Weighting asset allocations in tax-advantaged accounts

[jatwell]

I came across an article on Fairmark that got me thinking about allocations in Roth and TIRA/401k accounts, but Roth especially.

http://www.fairmark.com/rothira/bigroth.htm

Amount Equivalent to $100 in a Roth Account
Tax Bracket Amount
10% $111.11
15% $117.65
25% $133.33
28% $138.89
33% $149.25
35% $153.85

I can see the TIRA and taxable accounts being weighted about the same, especially if you leverage things like physical gold and IBonds in your taxable account.  The thing I can't really get over is the advantage that anything in your Roth IRA will have in relation to other accounts.  Basically it's like having 11-50% more (depending on expected future tax bracket) in whatever assest class you have in your Roth.

For simplicity sake, say you're in the 25% tax bracket in retirement and had only one assest in your Roth, stocks for example.

100K (75k after tax) Gold - Taxable  23%
100K (75k after tax) LTT - TIRA 23%
100K (75k after tax) STT - TIRA 23%
100K (100K after tax) Stock - Roth IRA 31%

Effectively after taxes, you'd have 33% more in your Roth throwing your allocation percentages off to the numbers above, right?

[moda0306]

This is an extremely smart move. As a tax guy, I can't believe I haven't thought of weighting your investments based on the implied tax liability associated with the account.

[arjking]

An interesting idea but I don't see the point.  The purpose of the PP is 25/25/25/25 to minimize volatility year by year as you are watching your entire savings balance go up or down.  If your purpose is just to match the performance of the PP say after 20 years after-tax, then yes you could underweight the investments in the Roth.  But I think it is not necessary and I think if you did the Spreadsheet simulation you would see that your method would be more volatile.  Simply speaking, I do not agree that 1 share in the Roth is worth 1.X shares in the 401k, at least not for purposes of diversification.  In my mind's eye, taxes are not applied until the portion you are withdrawing is converted to cash anyway, so it does not come into consideration in terms of asset allocation. 

[TripleB]

I thought about doing this several years ago and I was intent on doing this, until I ran actual numbers and realized I was wasting my time. Additionally, I plan to pay zero taxes on my 401k/Traditional IRA money in retirement, because I intend to only withdraw as much as I can tax-free based on standard deduction/personal exemption.

I also have plans to do some accelerated depreciation on investment property and performing 401k to Roth IRA conversions during those years to maximize the use of non-refundable tax credits.

Thus, I intend to never pay taxes on the "tax-deferred" accounts, so it became meaningless to try to estimate the tax-weighted nature of my investments.

One thing that is worthwhile to keep track of, in a similar vein, is liquidity. If you had to liquidate all your accounts today, pay early withdrawal penalties, and pay income taxes, how much could you actually get access to? Consider any Roth IRA contributions as well as liquid.

[moda0306]

TripleB,

Depending on how close you are to retirement, be careful about assuming at which $ of income you'll start getting taxed.

Social security taxation is a bit odd, and leaves most people the ability to take in quite a bit more income before realizing a tax liability than when you are earning wages that are 100% taxable.

I'd hate to see you overdoing your Roth conversions and paying unnecessary tax.

Good thinking, though.  It's smart to think through tax brackets and how they effect your retirement strategy.

Further, if tax brackets do anything in the short-term, I'd actually assume for them to drop, making Roth conversions before than for someone near retirement even more risky.  The conversation in Washington is VERY much in fundamental tax reform mode, centered on cleaning out a lot of the deductions and reducing the tax rates.

[arjking]

Additionally, I plan to pay zero taxes on my 401k/Traditional IRA money in retirement, because I intend to only withdraw as much as I can tax-free based on standard deduction/personal exemption.

I wonder how you plan to do this with the "required minimum distribution".  I do not know exactly what the RMD rules are, but I think the government may be one step ahead of you there.

[TripleB]

Additionally, I plan to pay zero taxes on my 401k/Traditional IRA money in retirement, because I intend to only withdraw as much as I can tax-free based on standard deduction/personal exemption.

