Author Topic: Pre-tax or post-tax or what?  (Read 5804 times)

Rulefollowing

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Pre-tax or post-tax or what?
« on: August 27, 2015, 07:47:17 PM »
Please help us na´ve newbies figure out what to do:

My wife and I are employed academics.  We recently became a two-paycheck family.

We can live on one paycheck, so we want to invest the other one. 

We are deliberating about how to invest the second paycheck. 

We can put it all into a tax-deferred TIAA cref account (403b).

Or--

We can put it into a Vanguard mutual fund (e.g VTSAX). 

Or--

We can put it into a Roth IRA post-tax account.

Or--

We can do some combination of the above.

Note-- we are already maxing out the 403b possibilities for one of us.

If we max out the second 403b, given that we are starting late in the year, we won't have any money left to invest elsewhere.

We have heard people say that it makes sense to max out the tax-deferred accounts first, then turn to Vanguard, etc. 

But we don't really understand this advice. 

Since tax deferred accounts are not ultimately tax free-- since one apparently must pay taxes on this money eventually-- why are they superior to other forms of investing?  (If they are superior ...)

Can someone kindly explain this to us, please? 

And offer whatever other advice is relevant?

Thanks so much.

Dicey

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Re: Pre-tax or post-tax or what?
« Reply #1 on: August 27, 2015, 08:26:05 PM »
Since tax deferred accounts are not ultimately tax free-- since one apparently must pay taxes on this money eventually-- why are they superior to other forms of investing?  (If they are superior ...)

Can someone kindly explain this to us, please? 

And offer whatever other advice is relevant?

Thanks so much.
I'm not smart enough to answer all of your excellent questions, so I just broke a hunk off the bottom.

The primary advantage to tax deferred accounts is that you put more money to work sooner. More soldiers in the field generally translates to more dollars to liveon and pay taxes with at the other end. Yeah, there are ways around those taxes, too. I believe Jeremy of GoCurryCracker.com is the reigning champion of that topic.

Other relevant advice:
The more you save and the earlier you save/invest it, the fewer actual dollars you will need to fund your retirement. It is great to live off money that your investments, not your hard labor, earned. Besides the folks right here on this fine forum, and the esteemed MMM himself, jlcollinsnh.com is also a terrific resource.

If RE is in your future, you must also save in taxable accounts so you have something to live on until you can start drawing down your retirement accounts without consequence. Yes, there are some workarounds, but you're still gonna need money to live on.

With that, I shall step aside, so the smarter people can tackle your list.

MDM

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Re: Pre-tax or post-tax or what?
« Reply #2 on: August 27, 2015, 09:02:25 PM »
Adding to what Diane C said.

In a taxable account, you may pay taxes 3 times:
1) On the money you have earned from salary/wages before you invest it
2) On dividends/interest while you hold the investment
3) On gains when you sell the investment.

An HSA, when used for medical expenses, eliminates all 3 of those taxations.

Tax-advantaged accounts such as 401k, 403b, 457, IRA, etc., eliminate the "while you hold the investment" taxes and then either tax #1 (in a "Roth" account) or tax #3 (in a "traditional" account).

Your choice between traditional and Roth should be based on the marginal tax rate you pay now on money you will invest, vs. the marginal tax rate you expect to pay when you withdraw that money and its returns.  Comparing spendable amounts, with
P = Pre-tax amount
t1 = Current marginal tax rate
t2 = Marginal tax rate in retirement
i = investment return per year
n = number of years invested

Roth = P * (1 - t1) * (1 + i)^n
Traditional = P * (1 + i)^n * (1 - t2)
So if t1 = t2, your result is identical.

At least, that's the short version.  See the following for more arcane details:
http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758
http://forum.mrmoneymustache.com/investor-alley/rolling-over-a-401k/
http://forum.mrmoneymustache.com/ask-a-mustachian/case-study-new-job-new-life/
http://forum.mrmoneymustache.com/investor-alley/fund-401k-or-roth-ira-first/

For more general prioritization, consider:
WHAT
0. Establish an emergency fund to your satisfaction
1. Contribute to 401k up to any company match
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.
3. Max HSA
4. Max Roth or Traditional IRA based on income level
5. Max 401k (if 401k fees are lower than available in an IRA, swap #4 and #5)
6. Fund mega backdoor Roth if applicable
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.
8. Invest in a taxable account with any extra.

