To defer or not to defer (taxes), that is the question

[classical_Liberal]

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[George the original one]

So many things are in flux right now that I would probably try a shotgun approach.

Looking at the tax proposals floated so far, it doesn't sound like Roth conversions will go away, so having a certain amount of money in regular IRAs should be useful. Neither have I seen any proposals changing the lowest tax bracket unless it is through the backdoor by eliminating deductions.

There's no guidance on whether there will be healthcare subsidies for the lowest tax brackets nor is there guidance for whether you'll need a minimum income to qualify for subsidies if they still exist once Obamacare is repealed. If no subsidies, then you should be able to eliminate your federal tax liability by merely deducting the insurance premiums.

So... do what you can to reduce 2016 tax burden and then wait for new tax proposals to firm up before making any commitments in 2017. While you're waiting, figure out how much you can withdraw from your 401k with an early exit (or what it would be if converted to IRA and substantially equal payments).

[OTCW]

I use the shotgun approach. I have money in an HSA, an IRA, a Roth IRA, a 401k, a Roth 401k, and brokerage accounts. Also an annuity. No life insurance. I'm also thinking of real estate investing.

[George the original one]

Forgot to mention that I do like Roth IRAs because you can withdraw the original principal without penalty before age 59.5.

[Fish]

Great topic idea @classical_Liberal. This is something I'm also contemplating. My tax-deferred bucket was always filled first, so assets in retirement accounts are several multiples of those held in taxable accounts. Like you I'm about 3 decades from normal retirement age.

Due to focus on earned income I will not be able to do Roth conversions at favorable rates. I would be willing to pay 25% taxes to convert the retirement funds to taxable but my marginal tax rate is higher than that. From a flow/FI perspective I'd rather see the dividends paid into taxable even if it means paying more taxes overall. Retirement accounts feel like play money because it's hard to do anything practical like buying a loaf of bread.

A few years ago I went full optimization including backdoor Roth. I don't really think this is worth the effort anymore. Due to being overweight in retirement accounts I reduced contributions to the pre-tax limit to divert more to taxable. I'm also thinking of cutting back even further to just get the employer match so taxable builds up even faster.

Does anyone here advocate accumulating heavily in retirement accounts to get the asset and creditor protections afforded to 401k plans? I'm not sure how to balance my desire to set up income systems for FIRE vs. having better tax efficiency and some protection against catastrophic life events. Any thoughts would be appreciated.

[IlliniDave]

I don't know what kind of consensus OP is looking for. I will possibly do small annual Roth conversions when I'm retired prior to SS up the the limit of the 15% bracket (if nothing changes). Since I will be have income from a retirement annuity, and possibly SEPP withdrawals from my 401k, there's not much, if any, space left to the 15% cutoff for a single filer like me. My tax rate is too high now for conversions or Roth 401k contributions to make sense--I'm definitely in defer tax mode. Even if I wanted to, my 401k doesn't allow for conversions so I'd have to wait until after I retire (and rollover to a traditional IRA) before I can do it. I do the backdoor Roth every year, but that's after maxing out my 401k and HSA.

I have a philosophy a little like OTCW--I have taxable investment accounts, a pre-tax 401k, a Roth IRA and an HSA. The 401k is disproportionately large, but that's mainly because the account is almost 30 years old. But I have enough money in enough tax treatment buckets that I can play the game on the margins and at least shave a little off my ongoing tax bills.

In hindsight I wish I'd have started a Roth IRA when they first came out in 1997, but when they did I was married to a rampant spendthrift and could barely count on being able to put enough in my 401k to get the full company match. Then by the time I became single again my income was above the single filer limit. Then when my company finally added a Roth 401k option my tax rate was too high for it to make sense. I've done the backdoor every year since the second year that option was available though, and will continue. Since all my other tax advantaged space is filled I'm paying the tax on the backdoor contribution anyway, so may as well shelter it.

[Chris]

I beleive income tax rates will increase, rather than decrease over the long term; while over the short term with Trump we may see a slight decrease.
...
Given these circumstances should I continue contributing to tax deferred accounts past my employer match? If I do, Isn’t it wishful thinking to believe I will find a way to reduce my tax burden at a later date? What were the determining factors for you regarding "enough" in deferred accounts? Are there factors/assumptions I am not considering?

Don't discount the impact of tax-advantaged compounding. Money you contribute to a pre-tax account might be more encumbered, but the compounding effect is also larger. In a tax-adavantaged account, a 5% dividend will allow for 5% compounding. But If that's in a taxable account, you'll knock off almost a whole point.

Let's take $20 and 5 years, @5% return for 10 years. 15% tax rate.

Post-tax: $17k into the account, future value is $25,689
Pre-tax: $20k into the account, future value is $32,872. Final spending value depends on if you take it out as a lump sum or only a portion, letting the rest compound.

So while there's only a $3k difference initially, the spread widens over time. Or in other words, you come out ahead as long as the additional compounding growth exceeds the future tax rate increase.