I wonder how you plan to do this with the "required minimum distribution".  I do not know exactly what the RMD rules are, but I think the government may be one step ahead of you there.

The RMDs start at something around age 70. I plan to retire no later than 40. So I have 30+ years to do Roth IRA conversions, tax-free, up to the max of my standard deduction/personal exemption.

As far as the previous comment on being careful not to pay too much tax, my point is to never do a Roth IRA conversion when I have to pay any tax. I will only do it to the limit of my "free" money, the standard deduction/personal exemption.

And Social Security... LOL! That's a good one. Maybe I can take my hover car down to the Social Security office in 30 years and pick up my check

[arjking]

The RMDs start at something around age 70. I plan to retire no later than 40. So I have 30+ years to do Roth IRA conversions, tax-free, up to the max of my standard deduction/personal exemption.

How ill you support yourself between the ages of 40-70?  Using the cost-basis of your Roth only?  I'm curious.

[TripleB]

The RMDs start at something around age 70. I plan to retire no later than 40. So I have 30+ years to do Roth IRA conversions, tax-free, up to the max of my standard deduction/personal exemption.

How ill you support yourself between the ages of 40-70?   Using the cost-basis of your Roth only?  I'm curious.

Taxable savings.

Work from Age 20 to 40. Max out 401ks, Traditional IRAs, and still contribute to taxable savings.

Age 40 retire. Live off taxable investments for 30 years. Over these 30 years, do Roth IRA conversions, tax-free, whenever you can do so due to unrealized tax-losses and standard deduction/personal exemption.

Then when you're 70, you have most or all of the 401k/IRA money moved into a Roth IRA and will never pay taxes on withdrawing it. Considering you never paid taxes on the income ever (Because it was from a 401k/Traditional IRA), you made out pretty well.

Of course, if you need $50k per year to live on because you want to live in San Francisco or in a McMansion, then you can't do this. If you can live on $15k to $20k per year then you're good to go.

[arjking]

Of course, if you need $50k per year to live on because you want to live in San Francisco or in a McMansion, then you can't do this. If you can live on $15k to $20k per year then you're good to go.

20k per year is a completely different way of life that I am accustomed to.  I would find that very difficult.  I hope to be earning at least $80k in retirement in today's dollars.  I don't know what I would do with myself between the ages of 40 and 100 without work.  I would work at least till 65 if not more if I have good health.

[TripleB]

Of course, if you need $50k per year to live on because you want to live in San Francisco or in a McMansion, then you can't do this. If you can live on $15k to $20k per year then you're good to go.

20k per year is a completely different way of life that I am accustomed to.  I would find that very difficult.  I hope to be earning at least $80k in retirement in today's dollars.  I don't know what I would do with myself between the ages of 40 and 100 without work.  I would work at least till 65 if not more if I have good health.

How do you manage to spend $80k per year while working full-time? Do you skeet sheet uncut diamonds? 

In all seriousness I live off $15k per year using modest expense control. If I wanted to I could do a few more things and maybe up my expenses to $30k, to include a few vacations. I can't imagine myself spending $80k per year.

[Storm]

Of course, if you need $50k per year to live on because you want to live in San Francisco or in a McMansion, then you can't do this. If you can live on $15k to $20k per year then you're good to go.

20k per year is a completely different way of life that I am accustomed to.  I would find that very difficult.  I hope to be earning at least $80k in retirement in today's dollars.  I don't know what I would do with myself between the ages of 40 and 100 without work.  I would work at least till 65 if not more if I have good health.

How do you manage to spend $80k per year while working full-time? Do you skeet sheet uncut diamonds? 

In all seriousness I live off $15k per year using modest expense control. If I wanted to I could do a few more things and maybe up my expenses to $30k, to include a few vacations. I can't imagine myself spending $80k per year.

Your frugality is admirable, but if you live on either coast you should expect to at least triple that expense.  $15K a year will only pay rent for a 1 bedroom apartment in a ghetto like Oakland or Bridgeport, much less any other expenses.

[mkchiu]

Oakland, CA isn't so much of a ghetto depending on location. 1 BR in is around ~9K$/yr for rent. 1 BR on the roughly urban suburb Alameda, CA is ~10K$/yr for rent. So 15K$/yr total expenses isn't hard here...for someone single...without a smartphone and cable.