WHY
0. Give yourself at least enough buffer to avoid worries about bouncing checks
1. Company match rates are likely the highest percent return you can get on your money
2. When the guaranteed return is this high, take it.
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.
4. Rule of thumb: trad if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between
5. See #4 for choice of traditional or Roth for 401k
6. Applicability depends on the rules for the specific 401k
7. Again, take the risk-free return if high enough
8. Because earnings, even if taxed, are beneficial
« Last Edit: August 29, 2015, 06:13:07 PM by MDM »

john6221

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Re: Pre-tax or post-tax or what?
« Reply #3 on: August 28, 2015, 06:52:13 AM »
Well one of the biggest advantages is that they take taxable income off the top, yet when you withdraw, replace it from the bottom.

Gin1984

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Re: Pre-tax or post-tax or what?
« Reply #4 on: August 28, 2015, 07:13:49 AM »
What is the highest bracket you will be in without the 2nd 403b savings?

forummm

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Re: Pre-tax or post-tax or what?
« Reply #5 on: August 28, 2015, 07:31:38 AM »
As academics you may have 457 accounts available too. You can both max out a 403b and 457 as well as your IRAs. That would be something like $18k+$18k+$5500 for you and $18k+$18k+$5500 for spouse if available.

zolotiyeruki

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Re: Pre-tax or post-tax or what?
« Reply #6 on: August 28, 2015, 07:43:09 AM »
jdcstp2013 hit it on the head.  Your income now is higher than your income is likely to be when you retire.  So your tax bracket will be higher now than it will be in retirement.  By using tax-deferred accounts, you are decreasing your current taxable income (which is taxed at a higher rate), and increasing your taxable income when you retire (when you'll be taxed at a lower rate).

mschaus

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Re: Pre-tax or post-tax or what?
« Reply #7 on: August 28, 2015, 07:45:11 AM »
Good answers here for the nuts and bolts. Unsurprisingly (and appropriately!), the advice here has centered around achieving FI through wages, frugality, and the stock market. This is one great path, but there are many paths to take! If you are early on in your family finances, make sure to do a big-picture evaluation of your goals.

Simplest example is that you may be interested in real estate investments (or your own house), where you would need to have some chunks of cash (tens of thousands) not in tax-deferred accounts. Or maybe you want to spin off some of the technology from your research and start your own company, in which case you would need money for living expenses to get moving before venture capital comes in.

Defaulting to saving money now, then sorting out the rest while already saving, is probably good way to do it regardless!

Rulefollowing

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Re: Pre-tax or post-tax or what?
« Reply #8 on: August 29, 2015, 04:11:15 PM »
Thanks, everyone -- especially to MDM-- for so much, so helpful advice 

To address some thoughts/questions:

Q: Gin1984: What is the highest bracket you will be in without the 2nd 403b savings?
A: 25%.

Q: forummm: As academics you may have 457 accounts available too.
A: Apparently, we don't have this available to us at our (private) institution.

Q:  mschaus: Or maybe you want to spin off some of the technology from your research and start your own company, in which case you would need money for living expenses to get moving before venture capital comes in.
A: She is in literature; I am in philosophy-- very little chance of spinning off technology and starting our own company, unfortunately!

Thanks again, everyone-- we feel that we are on the right path, now...  We intend to use a Roth IRA for emergency funds and put the rest into Traditional IRA's or 403b. 


Gin1984

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Re: Pre-tax or post-tax or what?
« Reply #9 on: August 29, 2015, 07:58:44 PM »
Put in enough in your 403b to get out of the 25% bracket and into the 15%.  My mom is living decently within the 15% bracket retired and that should save you a ton of money.

Trudie

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Re: Pre-tax or post-tax or what?
« Reply #10 on: August 30, 2015, 01:48:07 PM »
Put in enough in your 403b to get out of the 25% bracket and into the 15%.  My mom is living decently within the 15% bracket retired and that should save you a ton of money.

I agree with this.  My husband is an academic and I am an accountant.  Our combined gross pay is a bit over $140K.  We both max out our 401k/403b, and with exemptions and deductions get ourselves into the 15% tax bracket.  I would advise anyone to do this if possible because at that level ordinary income AND capital gains tax rates are both lower.  This year we may pre-pay some property taxes and charitable donations so we can stay within that limit.  (It's getting more difficult as we pay less mortgage interest and we have fewer tax shelters available to us.)

Other than mortgage, we have no debts, and this is the order in which we do our retirement savings:

(1)  Husband maxes 403b, including age 50+ catch-up contribution with TIAA-CREF (24K)
(2)  Wife maxes 401K with employer (18K)
(3)  Max out Roth IRA contributions (5500 for wife; 6500 for husband)
(4)  Wife contemplating mega back door Roth to make additional contributions.

We do not have an HSA available to us.

