TAX-DEFERRED ACCOUNTS: A NO-BRAINER?

[gaston]

Hi all,

I am undecided about whether or not I should open a tax-deferred account. Here in Canada we have RRSPs, which are roughly equivalent to US 401k’s/IRAs. So far I have avoided them (not having spent a lot of time studying the question I admit), because:

1. I don’t like the fact that what’s in these accounts is not really yours until you pay tax on it. The government can change the rules at any time such as what is an eligible investment or what is the tax rate, creating a lot of uncertainty. Who knows what are the rules going to be in 20 years? Maybe tax rates will be much higher than they are now (just look at some European countries). Using an RRSP feels like a gamble.

2. I also feel that it creates accounting complications, for example if the assets in the tax-deferred account (say bonds) go up a lot and need to be rebalanced, you would need to sell some and add to your taxable income, which may not be what you want in that given year and influence your rebalancing decisions. In the same vein, don’t you need to account for the fact that money in the tax deferred account is pre-tax and apply some sort of ‘correction factor’ to your asset allocation?

3. I like to keep my options open, such as moving to another country. Taking the money would incur significant withholding taxes. The withholding tax is currently less than my current tax rate, but this may change. I feel like this restricts my freedom, even if it’s only psychological.

4. It seems to me that having such an account creates an incentive to have your income drop as you get older in order to be in a lower tax bracket to maximize your advantage. Feels like planning on being poor. What if you feel like starting your business, increasing your income and working until you drop dead? Does a tax deferred account still make sense?

5. To maximize the benefits, you have to sell down the assets as you get older (ideally hitting 0 on the day you die), effectively killing the golden goose for your heirs.

However Harry Browne seemed adamant that taking advantage of these accounts was a no brainer, and reading what most people are writing on this forum and elsewhere, it looks like these considerations are hardly ever discussed. I understand that the advantages are tempting:

1. The growth inside the account is never taxed (as explained here https://www.youtube.com/watch?v=_Q5q8TEHfuI), allowing the assets to compound tax free.

2. The assets in the account should be protected from litigation sharks (however I think holding the assets in a foreign country would achieve the same).

By not taking advantage of these accounts, if I am not mistaken I am basically giving up tax free compounding in exchange for complete freedom with my money, and simplicity.

I am curious whether some people on this forum feel the same way, or if I’m just being silly as my friends are telling me. I would appreciate your opinions on the matter.

Thank you,

[ochotona]

You raise valid points. You definitely get a plot of restrictions in exchange for avoiding tax, and you cite reasons for using the tax-deferred accounts as well. If you're unsure about what to do... then split the difference. Put 50% into tax-deferred, and 50% into taxable. That way you'll never be in the best or worst of all possible worlds. I hope gold is not taxed in any way in Canada.

[gaston]

ochotona,

The maximum contribution for RRSPs is 18% of the yearly income so yes the tax-deferred account would only be for a fraction of our savings. There are no sales tax on gold in Canada, and capital gains are taxed at half your marginal rate.

[ochotona]

Do you have hardship withdrawal provisions like we do here for our IRAs? That would provide more access to your money prior to retirement in case of emergency. Investigate that angle. Is it all for retirement or for other purposes?

[gaston]

Yes there are provisions for 'unlocking' locked-in retirement accounts in case of hardship.

However this would not apply as RRSPs initiated on your own are never locked-in. You can withdraw as much as you want at any time, and whatever you withdraw is added to your yearly income and taxed as such. At 71 you have to convert the RRSP to an RRIF and start making mandatory withdrawals. So I've heard people say that you can create a trap for yourself if you have too much in it, because then you would be taxed at the highest rate.

No particular use for the capital but I guess retirement would be part of it. I like the flexibility it provides.

[ochotona]

Maybe you can budget a maximum amount to go into the RRSP so you don't have to make the mandatory withdrawals on such a large bucket of money.

Let's say you're 30 now, and you don't want more than $1,000,000 in by age 71. You have 41 years.

The Permanent Portfolio delivers ~4% after inflation, so we will keep everything in today's money. The Government will index RRSP limits with inflation, also.