Marginal rates don't seem very good for visualizing tax impacts since the rates, and brackets change over time. Like how California shifts brackets so you will pay about the same amount of taxes assuming your salary were inflation adjusted.

For example, if gross is currently 50K$, 30 yrs until retirement, 4% annual inflation, 80% of current income needed during retirement, then 0.80*50,000*(1.00+0.04)^30=130K$. Assuming tax brackets and tax bracket rates do not shift right / decrease at all, then the future effective tax increases from about 17% (of 50K) to 23% (of 130K).

Although I suspect if inflation adjusted tax rates were visualized, those rate curves would be fairly similar.



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[dragoncar]

1 BR on the roughly urban suburb Alameda, CA is ~10K$/yr for rent.

Don't give away our secrets.

[MediumTex]

How do you manage to spend $80k per year while working full-time? Do you skeet sheet uncut diamonds? 

In all seriousness I live off $15k per year using modest expense control. If I wanted to I could do a few more things and maybe up my expenses to $30k, to include a few vacations. I can't imagine myself spending $80k per year.

Kids are one way of getting rid of a lot of money.

Dr. visits, dance classes, sports, school lunches, clothes, video games, babysitters, McDonalds, birthday parties, college savings.

It adds up.

[travelingheelfan]

How do you manage to spend $80k per year while working full-time? Do you skeet sheet uncut diamonds? 

In all seriousness I live off $15k per year using modest expense control. If I wanted to I could do a few more things and maybe up my expenses to $30k, to include a few vacations. I can't imagine myself spending $80k per year.

Kids are one way of getting rid of a lot of money.

Dr. visits, dance classes, sports, school lunches, clothes, video games, babysitters, McDonalds, birthday parties, college savings.

It adds up.

You've got that right.....

[Jimbo]

If the original poster is still around...... Her understanding is a bit skewed  Instead of ..."After 25% tax, you'd have 33% more in your Roth throwing your allocation percentages off to the numbers above, right?"  the correct understanding is "At the 25% withdrawal tax rate, you will need 33% more inside your 401k or TIRA in order to have the same after-tax principal (as assets in Roth or taxable accounts) after you take it out."

The principal in both the taxable accounts and the Roth will never be touched

So instead of weighting :

"100K (75k after tax) Gold - Taxable  23%
100K (75k after tax) LTT - TIRA 23%
100K (75k after tax) STT - TIRA 23%
100K (100K after tax) Stock - Roth IRA 31%

You should weight:

100K gold in taxable
133K debt in TIRA
133k cash in TIRA
100K stock in Roth

[yankees60]

This is potentially a major issue in setting up and maintaining a Permanent Portfolio.

$100,000 in a Roth IRA is NOT equivalent to a Traditional IRA since it will not generate any taxes when withdrawals are made. Therefore, on an after-tax basis, investments in a Roth IRA are worth far more than an investment in a Traditional IRA.

How many you make this distinction?

Vinny

[yankees60]

If the original poster is still around...... Her understanding is a bit skewed  Instead of ..."After 25% tax, you'd have 33% more in your Roth throwing your allocation percentages off to the numbers above, right?"  the correct understanding is "At the 25% withdrawal tax rate, you will need 33% more inside your 401k or TIRA in order to have the same after-tax principal (as assets in Roth or taxable accounts) after you take it out."

The principal in both the taxable accounts and the Roth will never be touched

So instead of weighting :

"100K (75k after tax) Gold - Taxable  23%
100K (75k after tax) LTT - TIRA 23%
100K (75k after tax) STT - TIRA 23%
100K (100K after tax) Stock - Roth IRA 31%

You should weight:

100K gold in taxable
133K debt in TIRA
133k cash in TIRA
100K stock in Roth

How many of you take the above into account? Do you do the 25 /25 / 25/ 25 irrespective of how it will be taxed? Or, do you take into account how it will eventually be taxed and therefore, calculate the 25% based upon its after-tax value?

Vinny