Re: future tax rates. I'm more optimistic than you. Here's the reason: retiring baby boomers. Even if you're not one of them, you'll still be in a good position if your tax return looks like theirs. Old people vote. That's why I expect favorable treatment to continue for retirement accounts, qualified dividends, and LT cap gains.

Now taking these two together (similar future tax rates + tax-free growth): you might do well to use pre-tax accounts and just pull the money out as needed, even without doing conversions or anything. This blog post explores such an idea. Basically, the initial tax advantage plus the tax-free growth might exceed the future tax rate plus the early-withdrawal penalty, under certain assumptions.

[classical_Liberal]

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[classical_Liberal]

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[IlliniDave]

Now taking these two together (similar future tax rates + tax-free growth): you might do well to use pre-tax accounts and just pull the money out as needed, even without doing conversions or anything. This blog post explores such an idea. Basically, the initial tax advantage plus the tax-free growth might exceed the future tax rate plus the early-withdrawal penalty, under certain assumptions.

I understand your thought process here, but the amount of time until the withdrawal and rate of return is key to the compound growth of deferred taxes. If I expect to need the money soon, in only a few years (which I would) and if I am expecting less than average returns in the next several years (which I am), the benefit is lost. Assuming all things being equal (same tax rates), I am trading 25 percent tax rate now, for a 15 percent + 10 percent penalty later. At least by paying the 25 percent now, any capital gains I do achieve in those years will be tax free if I buy & hold (assuming the 15% tax bracket).

Have you looked at SEPP withdrawals (aka the 72t exception)? It's a little rigid but it is a way to get money out of an IRA penalty-free prior to age 59.5.

[IlliniDave]

Roth conversions when I'm retired prior to SS up the the limit of the 15% bracket (if nothing changes).

This was/is my plan as well. "Brown out" with my current career and success reducing cash needs over the past two years has lead me to believe It's more likely I will enjoy ERE with a wage income component . The fact that I will likely have income in most years significantly reduces the amount of conversions available at this tax level. I would imagine I could purposely manufacture my income to suit optimal conversions, but I would rather not have to interrupt jobs or projects I enjoy simply to ensure I'm in the right tax bracket. This feels counterproductive to the goal of having freedom to participate in whatever opportunities are of interest and stop if they become unfulling.

It depends I guess on what you plan to do for work. If I work for wages I expect it will be something low-paying and part time that I might find "fun". My plan is stick essentially all of that money first into my HSA (presuming I have an elgible plan) then above that cap into my Roth IRA. Since I'll have taxable outside income anyway some of it could go into the Roth at > 15%, but I'd pay the same taxes if I don't put it into the Roth. I could get a tax break by contributing to a TIRA, but by then my goal will be more about setting up my estate for my heirs than for my own day-to-day finances. For that purpose Roth is the best and taxable is, IMO, second best (cost basis is reset when I croak). Pre-tax is third because it is subject to RMDs that don't get dividend/cap gain tax treatment.

That's one thing I forgot to mention. Subject to what happens with the changes in healthcare legislation, I plan on maintaining HSA eligibility (by plan selection) and continuing to stuff money in there up to the limit. My understanding is that you don't need earned income to fund an HSA and receive the tax deduction (like you do with IRAs). HSAs are great because if used for eligible expenses there's no tax on either end, and even if you use them for non-eligible expenses once past a certain age (70 iirc) there's no penalty (although they get taxed like a TIRA/401k). Since I have one now I'm saving all my eligible receipts (which I'm paying with after-tax money). I don't think there's a time limit to reimburse yourself once you start an HSA. That will allow me to pull money out down the road with no tax or penalty and use it for whatever I need to at the time because from a tax perspective I'm using it to reimburse myself for eligible medical expenses incurred in prior years and paid out-of-pocket. Unfortunately, perhaps, my health is good now and my eligible expenses last year for example were about $150. Still, I suspect I'll be able to easily get all the money out tax free as healthcare expenses typically spike for older folks, and especially if they follow through with making healthcare premiums eligible expenses for HSAs (I'm pretty sure they aren't now).

[halfmoon]

@IlliniDave, this is an excellent overview of HSAs. You hit all the relevant points. Correct that health insurance premiums generally aren't currently eligible HSA expenses, though there are a few specific exceptions. Also: under current regulations, you can't contribute to the HSA once you're on Medicare (no need for the HDHP at that point anyway).

[Fish]

Here is an entry-level article on the subject by MMM: How much is too much in your 401k?

Most finance-savvy people are beyond that level. It's like chess where merely knowing the rules and playing well are two completely different things. I think where people (including myself) get stuck is that applying the rules tactically doesn't produce a cohesive strategy.

Probably the thing to do is actually put together some example but concrete plans for FIRE, semi-retirement and continued full-time work and then vary the parameters to find a contribution/withdrawal strategy that performs reasonably under all conditions. Optimization doesn't work here because FIRE and full-time employment are vastly different. To optimize one needs to fix the boundary conditions for earned income. Otherwise there are too many unknowns.