To hit $1,000,000 in 2017 Dollars by in 41, starting from scratch, at 4% interest, you have to save $10,017 per year, or $835 per month. But you'd then have to index the $10,017 amount by inflation each year to hit $1,000,000 in today's dollars in 41 years, which could be "who knows how many 2058" dollars.

That's from an HP 10bII+ financial calculator. Very handy. You can find free versions for your phone.

Let me know if you want another time frame and amount computed.

[sophie]

I know we'd all prefer to maintain maximum control over our savings, but unfortunately...yes, maximizing tax-deferred accounts is the biggest free financial gift you will ever get. It's worth the added complexity. I once ran some spreadsheet simulations to try out various scenarios (reported in another thread, a long time ago in a galaxy far far away etc), and there was simply no way for a taxable account to beat tax-deferred if you assume a slow, steady investment gain. After a few years, you come out ahead even if you withdraw early and pay the 10% penalty.

I also remember Canadian posters on the forum saying that there were no penalties for dipping into their RRSPs. Which makes that even more of a no-brainer.

[mathjak107]

The wild card for us here in america is the fact that deferred accounts can cause other issues that will cost you if you don't plan a lot more carefully.

Getting your ss taxed because you have to live off traditional ira's or getting hammered with medicare premium increases , loss of aca subsidy's etc can un-do a lot of that , and the advantage can go away. Especially when rmd's kick in , the secondary damages tax wise can really sting.

The best is a mix of all types of choices as to where to draw income from at different times or scenarios

[sophie]

If you have too much $$ in tax-deferred accounts, one can always defer SS for a few years and spend that time converting some of the money to your Roth. Then start drawing SS at a higher rate while using the built-up Roth to reduce taxable income as needed.

Of course, the extra taxes are STILL no match for tax-free compounding, even if you do end up paying them. Try it out on a spreadsheet and see. Giving up a ton of money to save a little doesn't exactly make sense.

[ochotona]

If you have too much $$ in tax-deferred accounts, one can always defer SS for a few years and spend that time converting some of the money to your Roth. Then start drawing SS at a higher rate while using the built-up Roth to reduce taxable income as needed.

Of course, the extra taxes are STILL no match for tax-free compounding, even if you do end up paying them. Try it out on a spreadsheet and see. Giving up a ton of money to save a little doesn't exactly make sense.

Agreed, thankfully my employer has a Roth 401(k), and I can punt 50% of my funds to Schwab also, which is super.

[gaston]

Ochotona: thanks for the calculation. I have found a great resource for making tax-deferred account decisions: http://www.retailinvestor.org/rrsp.html
This website has a spreadsheet to calculate the benefit/penalty of using an RRSP depending on your tax rate when you contribute and withdraw, your rate of return, etc. The writer demonstrates that a lot of the information you read on the subject is wrong, which is pretty fascinating. There is also a spreadsheet that helps you determine which assets to put in tax advantaged accounts first based on total expected returns. Interestingly it seems that nowadays it makes more sense to put stocks rather than bonds (at least for longer timeframes).

Sophie: you are right, if you make the calculations using tax-deferred accounts makes sense. Over a long enough timeframe and provided you manage your income properly one should come out way ahead (unless tax rates are increased to 50% or something...)

One thing I am wondering is this: do you need to adjust the weightings of the assets inside of the tax-deferred account for the fact that you will have to pay taxes on them on withdrawal? For example, if I put the PP 25% stocks in the account, and if my expected tax rate upon withdrawal is 20%, only 80% of those stocks are really mine. So in that case wouldn't I have to bump the stocks percentage to 31.25%? This way if I were to make withdrawals in kind (hypothetically), I would be left with a balanced PP 4x25. I have never seen this discussed so it's probably wrong but then what is the right way to look at it?

[gaston]

Apparently the assumption in my last question may be correct, as explained here: http://www.retailinvestor.org/rrsp.html#aa
(see 'Asset Allocation Weightings') (I didn't really get it the first time...)

