Author Topic: Ideal allocation of tax sheltered retirement accts at target income levels  (Read 547 times)

dsteve333

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Asset allocation and investment order are fairly straight forward to me; however, what about actual target percentages for different accounts ( t/roth401k, t/Roth IRA, HSA, ...) How should individuals with different target retirement income levels try to Ballance not their %stocks vs bonds, but how much to have in their 401k including Roth 401k, Roth or traditional IRA and taxable accounts.  This can be a very dynamic question based on income during working year's and tax advantages to different accounts, as well as every individual's starting point, plus in this community people want to ignore the status quo and retire in their 30's and 40's.

Because of the above variables, if a married couple wanted to retire at 52 with a combined pre retirement income of around 130k, and a target retirement income of around 80k with the least tax burden, what is the ideal amount to have in Roth vs traditional IRAs, Roth vs traditional 401k's, HSA, and taxable accounts. 

I don't want to include Social security income

If someone only has a traditional 401k at the time of retirement they would not be in an ideal situation.  So what is that ideal situation?

seattlecyclone

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Re: Ideal allocation of tax sheltered retirement accts at target income levels
« Reply #1 on: February 22, 2019, 08:20:45 PM »
If someone only has a traditional 401k at the time of retirement they would not be in an ideal situation.

Maybe, maybe not. Don't be too quick to assume that this is obviously a bad thing.

If you're in this situation where all of your assets are in a pre-tax retirement account, you were saving taxes every year at your top marginal rate while you were working. In this example with a married couple earning $130k, they would be solidly in the 22% tax bracket (this bracket covers taxable income from $78.9k-$168.4k in 2019). Retiring to withdrawals of $80k and taking the standard deduction ($24,400 in 2019), that would put your taxable income during retirement at $55,600.

The tax on this as an early withdrawal would be 10% of the first $19,400 of taxable income plus 12% of the last $36,200 of taxable income plus a 10% early withdrawal tax on the entire $80k. This adds up to $14,284 of taxes, or 17.855% of the withdrawal. Note that this is less than 22%. Once age 59 rolls around, this 17.855% tax goes down to a mere 7.855%.

What are the alternatives?

You could pay the 22% now, contribute to a Roth 401(k)/IRA, and pull the principal out tax-free prior to 59, and the growth tax-free afterward. You're paying 22% here.
You could pay the 22% now, contribute to a taxable account and buy index funds. Note that VTSAX pays out ~2% in dividends each year, which you will need to pay tax on at least until you retire and get into the 0% bracket for dividends and gains. Then you may need to pay tax on some of the gains when you sell. You're paying more than 22% here.

Just looking at the basic tax math, putting 100% of your savings in a traditional 401(k) seems to result in the lowest tax burden in your example. Note however that if you're able to save $50k each year (as assumed by the difference between current income and retirement spending), you're probably not going to be able to put that all into a pre-tax retirement account even if you wanted to! You'll be forced into putting some of that savings in a Roth IRA and/or a taxable account. These accounts have much lower costs of withdrawal pre-59, giving you more flexibility than if you had invested solely in a pre-tax 401(k).

Also note that the ACA adds an additional wrinkle here if you're going to be buying insurance through your state's marketplace. The phase-out of the premium tax credits effectively add a few percentage points on to your retirement tax bracket. This tilts the scales a bit in favor of Roth and taxable investing. 100% of your pre-tax withdrawals will count toward your MAGI, but 0% of your untaxed Roth withdrawals will count. For taxable account withdrawals only the dividends and gains count, but not the return of your principal.

dsteve333

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Re: Ideal allocation of tax sheltered retirement accts at target income levels
« Reply #2 on: February 22, 2019, 11:49:10 PM »
So if in retirement your income is in the same tax bracket as your working bracket, I thought you would be better off contributing at least a portion to a Roth IRA, but that doesn't seem to hold true here.

If that same couple made $130k  in retirement income and retired at 52, they would pay taxes on $105,600 plus pay the 10% penalty.  Which comes out to $14,949 plus the $13,000 penalty, totaling 21.5% (this is less than the marginal rate of 22%).  So they would still pay less with only a traditional 401k and traditional IRA. I am honestly floored by this.  I do think taxes will go up in the near future, but that is pure speculation. The current tax law phases out during 2025, which would put less tax burden on the above couple if they had Roth IRA principle to withdraw without penalty.  But again who knows what the future holds.

My wife and I are in our late 20s and she is planning on going back to becoming an employee soon, she is currently a stay at home mom and honestly works harder than I do, so our income will jump up from $130,000 to $170,000.  If we both maximize pre tax accounts including our own 401ks and an IRA for each of us as well as an HSA, we would be sheltering $57000/year, and after the standard deduction we would roughly be paying taxes on $88,600.  Which after the $4000 credit for having 2 kids means about $7200 in taxes or an effective tax rate of 4.24% but still having a marginal rate of 22% which would be our rate for any Roth contributions made.