On thing I would add is that if you are contemplating early retirement before you are Medicare-eligible and will need to be health insurance under the ACA (we are) there are still some decent premium credits available on modest incomes.  Your AGI from line 37 on your tax return is what the IRS will look at to determine your eligibility.  This is where the character of your sources of income is very important; ordinary income, capital gains, and Roths are all taxed at different rates.

Roths are tax free (since they were taxed going in).  They are reported as an informational item, but do not carry down to line 37.

Capital gains rates are lower than ordinary income rates, and long term rates are ZERO if you stay in the 15% income tax bracket.

Ordinary income rates are the highest.


When you are no longer working for W2 wages and drawing on your investments you actually have a lot more latitude to "engineer" your income to reduce taxes, especially since you no longer pay payroll taxes and presumably -- since you have been reading MMM for decades -- you know quite a few things about paying off all debts and living richly on less. 

Our plan is to allocate our income sources in retirement so we can get ACA premium credits and still do the things we want.  We will probably draw more heavily on Roths and taxable accounts in our health care purchasing years.

This is a bit off topic - but since you're both academics, make sure you're deducting your qualified research expenses:
http://www.irs.gov/publications/p529/ar02.html#en_US_2014_publink100026947

And by the way, I think TIAA-CREF is the best thing since sliced bread.

garth

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Re: Pre-tax or post-tax or what?
« Reply #11 on: August 31, 2015, 07:48:38 AM »
And by the way, I think TIAA-CREF is the best thing since sliced bread.

Can you expand on why you feel this way? I'm largely TIAA-CREF clueless. My university offers a 457 with matching through them, so I'm taking the free money...but I don't really understand the annuity products that I'm buying or how I should fit them into my portfolio.

Gin1984

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Re: Pre-tax or post-tax or what?
« Reply #12 on: August 31, 2015, 08:10:35 AM »
And by the way, I think TIAA-CREF is the best thing since sliced bread.

Can you expand on why you feel this way? I'm largely TIAA-CREF clueless. My university offers a 457 with matching through them, so I'm taking the free money...but I don't really understand the annuity products that I'm buying or how I should fit them into my portfolio.
TIAA-CREF is normally (not always) the cheaper option for non-profits.  They have no problem using vanguard funds (as long as your employer is ok with it) etc.  I do love them too.

Trudie

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Re: Pre-tax or post-tax or what?
« Reply #13 on: August 31, 2015, 08:19:00 AM »
And by the way, I think TIAA-CREF is the best thing since sliced bread.

Can you expand on why you feel this way? I'm largely TIAA-CREF clueless. My university offers a 457 with matching through them, so I'm taking the free money...but I don't really understand the annuity products that I'm buying or how I should fit them into my portfolio.
TIAA-CREF is normally (not always) the cheaper option for non-profits.  They have no problem using vanguard funds (as long as your employer is ok with it) etc.  I do love them too.

Yes - you can add a brokerage window to your retirement accounts and hold lots of funds (from other companies) for free.  I do keep some unqualified money with Vanguard because TIAA-CREF can't hold them.  And Vanguard offers pretty cheap stock trades.

I use an online tool with TIAA-CREF called "360".  I've linked all of my accounts -- both inside and outside TIAA-CREF -- and have a dashboard set up.  I get real-time net worth and performance information.

Trudie

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Re: Pre-tax or post-tax or what?
« Reply #14 on: August 31, 2015, 08:37:41 AM »
And by the way, I think TIAA-CREF is the best thing since sliced bread.

Can you expand on why you feel this way? I'm largely TIAA-CREF clueless. My university offers a 457 with matching through them, so I'm taking the free money...but I don't really understand the annuity products that I'm buying or how I should fit them into my portfolio.

In sum, why I love TIAA-CREF:
(1) Low fees.
(2) High industry performance ratings (Lipper.)
(3) They exist to serve the higher ed/research community.  Not shareholders.  I just don't ever see them taking shortcuts that would hurt their constituents.
(4) Once you have $500K in assets you qualify for a personal free wealth advisor.
(5) Prior to that point, there are many other services you can get for free.
(6) You can hold investments from many other fund companies within TIAA-CREF.  Also, you can set up brokerage accounts and windows and purchase ETFs and individual stocks.
(7) Much of the praise heaped on Vanguard (which I like) could be said of TIAA-CREF.  It's just that not everyone has access to TIAA-CREF.
(8) They don't make their money by selling you suspect investments or "upselling" you.
(9) Despite the fact that they don't hard sell, they do have some excellent term life insurance and mortgage products.
(10)

I would talk to HR and sit down with the TIAA-CREF right away and ask lots of questions about their services.

