Post by 80sjunkie on Sept 27, 2012 10:31:51 GMT -5
I read an article last night about Romney's taxes and there was an interesting perspective brought up about the potential disadvantages to retirement accounts.
"Middle-income people tend to make most of their investments via mutual funds and 401(k) plans. Those retirement funds do give you an immediate write-off of your contribution, but here's what else they do: They turn capital gains, taxed at a maximum rate of 15 percent, into ordinary income, taxed at a maximum rate of 35 percent."
This is slightly different than our debates on pre vs. post tax retirement investments and I honestly hadn't really thought of it. Of course I realize that we have no idea what capital gains taxes will be in the future but it was an interesting perspective. Thoughts?
Wow, I feel dumb because I had never once thought of it that way, either. Maybe DH is right not wanting to tie up all our investments in retirement accounts!
Two things come to mind, both of which could be completely wrong...
Isn't part of thought process behind the 401(k) that those dollars fill in the lower brackets of the marginal tax rate? Even if I was in the 35% tax bracket when I take that money out, some of it (a lot of it?) would be taxed at the (much) lower marginal rates below 35%.
Also, my traditional 401(k) funds are only taxed once, while money outside retirement accounts would be taxed at least twice, right? So if I'm at 35% now, and have $10,000 pre-tax to put one place or another, if I put it in my 401(k) I get all $10,000 of it, but if I decide to take the money now and invest it in mutual funds, I'll only get $6500 (oversimplifying, but anyway...) to play with. Then either way I'll get taxed on it when it's coming out, either at a capital gains rate or marginal income, depending on where it is.
And if I reinvested the non-retirement mutual fund, I'd pay capital gains taxes along the way, while I wouldn't if it was in my 401(k), right? So there may not be all that much of a difference really.
Two things come to mind, both of which could be completely wrong...
Isn't part of thought process behind the 401(k) that those dollars fill in the lower brackets of the marginal tax rate? Even if I was in the 35% tax bracket when I take that money out, some of it (a lot of it?) would be taxed at the (much) lower marginal rates below 35%.
Also, my traditional 401(k) funds are only taxed once, while money outside retirement accounts would be taxed at least twice, right? So if I'm at 35% now, and have $10,000 pre-tax to put one place or another, if I put it in my 401(k) I get all $10,000 of it, but if I decide to take the money now and invest it in mutual funds, I'll only get $6500 (oversimplifying, but anyway...) to play with. Then either way I'll get taxed on it when it's coming out, either at a capital gains rate or marginal income, depending on where it is.
And if I reinvested the non-retirement mutual fund, I'd pay capital gains taxes along the way, while I wouldn't if it was in my 401(k), right? So there may not be all that much of a difference really.
I'm not understanding this. Your money would be taxed as ordinary income before you invest in a mutual fund, but from my understanding, only the earnings would be taxed as capital gains coming out, not what you also contributed. Am I misunderstanding?
I don't see how it's a disadvantage. And the claim that they turn capital gains into ordinary income does not make sense at all.
It is saying if you invested in a stock and didn't pay taxes on it until you sold, the taxes are at 15%.
However, if you put that money into a traditional IRA or traditional 401(k), when the money is distributed, its taxed as regular income. However, this doesn't apply for ROTH IRAs/401K-- just traditional.
But V's comments about double taxation are valid-- If you don't put money into a retirement account, but rather into a stock-- you are using post-tax income, then you are taxed on the income again when you sell the stock.
This article does make me think that putting my non-retirement money into a mutual fund may not be the best idea-- but it feels so much less risky than investing in individual stocks.
I wonder what volenti's thoughts are, I'm going to forward this to her.
I don't see how it's a disadvantage. And the claim that they turn capital gains into ordinary income does not make sense at all.
It is saying if you invested in a stock and didn't pay taxes on it until you sold, the taxes are at 15%.
However, if you put that money into a traditional IRA or traditional 401(k), when the money is distributed, its taxed as regular income. However, this doesn't apply for ROTH IRAs/401K-- just traditional.
