AM »
It's all just money in the account, so to speak. But Roth IRAs have a contributions first principle, which states that all of the money you withdraw from the account is characterized as contributions until there are no more contributions left. So in your example, you wouldn't start withdrawing dividends or price appreciation until the $5,001st dollar. Does that make sense?

Nephi

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Re: Max out IRA or invest in brokerage account?
« Reply #31 on: June 28, 2012, 04:55:39 PM »
Yup! That's what my understanding of it was, so thanks for the clarification. :)

 

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