We are at the point that we have a personal wealth advisor.  I love it.  I am not totally "DIY" when it comes to investment allocations, but the service costs us nothing and we've consolidated all of our retirement investments in one place.  We model things once a year to make sure we're on track.  When we consolidated everything with them they set up a phone call and had all of our allocation information in hand.  We avoided the dreaded "automated phone system" and they led us through everything.

I use a free online tool called TIAA-CREF 360 and can track our net worth daily.  I look at it more than I should:-)

Retirement investing is extremely important, but I've never fancied myself a stock picker.  My time and skills are better used on managing my personal budget and tax planning.  Having such great service from TIAA-CREF allows me to do what I'm better at and what I actually have more control over.

garth

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Re: Pre-tax or post-tax or what?
« Reply #15 on: August 31, 2015, 10:27:22 AM »
I agree that the fund options are good (though I only have access to TIAA-CREF funds) and the fees are low. I am limited to annuity products though. Right now, I'm buying equity funds consistent with my asset allocation plan. I guess I'm asking why you like TIAA-CREF because I'm still trying to decide what to do with the money when I leave my university. I can roll it into a traditional IRA at Vanguard. Or I can keep it with TIAA-CREF as a variable or fixed annuity. But maybe you guys are not using their annuity products? I'm starting to lean toward keeping the money with TIAA-CREF since I'd be able to make withdrawals without penalty whenever I leave my job. And I could treat a fixed annuity as the bond portion of my portfolio. I'll have to talk to a rep about my options next year after my funds vest and transfer to TIAA-CREF.

Gin1984

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Re: Pre-tax or post-tax or what?
« Reply #16 on: August 31, 2015, 11:25:00 AM »
I agree that the fund options are good (though I only have access to TIAA-CREF funds) and the fees are low. I am limited to annuity products though. Right now, I'm buying equity funds consistent with my asset allocation plan. I guess I'm asking why you like TIAA-CREF because I'm still trying to decide what to do with the money when I leave my university. I can roll it into a traditional IRA at Vanguard. Or I can keep it with TIAA-CREF as a variable or fixed annuity. But maybe you guys are not using their annuity products? I'm starting to lean toward keeping the money with TIAA-CREF since I'd be able to make withdrawals without penalty whenever I leave my job. And I could treat a fixed annuity as the bond portion of my portfolio. I'll have to talk to a rep about my options next year after my funds vest and transfer to TIAA-CREF.
Oh Gods, no I am not using their annuity. The two companies I was aware of using TIAA_CREF had equity funds.  The current one also has annuities and vanguard target date funds as well.  But ick, no if they only have annuities that sucks.  Are you sure?  Why not call them now?

garth

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Re: Pre-tax or post-tax or what?
« Reply #17 on: August 31, 2015, 12:20:30 PM »
I agree that the fund options are good (though I only have access to TIAA-CREF funds) and the fees are low. I am limited to annuity products though. Right now, I'm buying equity funds consistent with my asset allocation plan. I guess I'm asking why you like TIAA-CREF because I'm still trying to decide what to do with the money when I leave my university. I can roll it into a traditional IRA at Vanguard. Or I can keep it with TIAA-CREF as a variable or fixed annuity. But maybe you guys are not using their annuity products? I'm starting to lean toward keeping the money with TIAA-CREF since I'd be able to make withdrawals without penalty whenever I leave my job. And I could treat a fixed annuity as the bond portion of my portfolio. I'll have to talk to a rep about my options next year after my funds vest and transfer to TIAA-CREF.
Oh Gods, no I am not using their annuity. The two companies I was aware of using TIAA_CREF had equity funds.  The current one also has annuities and vanguard target date funds as well.  But ick, no if they only have annuities that sucks.  Are you sure?  Why not call them now?

Unfortunately, annuities are our only option. But it's not all bad. I am buying equity index funds (e.g., large cap, small cap, international) that can be rolled to a traditional IRA when I leave the job. So the plan can function like more traditional index funds (i.e., the contributions and growth do not necessarily have to be annuitized). And the plan offers a good initial ROI: My employer contributes $1.33 for every $1 I contribute. These contributions (both mine and my employer's) are in addition to my 403b contributions (which do not go to annuities), so I can end up with about $45,000 of pre-tax contributions each year, which is nice.

Let's say I don't get tenure and leave my job 6 years from now. I could leave that money (roughly 150k in contributions) with TIAA-CREF for another 6 years until I'm FI. If I decide to stop working, I could then annuitize the TIAA-CREF holdings as the fixed income portion of my portfolio, though I have no idea how much the pay out would be. Probably pretty low given I'd be 45.

