Tax free compared to taxable

[PhysicianOnFIRE]

Kon Litovsky wrote:

Actually, what’s interesting is that using Roth conversions you can indeed bring the tax-deferred account in the same ballpark as far as taxes with the after-tax account, assuming tax-efficient investing.

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Roth conversions are a great idea once you retire and (presumably) drop into much lower tax brackets. I'd like to be in a position to have my tax deferred dollars converted to Roth by the time I hit 70.5 and RMDs are due.

In my case, the 401(k) is a pretty small percentage of my portfolio (~12%) so I should be able to convert a relatively small amount (~ $30,000 per year) and can have it all converted in 10 to 15 years depending on market returns.

 

[litovskyassetmanagement]

PhysicianOnFIRE wrote:

Gonefishin wrote:

Yup. You are right about the whole life pitch. 

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Some use the term “advisor” very loosely. It would seem to imply the person is giving advice, but this guy was trying to sell you a product that would probably net him $10,000 to $20,000 as a commission.

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Actually, what's interesting is that using Roth conversions you can indeed bring the tax-deferred account in the same ballpark as far as taxes with the after-tax account, assuming tax-efficient investing.  I haven't done a big study on this, but I did try various scenarios, and it turned out that the average tax rate you'd pay with Roth conversions is on par to the average rate you'd pay to keep the after-tax account.  Of course, it all depends on the initial assumptions, and the value of the assets.  And you need after-tax assets to pay the taxes on the Roth conversion.  But then you get a Roth out of the tax-deferred account, which is a lot more preferable than an after-tax account in the long term.

[PhysicianOnFIRE]

Gonefishin wrote:

Yup. You are right about the whole life pitch.

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Some use the term "advisor" very loosely. It would seem to imply the person is giving advice, but this guy was trying to sell you a product that would probably net him $10,000 to $20,000 as a commission.

[Gonefishin]

Yup. You are right about the whole life pitch. He was arguing that 1 million in cash value whole life would be the equivalent of 2 million in a taxable market investment.

[WallStreetPhysician]

Of course it depends. It is definitely not 2 million. At best (worst), $1.25 million in unrealized capital gains would be taxed at a (roughly) 20% tax rate and you'd end up with $1 million.

[Zaphod]

I dont get it, this is basically a very simple question. There will be some minor issues with tax drag on dividends, and maybe different funds to avoid such, however its basically a very simple math problem.

Its whatever is in your tax free account plus or minus (it can happen) the tax difference between your earning years vs. your draw down years. This ignores the tax free compounding part,

The mistake is made in that thinking its a double up situation, but because there is more in the account than you would otherwise have due to tax deferral up front that isnt exactly the case.

[PhysicianOnFIRE]

Gonefishin wrote:

An advisor told me today you would have to have 2 million.

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The advisor is either lying or incompetent.

A taxable account is a post-tax account. You've already paid taxes on that money. @LiveFreeMD explained it well.

If you invest in tax-efficient funds, the taxes owed each year will be at the long-term capital gains rate on dividends only each year. Invest in growth funds or stocks with no dividend, and you will owe very little in tax on it.

For example, I've got a low 7-figure taxable account. Last year, the mutual funds paid out dividends of $20,000. I got a foreign tax credit of about $300. I pay high taxes on the dividends now (15% + 3.8% NIIT + 9.85% state), so taxes were about $5800. So having a million dollars there cost me $5500 or 0.55%. That's probably lower cost than the expense ratios of the funds most advisors would put you in.  In retirement, I don't expect to pay the 3.8% NIIT and state tax will be lower.

If you sell in retirement when your taxable income is low, you may be able to avoid capital gains taxes. As long as you stay within the 15% federal income tax bracket (easier for the early retiree without huge tax deferred accounts), no federal tax is due on the capital gains.

 

 

[ENT Doc]

Hard to answer.  As a married filing jointly couple, you could take out nearly $96k a year from your taxable account and pay zero income taxes because you'll be in the 15% bracket after deductions/exemptions.  In the 10 and 15% brackets you pay no long-term CG tax or qualified dividend tax.  Really depends on when you retire and how you plan on drawing down your accounts.  But I hardly think it's anywhere close to double even under the most damaging assumptions.

[Live Free MD]

I'm assuming that by tax-free you mean Roth?

The answer to your question is complicated and depends on several factors including the amount of time you will be in retirement (tax-drag on a taxable account), the investments in your taxable portfolio, whether you have any other sources of income (social security, rental income, part-time work, etc.), and your expected tax bracket when you withdraw the taxable funds.  Keep in mind that in a taxable account, you are only taxed on the appreciation of the funds (not on the basis, for which you have already been taxed), and much of the taxable funds may be taxed at long-term capital gain rates.

As a simple example, if you have no other sources of income and you need $80,000 per year to live, you will likely be in a marginal ordinary income tax bracket of around 25%.  Your long-term capital gains rate will be around 15%.  If you assume that 100% of your taxable withdrawals will be taxed at a long-term capital gains rate, and you also assume that 100% of your taxable funds represent appreciation (it will likely be less than this), you would need to pull out $94,000 (80,000 / 0.85) from your taxable account.  In this case, you would need 17.6% (1 / 0.85 ) more in a taxable account than a tax-free account.  Of course, it isn't actually this simple.  This percentage will be higher if you are in a higher tax bracket or if some of the withdrawals from the taxable account are taxed at ordinary income tax rates.  This also doesn't take into account tax drag in a taxable account compared to a tax free account.

I can't give an exact answer to your question due to the many variables involved, but a reasonable estimate to your question might be that you need 25% more in a taxable account compared to a tax-free account.  I doubt that 100% more (as your advisor suggested) is needed.

I'm sure others on this forum will be able to point out a few things that I missed in this highly simplified analysis.

[Gonefishin]

Say you had 1 million in tax free retirement account. What would you say you would need the equivalent to be in a taxable account to be the same. An advisor told me today you would have to have 2 million.  Thoughts?Agree or disagree?