But V's comments about double taxation are valid-- If you don't put money into a retirement account, but rather into a stock-- you are using post-tax income, then you are taxed on the income again when you sell the stock.
This article does make me think that putting my non-retirement money into a mutual fund may not be the best idea-- but it feels so much less risky than investing in individual stocks.
I wonder what volenti's thoughts are, I'm going to forward this to her.
That first quoted sentence is really badly worded and I had to read it a few times to understand. You are, in fact, taxed at ordinary income rates when you eventually take money out of your retirement accounts assuming that money was not taxed on its way in (I have some IRAs that are post-tax as I was phased out of pre-tax benefits, so now they grow tax free forever, even upon withdrawal). So it's not that investing in mutual funds = ordinary income tax, it's withdrawing mutual fund dollars inside your retirement accounts that does.
But v's analysis is also correct in that your 401k/IRA money is taxed once upon withdrawal whereas money invested outside tax-advantaged accounts is taxed twice--once as ordinary income and then again as capital gains. It's anyone's guess which way the math will work out better in the long run.
The key is remembering that if you're saving and investing wisely, you'll be better off in retirement, no matter how Uncle Sam gets paid
I understand what you're saying. I just don't understand why capital gains tax can be compared to the tax on your retirement account withdrawals. The capital has been taxed using income tax rate. The capital gains are additional tax to the investment. With retirement investments (pre-tax), there was never a tax until withdrawal. Yes, they are claiming that the gains are then taxed at income tax rate. But it's not necessarily a bad thing because not having paid taxes on the invested amount means higher gains. And IF the income tax rate is the same in both scenarios, investing in a retirement account is a better option and you'll have more $$$ at the end after paying the taxes.
I'm not understanding this. Your money would be taxed as ordinary income before you invest in a mutual fund, but from my understanding, only the earnings would be taxed as capital gains coming out, not what you also contributed. Am I misunderstanding?
You are 100% right and I missed that point. I knew I was forgetting something, LOL.
This article does make me think that putting my non-retirement money into a mutual fund may not be the best idea-- but it feels so much less risky than investing in individual stocks.
I don't understand your point. You're taxed the same if you invest in mutual funds or in stocks.
Post by 80sjunkie on Sept 27, 2012 11:30:00 GMT -5
It is true that the money invested outside of retirement vehicles would initially be taxed as income, but if we are talking about letting said money sit for 30+ years then the differential between 15% and 35% at time of withdrawal would still be substantial, no? Put differently, the amount of money being taxed as ordinary income should be small beans compared to what you will ultimately withdrawal.
V's point is a good one. However, one of my concerns has always been the mandatory distribution requirement for retirement accounts. It is possible to have enough in retirement accounts for the mandatory distribution requirement to put you in the highest tax bracket. Now as V noted you wouldn't be paying 35% on all of the money, but your effective tax rate would still be higher than 15%...
When you buy and hold an individual stock or bond, you must pay income tax each year on the dividends or interest you receive. But you won't have to pay any capital gains tax until you actually sell and unless you make a profit.
Mutual funds are different. When you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends in the year you receive or reinvest them. And, in addition to owing taxes on any personal capital gains when you sell your shares, you may also have to pay taxes each year on the fund's capital gains. That's because the law requires mutual funds to distribute capital gains to shareholders if they sell securities for a profit that can't be offset by a loss.
How many people are going to invest in non-retirement accounts and never move it around? I'd say that is very rare which means they are taxed on their capital gains multiple times unlike a retirement account.
It just seems relying on non-retirement investments will end up costing more in taxes in the long run.
It is true that the money invested outside of retirement vehicles would initially be taxed as income, but if we are talking about letting said money sit for 30+ years then the differential between 15% and 35% at time of withdrawal would still be substantial, no? Put differently, the amount of money being taxed as ordinary income should be small beans compared to what you will ultimately withdrawal.
No. Here's an example.
