Author Topic: Net Worth calculation of tax-deferred accounts  (Read 1598 times)

ScroogeMcDutch

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Net Worth calculation of tax-deferred accounts
« on: October 31, 2014, 06:12:22 AM »
Hello all,

I have tried to search the forums but couldn't quite find the answer to this. As I am not entirely familiar with the US tax / pension system, it seems as though the 401(k) and Roth IRA terminology used here are tax-deferred accounts. This means any contribution you do to them is to be substracted from your income, but any payment you receive from those accounts at time of retirment also get taxed as if it was ordinary income?

In the Netherlands we have a very comparable system where you can deposit in a blocked account, and those deposits you can deduct from your income (at approximately 42% income tax). Once you retire, you can turn those deposits into a lifelong annuity payment, and those payments are also counted as income, and are generally taxed at a lower rate than you deposited (I'd expect ~25% on average)

If I look at the networth calculations here on the forum and at other personal finance blogs, the amount in these tax-deferred accounts seems to be counted 100% in the networth calculations. Why is this, as you still have a tax liability on those accounts? For example, if I'd have a retirment account with 200k in it, but expect a 25% tax on average, why would I count the full 200k as part of my networth?

Maybe there is something I am not getting, but with some of the FIRE calculations on here, I don't feel particularly comfortable counting my retirement accounts as 100% to my net worth just yet.

Am I missing something?

Thanks

Scrooge

kpd905

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Re: Net Worth calculation of tax-deferred accounts
« Reply #1 on: October 31, 2014, 06:29:09 AM »
In the US, assuming they have no other income, a married couple could withdraw ~$20,000 from a tax-deferred account and pay zero federal tax.  The next ~$18,000 can be taken out with a 10% federal tax rate.  This means you pay about a 4.7% tax rate on the first $38,000.

To get your 25% average tax rate (federal only) that you propose, they would need to withdraw $360,000 per year, or a single person would need to withdraw about $240,000 per year.

They could also withdraw $20k and take another ~$70k in qualified dividends and capital gains and still pay zero federal tax.
« Last Edit: October 31, 2014, 06:33:36 AM by kpd905 »

JGB

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Re: Net Worth calculation of tax-deferred accounts
« Reply #2 on: October 31, 2014, 06:34:20 AM »
Roth IRAs are after-tax vehicles. You do not pay taxes on money that is in them; you've already paid tax before putting the money in.

Traditional IRAs and 401ks are pre-tax, tax-deferred vehicles. You pay taxes at whatever rate matches your income at the time of withdrawal.

There are a lot of tax avoidance methods to reduce or eliminate the amount of tax you pay when withdrawing money from the tax-deferred vehicles - namely centered around minimizing your taxable income in order to fall into a very low tax bracket. There is a level at which you will pay no taxes, provided that you can make sufficiently little in income + withdrawal from tax-deferred accounts. That amount varies depending on your marital status and your dependents.

Finally, most people on here include estimated taxes as part of their post-retirement expenses. So it's taken care of there instead of reducing the amount of the account (which is more accurate, for the reasons listed in the second paragraph). It would be a very extreme situation that you have a frugal early-retiree taxed at the 25% level. For instance, my family's current spending levels would result in an effective post-retirement tax rate of around 4% as long as we only withdraw enough to cover our expenses.

ScroogeMcDutch

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Re: Net Worth calculation of tax-deferred accounts
« Reply #3 on: October 31, 2014, 06:36:28 AM »
Thanks a lot for the answers - it clarifies a lot. The ~25% would be what I expect to have to pay in taxes in the Dutch situation, but I will just add taxes as a cost postretirement instead of trying to get networth to reflect the latent taxes.

Cheers