Another issue I just realized with Roth accounts is that to get to the $6000 dollar Roth IRA maximum, you lose 7320 each in take-home pay.  Whereas a traditional IRA you only pay in the $6000.  That combined $2460 if invested into a taxable account over 25 years would grow unsheltered from taxes and end up likely adding more annual ncrease than you would have paid to originally upcharge the traditional IRA to a Roth IRA. 

Now it isn't looking like there is any real benefit to Roth accounts other than no penalty for withdrawal of principle (after 5 years) for a Roth IRA for early retirees.

I suppose if we saved at that rate untill we were 72 we would benefit from at least a portion of our retirement in roth accounts.

Did I swing to far in the other direction with my thinking? What am I missing?

seattlecyclone

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Re: Ideal allocation of tax sheltered retirement accts at target income levels
« Reply #3 on: February 23, 2019, 11:02:49 AM »
If that same couple made $130k  in retirement income and retired at 52, they would pay taxes on $105,600 plus pay the 10% penalty.  Which comes out to $14,949 plus the $13,000 penalty, totaling 21.5% (this is less than the marginal rate of 22%).  So they would still pay less with only a traditional 401k and traditional IRA. I am honestly floored by this.

The effective rate is lower than 22% for this level of income, but marginal tax rates still do matter here. You're paying 32% on the portion of taxable income that goes over the bottom of the 22% bracket, at least until you turn 59. You would therefore be better off saving enough in Roth to cover any spending over this threshold prior to age 59.

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My wife and I are in our late 20s and she is planning on going back to becoming an employee soon, she is currently a stay at home mom and honestly works harder than I do, so our income will jump up from $130,000 to $170,000.  If we both maximize pre tax accounts including our own 401ks and an IRA for each of us as well as an HSA, we would be sheltering $57000/year, and after the standard deduction we would roughly be paying taxes on $88,600.  Which after the $4000 credit for having 2 kids means about $7200 in taxes or an effective tax rate of 4.24% but still having a marginal rate of 22% which would be our rate for any Roth contributions made.

At that income level you probably won't be able to deduct traditional IRA contributions anymore. The ability to do so starts to phase out at $103k of MAGI, and disappears entirely at $123k. Certain things like pre-tax 401(k) contributions and HSA contributions and payroll-deducted health insurance premiums will bring down your $170k gross, but probably not enough to get below $123k. In that case you'll be "forced" into Roth IRA contributions.

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Another issue I just realized with Roth accounts is that to get to the $6000 dollar Roth IRA maximum, you lose 7320 each in take-home pay.  Whereas a traditional IRA you only pay in the $6000.  That combined $2460 if invested into a taxable account over 25 years would grow unsheltered from taxes and end up likely adding more annual ncrease than you would have paid to originally upcharge the traditional IRA to a Roth IRA.

I think I get what you're trying to say here: that if you have equal tax rates now and in retirement you're better off maxing out pre-tax and investing the tax savings than maxing out Roth. That's not actually correct. Given equal marginal tax rates now and in retirement, investing one pre-tax dollar in traditional vs. Roth will come out exactly the same. However as you note, the number of pre-tax dollars you can put in Roth is higher since the contribution limit is assessed on after-tax dollars in the Roth's case.

You recognize that the correct comparison is maxing out the Roth vs. maxing out traditional and investing the tax savings in a taxable account. In this latter scenario the traditional comes out slightly behind because you'll pay a small amount of tax on the dividends and capital gains in the taxable account, at least while your income is still above the 0% capital gains bracket. This isn't a huge factor, but it can act as a small tiebreaker in Roth's favor if you expect an identical marginal tax rate in retirement and are able to max out all of your available tax shelters.

Note however that the higher your savings rate is, and the more you have in Roth, the more likely it is for your tax rate to be lower in retirement than it is now.

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Now it isn't looking like there is any real benefit to Roth accounts other than no penalty for withdrawal of principle (after 5 years) for a Roth IRA for early retirees.

You can freely withdraw your Roth contributions at any time. You only have to wait five years for the portion of principal that came from a taxable traditional-to-Roth conversion.

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Did I swing to far in the other direction with my thinking? What am I missing?

The ACA can make a difference. The premium tax credit is calculated such that the second-cheapest silver plan would have a net cost after tax credit pegged to a set portion of your income. This is effectively a few extra percentage points added on to your nominal tax rate, tacking on 2%-9.5% depending on what your income is. If your reportable MAGI happens to be over 400% of the poverty level ($65,840 for a couple or $100,400 for a family of four) you get no tax credit at all. That can make a big difference! Furthermore if your reportable MAGI is under 250% of the poverty level ($41,150 for a couple or $62,750 for a family of four), there are "cost sharing subsidies" that grant you access to plans with lower deductibles and coinsurance amounts than you can buy at higher income levels.

What do I do personally? My family is in a similar ballpark of income to what you expect, and we put as much into pre-tax retirement accounts as we can. Because we make too much to deduct IRA contributions we do Roth for those. My wife and I have both worked at companies that have a mega backdoor Roth option, and we've taken advantage of that as well. Any savings beyond that goes into taxable. This gives us a nice diversity of options for how to get at our money in retirement, pushing our income up or down as it suits us.