Assume: years = 40 investment return = 5% per year income tax rate = 35% capital gains tax rate = 15% pretax amount to invest = $100,000
Option 1: Regular Investment initial invested amount after paying income tax = $65,000 value of account in 40 yrs before paying capital gains tax = $457,599 value after tax = $398,709
Optioin 2: 401k pretax initial invested amount = $100,000 value of account in 40 yrs before paying income tax = $703,998 value after tax = $457,599
It is true that the money invested outside of retirement vehicles would initially be taxed as income, but if we are talking about letting said money sit for 30+ years then the differential between 15% and 35% at time of withdrawal would still be substantial, no? Put differently, the amount of money being taxed as ordinary income should be small beans compared to what you will ultimately withdrawal.
No. Here's an example.
Assume: years = 40 investment return = 5% per year income tax rate = 35% capital gains tax rate = 15% pretax amount to invest = $100,000
Option 1: Regular Investment initial invested amount after paying income tax = $65,000 value of account in 40 yrs before paying capital gains tax = $457,599 value after tax = $398,709
Optioin 2: 401k pretax initial invested amount = $100,000 value of account in 40 yrs before paying income tax = $703,998 value after tax = $457,599
I believe this assumes the marginal rate of 35% is paid on every dollar of income, which is inaccurate. Because the amounts at withdrawal are significantly higher, more of your money will be taxed at the higher rate.
I want to be clear that I am simply trying to say that it isn't as clear cut as it seems.
I've always considered this, but at the same time, I need the tax advantage of 401K contributions to reduce my income now. I may be screwing myself when it comes time to retire, when I could have paid an extra $1000 now and not the 40% tax rate later. I do have a Roth now too...so hopefully it evens out somehow.
Assume: years = 40 investment return = 5% per year income tax rate = 35% capital gains tax rate = 15% pretax amount to invest = $100,000
Option 1: Regular Investment initial invested amount after paying income tax = $65,000 value of account in 40 yrs before paying capital gains tax = $457,599 value after tax = $398,709
Optioin 2: 401k pretax initial invested amount = $100,000 value of account in 40 yrs before paying income tax = $703,998 value after tax = $457,599
I believe this assumes the marginal rate of 35% is paid on every dollar of income, which is inaccurate. Because the amounts at withdrawal are significantly higher, more of your money will be taxed at the higher rate.
I want to be clear that I am simply trying to say that it isn't as clear cut as it seems.
But doesn't d0ri's math already take that into account? There, all of the money is being taxed at 35%.
I've always considered this, but at the same time, I need the tax advantage of 401K contributions to reduce my income now. I may be screwing myself when it comes time to retire, when I could have paid an extra $1000 now and not the 40% tax rate later. I do have a Roth now too...so hopefully it evens out somehow.
It's tricky. We do the same thing (all allowable pre-tax retirement accounts along with some Roth money). however, I do think that right now we have the most deductions we will ever have (mortgage in particular), and thus most likely the lowest tax rate we will ever have.
Post by hannamaren on Sept 27, 2012 12:02:51 GMT -5
For me, i assume I will be in a lower tax bracket at retirement so will be taxed less than if I got the money as income now. When we invest, we get a tax break (in Canada) so it is worth it. I also wont take all the money out at once.
I believe this assumes the marginal rate of 35% is paid on every dollar of income, which is inaccurate. Because the amounts at withdrawal are significantly higher, more of your money will be taxed at the higher rate.
I want to be clear that I am simply trying to say that it isn't as clear cut as it seems.
But doesn't d0ri's math already take that into account? There, all of the money is being taxed at 35%.
Perhaps I am confused, but because the money would not all be taxed at 35% that is an incorrect assumption. This was actually your point V. Although the article talks about 35% in reality you don't pay an effective rate of 35%. My argument is that your effective income tax rate might be significantly more come retirement, even if you are in a similar or the same tax bracket.
For example, folks that are barely in the 35% bracket that make 389,000 pay an effective rate of 28.2% assuming zero deductions. Come retirement, these same people might have an effective rate that's higher than 28.2%.
But doesn't d0ri's math already take that into account? There, all of the money is being taxed at 35%.