That being said, getting back to basic principles, I lifted this quote from Jacob in cmonkey's journal:

Over here at ERE HQ we take every single deduction we can. The 401ks are even maxed out early in the year in case we quit/get fired later on. [...] Tax optimization is where the money is.

I wonder whether the defer/don't defer decision is only a dilemma in a certain net worth range? It seems like a mid-to-late accumulation problem. With money is at either extreme (scarce or tap water) how it's managed doesn't make a difference to your lifestyle. In either of those two cases you'll make your move and get on with your life. But it's strange how it seems to matter so dearly when within striking distance of FI. One day I'll look at this from the other side and be amused by how much I cared about wanting to make the "best" move.

I'm leaning towards the "old person money" approach as described in the MMM article (I also think @classical_Liberal ran his cfiresim assuming this). I like its simplicity but it is a major mental setback for actually feeling FI, which to me is passive income=current expenses, rather than "capital for life". The "old person money" approach is more compatible with the latter notion of FI. So maybe I should be flexible with my thinking. Under this approach I would continue to apply a SWR target to deferred accounts for old-age retirement, and apply Jacob's finite-horizon equations (i.e. the "akratic tables") to gauge the sufficiency of a separate bucket of assets consisting of taxable and deferred account excess. A discounted cash flow analysis such as the one here might also be appropriate.

Since being enlightened with Jacob's "value generation for life" ideal, the actual attainment of FI is secondary to living well and in alignment with values in the present. This is fortunate since otherwise I would be agonizing over the decision. I think my plan will be to continue maxing out pre-tax deferrals and in addition to this, shelter as much as I can in tax-advantaged space (Roth etc.). Taxable is already some satisfactory FU multiple of expenses, so it can take a back seat to building long-term wealth for the legacy that I'll care about someday. The retirement accounts will be primarily "old person money" and a sort of backup emergency fund if taxable somehow gets exhausted due to bad luck or catching the FIRE bug.

And the finish line for FIRE gets pushed back even further...

[classical_Liberal]

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[Fish]

As someone both flexible (willing to work) and motivated (value generation for life) (*), the more I thought about this subject the more I realized a similarity with Jacob's recipe for tortilla chips. (Abstract: ...it doesn't matter.)

And if the specifics of the plan are not significant, may as well do what future self will appreciate.

(*)As a recent convert to both of those principles I fully expect someone older/wiser to tell me that I'll get over it.

@classical_Liberal: I think that plan is very sensible. Although only allocating 7-9x for ~18 years of retirement in the pre-60 bucket, you can also adjust this target depending on your investment returns on the post-60 side.

[Mister Imperceptible]

I don’t want to pay more taxes but I don’t want to push FIRE further back.

I wanted to write a long post but I’ve been reading and thinking about this all day, and now my brain hurts. Thinking about setting up a SEP IRA and getting to a Backdoor Roth conversion down the line. I’m early in accumulating, not yet have FU money but getting there fast with a high income. The high income (new for me) means the stakes of my decision are higher. I really do not like the idea of feeling like my money is held hostage in a tax-deferred account. Also, once the money is in there, I lose the option of investing it in directly owned real estate or other alternative investments. But I’m pretty convinced by the Austrian Business Cycle Theory so any immediate contributions would be sitting in cash anyway, based on current valuations. Less than optimal for a tax-advantaged account.

Have a month to figure it out.

I love reading about investing, but I hate figuring out taxes. I expect my accountant to be worthless as I am sure he has no other FIRE candidates in his roster of clients.

My poor brain.

[Seppia]

If you have a high income you should be able to do both: max out 401k and add something more in a regular brokerage account.
In this way you should have the best of both words.

[jacob]

Indeed, I think the answer to this question depends a lot on how much you make.

Now, it's possible to make the spreadsheets for one's lifetime networth, income, and spending year by year that includes such tax-concerns. The problem is that the laws will probably change a few times over that course. Therefore, perhaps, the best solution is to diversify into various tax-vehicles.

Imagine for example that qualified dividends no longer got special (0%) treatment in the taxable account; imagine that the brackets change by the time to take out the IRA money or that it gets treated differently than earned income; ...

Suppose, for example, that GDP drops or flattens with no recovery because humans can't sustain the flow of energy that keeps this civilization alive. IOW, earned income drop like a rock. Future voters (todays children) might not like the fact that boomers, genx, and millennials sit on quantitatively inflated purchasing power relative to what one can buy working in the salt mines.

[ThisDinosaur]

Fish posted a very helpful table in another thread. Its useful for figuring out how much to put into tax deferred/creditor protected vehicles. You can choose to put only enough in vulnerable/taxable accounts to last until traditional retirement age. Yes, tax laws will change, so its best to have a little more in accessible/taxable accounts just in case.

[jacob]

https://www.marketwatch.com/story/if-yo ... 2018-03-16 ... from the people who brought you Mitt Romney

(taxes in the last part of the article)