For now, the right thing to do is to contribute and take the free money. I may have to wait and see where I am in 6 to 10 years before I can decide whether to stick with TIAA-CREF long term.

Trudie

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Re: Pre-tax or post-tax or what?
« Reply #18 on: August 31, 2015, 12:46:22 PM »
I agree that the fund options are good (though I only have access to TIAA-CREF funds) and the fees are low. I am limited to annuity products though. Right now, I'm buying equity funds consistent with my asset allocation plan. I guess I'm asking why you like TIAA-CREF because I'm still trying to decide what to do with the money when I leave my university. I can roll it into a traditional IRA at Vanguard. Or I can keep it with TIAA-CREF as a variable or fixed annuity. But maybe you guys are not using their annuity products? I'm starting to lean toward keeping the money with TIAA-CREF since I'd be able to make withdrawals without penalty whenever I leave my job. And I could treat a fixed annuity as the bond portion of my portfolio. I'll have to talk to a rep about my options next year after my funds vest and transfer to TIAA-CREF.

I think I was probably still typing while you were asking why I like TIAA-CREF (see response above).  When it comes time to withdraw, I guess I want some guidance on that as well.  Some of it's personal... my husband is older than I am and so statistically speaking I will be on my own for awhile.  I consider myself capable and non-traditional and handle most of our finances (taxes, insurance, health insurance), but I don't want this on my plate as well.  And, if I'm overwhelmed with life when he passes, I guess I'd like some service.

Trudie

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Re: Pre-tax or post-tax or what?
« Reply #19 on: August 31, 2015, 12:57:07 PM »
I should add -- and it's been awhile since I've looked at the withdrawal strategies -- but there's a lot of latitude in how/or if you choose to annuitize.  While in the accumulation phase I've not obsessed over this, because we get great service, returns have been on target, fees are low, and ultimately I know that if I'm not happy we could roll it over someday.  But I really think TIAA-CREF will be flexible enough to handle what we want to do.

They have all kinds of tools and planners... haven't used any of them yet, but I might.  Mostly our strategy is to plow it in 'til it hurts.  We're so focused on that; I had a brochure from them a long time ago and withdrawals and paid attention to it enough (to be comfortable) but I can't find it.

garth

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Re: Pre-tax or post-tax or what?
« Reply #20 on: September 11, 2015, 08:47:05 AM »
I agree that the fund options are good (though I only have access to TIAA-CREF funds) and the fees are low. I am limited to annuity products though. Right now, I'm buying equity funds consistent with my asset allocation plan. I guess I'm asking why you like TIAA-CREF because I'm still trying to decide what to do with the money when I leave my university. I can roll it into a traditional IRA at Vanguard. Or I can keep it with TIAA-CREF as a variable or fixed annuity. But maybe you guys are not using their annuity products? I'm starting to lean toward keeping the money with TIAA-CREF since I'd be able to make withdrawals without penalty whenever I leave my job. And I could treat a fixed annuity as the bond portion of my portfolio. I'll have to talk to a rep about my options next year after my funds vest and transfer to TIAA-CREF.
Oh Gods, no I am not using their annuity. The two companies I was aware of using TIAA_CREF had equity funds.  The current one also has annuities and vanguard target date funds as well.  But ick, no if they only have annuities that sucks.  Are you sure?  Why not call them now?

Unfortunately, annuities are our only option. But it's not all bad. I am buying equity index funds (e.g., large cap, small cap, international) that can be rolled to a traditional IRA when I leave the job. So the plan can function like more traditional index funds (i.e., the contributions and growth do not necessarily have to be annuitized). And the plan offers a good initial ROI: My employer contributes $1.33 for every $1 I contribute. These contributions (both mine and my employer's) are in addition to my 403b contributions (which do not go to annuities), so I can end up with about $45,000 of pre-tax contributions each year, which is nice.

Let's say I don't get tenure and leave my job 6 years from now. I could leave that money (roughly 150k in contributions) with TIAA-CREF for another 6 years until I'm FI. If I decide to stop working, I could then annuitize the TIAA-CREF holdings as the fixed income portion of my portfolio, though I have no idea how much the pay out would be. Probably pretty low given I'd be 45.

For now, the right thing to do is to contribute and take the free money. I may have to wait and see where I am in 6 to 10 years before I can decide whether to stick with TIAA-CREF long term.

I stopped into TIAA-CREF today and got clarification on my plan. As it was explained to me, I do not have to annuitize my funds when I go to make withdrawals. Instead, I'll have full access as if they are in regular old mutual funds. It makes me wonder why they don't abandon the confusing annuity language, but whatever. I'm satisfied.