Perhaps I am confused, but because the money would not all be taxed at 35% that is an incorrect assumption. This was actually your point V. Although the article talks about 35% in reality you don't pay an effective rate of 35%. My argument is that your effective income tax rate might be significantly more come retirement, even if you are in a similar or the same tax bracket.
For example, folks that are barely in the 35% bracket that make 389,000 pay an effective rate of 28.2% assuming zero deductions. Come retirement, your effective rate will be higher than 28.2%.
Yes, I agree. Is my effective tax rate lower now than when I retire or will the opposite be the case? No way am I paying a 35% effective tax rate now. I may one day but not now so is this one of those things that changes over time as you make more money and your tax rate increases?
It's not so clear cut and like I said, who invests in non-retirement accounts and won't sell anything for 30 years? Each time you sell and reinvest that money, you are paying taxes. This doesn't happen in retirement accounts.
But doesn't d0ri's math already take that into account? There, all of the money is being taxed at 35%.
Perhaps I am confused, but because the money would not all be taxed at 35% that is an incorrect assumption. This was actually your point V. Although the article talks about 35% in reality you don't pay an effective rate of 35%. My argument is that your effective income tax rate might be significantly more come retirement, even if you are in a similar or the same tax bracket.
For example, folks that are barely in the 35% bracket that make 389,000 pay an effective rate of 28.2% assuming zero deductions. Come retirement, these same people might have an effective rate that's higher than 28.2%.
I think that proves d0ri's point even more clearly, because 35% is an inflated number. If anything option 2 is comparatively even better off than d0ri's math suggests.
Normally the assumption is that your effective tax rate should be lower when you retire (assuming that tax rates stay the same), right? Or the same? Usually I think it wouldn't be higher?
(But we do have some Roth money to play with in years when we want to withdraw a lot more income from our 401(k) than in other years -- that's something we can do, right?)
Post by 80sjunkie on Sept 27, 2012 12:25:42 GMT -5
I agree that is the usual assumption, but for folks that sock away lots of money into retirement accounts that might not be the case. Specifically it is mandatory distributions that are worrisome.
For example, our tax bracket is currently 33%. However, we put away so much money into retirement and we have only owned our house for a few years that our effective rate is actually around 17%. So if I am investing post-tax dollars, I am paying 17% not 33% or 35% as previously assumed. Let's assume that we do an awesome job investing and we end up with 10 million in retirement investments (a number another nestie once used as a retirement goal). The mandatory distribution of 5% on 10million would be 500,000 and would put you squarely into the 35% bracket. With no deductions, that is an effective rate of 27.5%. Comparing 27.5% to 17% is very different than saying 35% to 35%.
*This all assumes that tax rates won't increase. I also realize that I am taking 500,000 in today's dollars which in retirement might be the 33% tax bracket instead of 35%.
I agree that is the usual assumption, but for folks that sock away lots of money into retirement accounts that might not be the case. Specifically it is mandatory distributions that are worrisome.
For example, our tax bracket is currently 33%. However, we put away so much money into retirement and we have only owned our house for a few years that our effective rate is actually around 17%. So if I am investing post-tax dollars, I am paying 17% not 33% or 35% as previously assumed. Let's assume or hope that we do an awesome job investing and we end up with 10 million in retirement investments (a number another nestie once used as a retirement goal). The mandatory distribution of 5% on 10million would be 500,000 and would put you squarely into the 35% bracket. With no deductions, that is an effective rate of 27.5%. Comparing 27.5% to 17% is very different than saying 35% to 35%.
*This all assumes that tax rates won't increase. I also realize that I am taking 500,000 in today's dollars which in retirement might be the 33% tax bracket instead of 35%.
The today's dollars/future dollars thing makes a huge difference though, right? Say I have $10,000,000 in future dollars, and have to take $500,000 a year. That's going to be nothing compared to today's $500,000, right? 30 years ago, you got into the highest tax bracket (50%!) with a measly by today's standards $106,000 in income.* Today you get into the highest tax bracket by earning almost 4 times that. I'd imagine the same will occur in retirement and that $500,000 mandatory distribution would be more WAY modest then? Like not 33% modest?