Asset Allocation Weightings

How you weight different asset classes to effect your desired asset allocation, gets confused by the reality that the RRSP account includes the government's loan that will be paid back on withdrawal. Not all the account balance is yours. If all your savings are inside an RRSP then there is no problem. If you Asset Allocate each account you own independently then there is no problem. The problem is when you have assets in a taxable account or TFSA as well as a RRSP, and you Asset Allocate across the total portfolio.

Your goal is to determine the allocations as a percentage of your wealth - with the government's loan within the RRSP removed. And then translate the $$ allocations into the grossed-up RRSP account values - including the loan.

Say your taxable account = $100,000 and your RRSP account = $300.000. Your expected tax rate on eventual RRSP draws is 33%. The RRSP account includes a third that belongs to the government. Subtract 33% from its $300,000 balance. Only $201,000 is your own wealth. Your total wealth = $301,000 ( $201,000 in the RRSP and $100,000 in the taxable account). Note that TFSAs are treated no differently than taxable accounts.

(A) Account
Value
Wealth
RRSP 300,000 * (1 - 33% )
= 201,000
Taxable 100,000 100,000
Total 400,000 301,000

Say the Asset Allocation you want is 50% Debt and 50% Equity. Allocate your wealth, not the account totals.

(B) Asset Wealth
50% Debt 150,500
50% Equity 150,500
100% Total 301,000

Assume you have decided that Equity gets priority inside the RRSP.
* Fill the RRSP first with all the $150,500 Equity.
* There is still room in the RRSP so fill the remaining $50,500 with Debt (201,100 - 150 500).
* The remaining $100,000 Debt goes into the Taxable Account.
* The RRSP assets are grossed up to include the government's loan. These are the amounts of the actual investments inside the RRSP.


(C) Wealth Account
Value Account
Equity 150,500 / (1 - 33% )
= 224,627 RRSP
Debt 50,500 / (1 - 33% )
75,373 RRSP
100,000 100,000 Taxable
Total 301,000 400,000

Is there anyone here doing it this way?

[Xan]

Apparently the assumption in my last question may be correct, as explained here: http://www.retailinvestor.org/rrsp.html#aa
(see 'Asset Allocation Weightings') (I didn't really get it the first time...)

I definitely had that concern, and it's one of the things (but not the only one) that pushed me into having a separate PP in each tax treatment. That is, a PP in my already-taxed (Roth IRA), a second PP in my pre-tax (normal IRA), and a third PP in taxable.

But it was pointed out that all you really need is growth according to the allocation, and then when you sell, you rebalance. So you could do a PP (or any allocation) across all tax treatments, as long as you're prepared to rebalance when you sell.

In other words, if you skewed your allocation by expected taxes, then you end up with unbalanced growth. That's bad.

And when you sell, you pay whatever taxes are due, and then rebalance. No big deal.

[JohnnyFactor]

I went through this info in early 2016 and decided to create stand-alone PPs within each account (RRSP and TFSA). Rebalancing is simple and tax-free, and reflects the sentiment behind the PP in the first place-- keep it simple.

[gaston]

I've read a ton about investing but never came across these considerations before... It seems trying to have a neat and simple portfolio across all of these different accounts (RRSP, TFSA, Taxable, Institution1, Institution2, and foreign account if you are going to follow all the PP's rules) takes some thought.

In other words, if you skewed your allocation by expected taxes, then you end up with unbalanced growth. That's bad.

Xan, if you apply the correction factor before accounting for it, how is it unbalanced?

create stand-alone PPs within each account

This seems like the way to go, this way you don't have to guess what your tax rate is going to be. But physical gold doesn't really work then (gold in an RRSP can be done but fees are high and it sort of defeats the purpose).

[ochotona]

Gaston, your original idea to account for taxes in managing allocations is correct. Financial analysis is best done with cash flows after tax. That's a thing. It's how we calculate the value of oilfield investments.

[sophie]

I thought about adjusting amounts in tax-deferred to account for taxes, but that got too complicated. I didn't like the solution of creating different PPs for each account, because I wanted to able to place assets where they could do the most good, e.g. cash and physical gold in taxable. I finally decided to ignore the problem. It hasn't created any problems with yearly returns, and when it comes time to withdraw I'll simply count the taxes as part of the yearly expenses to be drawn against the cash allocation.

