Retirement Accounts, Part 1   1 comment

Yesterday I finished up my discussion of capital gains taxes (though I may realize in the future I left out a couple things). Capital gains taxes are relevant for your taxable investments. Today, I’ll be talking about your tax deferred or tax free investments.

There are many types of retirement accounts: Individual Retirement Accounts (IRAs), 401k’s, 403b’s, 457b’s, and 401a’s. Virtually all of them come in two flavors: the Traditional and Roth. Before I go into the specific details of the types of retirement accounts, I’ll cover the flavors first.

Traditional Accounts

For a Traditional retirement account, you get a tax deduction on the year of your contribution. This means the money you put in is not taxed. Then, starting in the calendar year you turn 59.5, you can withdraw money from the traditional account penalty free (if you withdraw before then, barring some exceptions, you will owe a penalty on the withdrawal). When you withdraw money from the traditional account, you owe taxes on the withdrawal. Thus, the traditional account is advantageous if your marginal tax rate now is greater than your average tax rate of your withdrawals.

[For the rest of this discussion, I am going to use 401k as a placeholder for any type of retirement account – IRA, 401k, 403b, etc. Also, when I say long term capital gains, I mean qualified dividends as well, as they are both taxed at the same favorable rates compared to normal income.]

I bold those two terms because sometimes I see examples floating around on the internet of how you should compare your marginal tax rate now to your marginal tax rate in retirement. This is the wrong comparison to make!

We are concerned about your marginal tax rate now because if you make a traditional contribution, then you get a tax deduction now. If we again use the example of Bob, who has $80,000 in income, single, no kids, and doesn’t itemize his deductions, we observe he has a marginal federal tax rate of 25%. If he contributes $18,000 to a traditional 401(k) this year, then he is only taxed on $62,000 of income. He has saved 0.25*18000 = $4500 in federal taxes. He can also invest the tax savings into a taxable brokerage account.

We are concerned about your average tax rate of 401k withdrawals in retirement because when you withdraw from a traditional account, typically not all of your 401k withdrawals are taxed at your marginal rate. Suppose Bob reaches 59.5 and starts withdrawing from his 401k. Suppose he has no other source of income. To go back to the bucket of water analogy, he is filling in the bucket of income from the bottom. Notice how he took money off the top of the bucket in his working years, and the money he’s pouring in at retirement fills in from the bottom. Not all of the withdrawals from his traditional 401k are taxed at the marginal rate. I see quite a few examples on the Internet assuming that all his traditional 401k withdrawals in retirement will be taxed at the marginal rate. The most common example is the scenario where they assume Bob will be in the same marginal tax bracket in his working years and in the future. They then say that because multiplication is commutative, in retirement he will just be paying back the same taxes he avoided in his working years, and hence, there is no advantage of using a traditional 401k. This is not typically true, because typically not all of his withdrawals will be taxed at the marginal rate (as we just saw in the previous example).

Now, I did say that typically not all of your 401k withdrawals are taxed at your marginal rate. We can certainly construct examples where all of your 401k withdrawals are actually taxed at your marginal rate. Suppose Bob had a pension that provided him $50,000 in 2014. In this case, his pension income already puts him in the 25% bracket. So long as he did not withdraw more than $49,500 from his 401k in 2014, he would stay in the 25% bracket, and hence, all of his 401k withdrawals would be taxed at his marginal rate. But what I said when I introduced traditional accounts is still true – I specifically said we should compare the marginal tax rate now to average tax rate of 401k withdrawals. It’s just that in this case, the average tax rate of 401k withdrawals is equal to his marginal tax rate.

So part of this comparison will require a prediction of the other income, if any, you anticipate when you withdraw 401k contributions. But, not only does it require the quantity of other income, it requires you anticipate the type of income as well. Recall from my last post that long term capital gains income “floats” on top of normal income (which is what a traditional 401k withdrawal is treated as). So you can have $99500 of income, but if $52450 of that is long term capital gains, and the other $47050 is 401k withdrawals, then the $52450 of long term capital gains is taxed at 15% (recall long term capital gains are taxed at lower rates than normal income), $10150 of the 401k withdrawal is not taxed, $9075 of the 401k withdrawal is taxed at 10%, and $27825 of the 401k withdrawal is taxed at 15%.