[mathjak107]

many times after the fact moving assets can be like telling the guy who built the brooklyn bridge " it is nice , but can you move it 2" left ".

it is just impossible down the road because it creates bigger tax issues than it saves .

[gaston]

Alright so after a week of mulling this over I opened an RRSP. Having gone through a lot of information and reflecting on scenarios for the future I think it makes sense and for the most part my initial concerns can be resolved. Let's go through the list again:

1. (About the risk of higher taxes at withdrawal): if you have a high savings rate and can live on a low income that creates an opportunity to 'retire' early (or probably start a business in my case) and start drawing on the RRSP way before the standard retirement age of 71 (I am planning on leaving the job between 35 and 40 yo). The contributions would be taxed at 31%, while income requirements would be taxed at 5-10% (considering that no more than half the assets would be in the tax deferred account and that there are tax credits for dividends and capital gains which may be outside the plan). So there is a bonus of 20% or more to be gained here, in addition to the absence of tax on growth.
Here is a fantastic resource for visualizing tax rates and planning the use of RRSPs: http://blog.citizenscode.org/2016/04/27 ... x-you-pay/
We can see from these charts that governments have tended to increase taxes on the high income and decrease them on low incomes. If your income needs are below 40k I think you should be pretty safe from tax increases. The lower the better obviously.

2. (About accounting complications): there are indeed complications for rebalancing if your asset allocation is spread over taxable/tax-deferred but you can always make adjustments in each category to balance things.
Regarding the problem of applying a 'tax discount' on assets inside the plan, it looks like there are 3 ways of dealing with it:

• A. Have a PP for tax-deferred and one for taxable/tax-free as suggested above. However there are issues with this: the tax benefit is not optimized, and it doesn't work for physical gold/ cash access.
  B. Spread assets across taxable and tax-deferred with a discount correction factor for tax-deferred, estimating taxes at withdrawal. This potentially optimizes the tax benefits.
  C. Same as B but with no correction factor (rebalancing if necessary on withdrawal). Since neither Harry's nor Craig's books talk about this I assume this is their preferred method? I am surprised this is never mentioned. Like Sophie I think I prefer this option.

3. (About leaving options open): if most of the cash is kept outside of the plan that should provide good flexibility. Currently for moving the assets abroad as a non resident there is a 25% exit tax which is still a 6% gain compared to contributions marginal rate in my case. However I wouldn't be surprised to see this one go up.

4. (About incentive to decrease income): with the scenario I have in mind I think this will be a non-issue. If starting a business I think you can reinvest profits without taking an income or paying yourself with dividends which are taxed at a lower rate. However for people being employed and working until later years I think maxing out the RRSP may be counter productive.

5. (About killing the goose): I think the way to solve that is to draw income needs from tax-deferred accounts early while building up assets outside in taxable land or within business entities.

So this is not really a no brainer as there are many things to consider. I think everyone has to run the numbers for themselves to see if it makes sense in their situation and to what extent it should be used.

[Libertarian666]

I believe I have found a way for US persons to avoid the RMD trap.

I'm updating my retirement calculator to illustrate this and will post when it is ready.

[Libertarian666]

I believe I have found a way for US persons to avoid the RMD trap.

I'm updating my retirement calculator to illustrate this and will post when it is ready.

I have done this but don't want to post the answer on a public forum. Message me if you are interested.

[farjean2]

I believe I have found a way for US persons to avoid the RMD trap.

I'm updating my retirement calculator to illustrate this and will post when it is ready.

I have done this but don't want to post the answer on a public forum. Message me if you are interested.

Just sent you a message. My situation is that I was forced to retire last year at age 67 and right now I'm delaying SS until 70 because my wife is younger and it seems like a no-brainer to delay in that case. Unfortunately, I will also have to start taking RMD's the same year I start collecting SS so RMD + SS + Wife's Salary = A lot higher income bracket than I hoped when I retired.