Income_LTCG_401k

401k withdrawals are in blue, and long term capital gains are in purple

In this scenario, despite the fact that there is a substantial amount of other income, because of the fact that long term capital gains income “floats” on top, all of the 401k withdrawals fill the bottom of the bucket. The average tax rate of the withdrawals is 10.8%. Meaning if you were in the 15% bracket or higher when you were making 401k contributions, you’ve come out ahead.

Roth Accounts

A Roth account is essentially the opposite of a traditional account. You do not get a tax deduction for your Roth contribution, but you do not pay any taxes when you withdraw the money. So, the correct comparison to make here is you should contribute to a Roth if your marginal tax rate now is lower than your average tax rate of hypothetical traditional 401k withdrawals in retirement (because you could have contributed to a traditional 401k account instead). Notice how this is just the opposite of the condition that a traditional account is advantageous. This is best illustrated by example.

Suppose you are in the 25% bracket. You can contribute $3000 to a Roth 401k or $4000 to a traditional 401k for the same $3000 out of pocket. If the investments double in value, then you have $6000 in the Roth and $8000 in the traditional. Now suppose that the average tax rate of 401k withdrawals is 25%. Then you end up with $6000 in either scenario. But if your average tax rate of 401k withdrawals is 30%, then the Roth account still has $6000 but you only end up with $5400 in traditional withdrawals. And you reach the opposite conclusion if the average tax rate of 401k withdrawals is less than 25%.

Consider state taxes

State taxes are another consideration you have to make. If you elect to use a Roth account you’re paying not only federal income tax but state income tax to be able to make the Roth contribution. However, if you decide to move to a no income tax state in retirement (such as Florida, Washington, Texas, or Alaska – I believe there’s eight in total), then this is a dead loss – you’ve prepaid state tax that you wouldn’t have had to pay in the first place. In this scenario, it makes far more sense to contribute to a traditional account to avoid the federal and state income tax now, and then upon withdrawal, you’re only subject to federal income tax.

But, of course, this requires you to know if you will retire to a no income tax state. And that’s not all that you would like to know in making the decision of a traditional vs Roth account.

But I don’t know what my future 401k withdrawal tax rate will be!

And I don’t think you ever will. You would need to know not only your anticipated retirement income and the type of income, but also the future tax brackets. There are some situations where it’s fairly obvious which type of account will be better. The Roth is better for students earning a fraction of what they will earn post graduation, and just in general jobs where there is a large expected increase in income in the future. Conversely, the Traditional account is better for people at the peak of their earning potential. In between, it can be murky. But keep this in mind: both the Traditional and Roth options are good options. Yes, it is almost certain that one of them will end up being better than the other. But you are always avoiding taxes at one stage – during contribution or withdrawal. Also, there is another benefit that I haven’t discussed yet – you’re not taxed along the way. Remember that stocks (and mutual funds and ETFs that hold stocks) throw off dividends and sometimes capital gains distributions. which are taxed before you can reinvest them. Bonds (and mutual funds and ETFs that hold bonds) throw off interest that is taxed as normal income. However, if you hold these assets in a retirement account, you do not pay taxes on such dividends, capital gains distributions, and interest. You are never taxed for any activity that is strictly within the account. You’re only taxed for either a contribution or a withdrawal.

The other thing you can do is hedge your bets—you can have both a traditional and a Roth account, and that way, you are tax diversified. Additionally, I’ll discuss this in greater detail tomorrow, but you may actually be forced to do this.

 




Now before I conclude my post, I should mention – there are limits on how much you can put into your retirement accounts every year. I’ll discuss those details, among other important facts, in my next post.

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Posted January 15, 2015 by Fiby in Uncategorized

One response to “Retirement Accounts, Part 1

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  1. Pingback: Do Your Taxes Yourself | Financial Independence by 40

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