(*Note: the highest tax brackets were higher in the 70s -- along the lines of $200,000, but people in that bracket were paying 70%ish!!!)
I agree that is the usual assumption, but for folks that sock away lots of money into retirement accounts that might not be the case. Specifically it is mandatory distributions that are worrisome.
For example, our tax bracket is currently 33%. However, we put away so much money into retirement and we have only owned our house for a few years that our effective rate is actually around 17%. So if I am investing post-tax dollars, I am paying 17% not 33% or 35% as previously assumed. Let's assume or hope that we do an awesome job investing and we end up with 10 million in retirement investments (a number another nestie once used as a retirement goal). The mandatory distribution of 5% on 10million would be 500,000 and would put you squarely into the 35% bracket. With no deductions, that is an effective rate of 27.5%. Comparing 27.5% to 17% is very different than saying 35% to 35%.
*This all assumes that tax rates won't increase. I also realize that I am taking 500,000 in today's dollars which in retirement might be the 33% tax bracket instead of 35%.
You are paying 35%. If you invest post-tax, your taxable income is $500,000 where $111,650 is taxed at 35%. So the $100,000 you want to invest post tax (instead of putting it into a 401k) is taxed at 35%. The effective tax rate has nothing to do with it. It's a choice of paying 35% now and invest post-tax OR paying 0% tax now and pay later (where the effective tax would matter more if the only income is the 401k).
Post by schrodinger on Sept 27, 2012 12:46:01 GMT -5
I hate the debate about pre-tax vs. post-tax investments. I think both have their place and individual circumstances will dictate which is "better." I max out my 401k so that we can get under the income cutoff for Roth contributions.
I think this article hinted at (but failed to discuss) tax diversification, which I find interesting. I own a mutual fund portfolio and have considered the mutual fund fees part of the price that I pay for the fund manager. I had never really considered the tax implications of mutual funds vs regular stocks.
I agree that is the usual assumption, but for folks that sock away lots of money into retirement accounts that might not be the case. Specifically it is mandatory distributions that are worrisome.
For example, our tax bracket is currently 33%. However, we put away so much money into retirement and we have only owned our house for a few years that our effective rate is actually around 17%. So if I am investing post-tax dollars, I am paying 17% not 33% or 35% as previously assumed. Let's assume or hope that we do an awesome job investing and we end up with 10 million in retirement investments (a number another nestie once used as a retirement goal). The mandatory distribution of 5% on 10million would be 500,000 and would put you squarely into the 35% bracket. With no deductions, that is an effective rate of 27.5%. Comparing 27.5% to 17% is very different than saying 35% to 35%.
*This all assumes that tax rates won't increase. I also realize that I am taking 500,000 in today's dollars which in retirement might be the 33% tax bracket instead of 35%.
The today's dollars/future dollars thing makes a huge difference though, right? Say I have $10,000,000 in future dollars, and have to take $500,000 a year. That's going to be nothing compared to today's $500,000, right? 30 years ago, you got into the highest tax bracket (50%!) with a measly by today's standards $106,000 in income.* Today you get into the highest tax bracket by earning almost 4 times that. I'd imagine the same will occur in retirement and that $500,000 mandatory distribution would be more WAY modest then? Like not 33% modest?
(*Note: the highest tax brackets were higher in the 70s -- along the lines of $200,000, but people in that bracket were paying 70%ish!!!)
Ok if we assume 3% inflation, 500,000 in 30 years will have the buying power of 206,000. That would be an effective tax rate of 24% with no deductions using today's taxes. That is still significantly more than 17%. Plus, tax rates are at an all-time low. Who knows if they will stay that way?
I hate the debate about pre-tax vs. post-tax investments. I think both have their place and individual circumstances will dictate which is "better." I max out my 401k so that we can get under the income cutoff for Roth contributions.
I think this article hinted at (but failed to discuss) tax diversification, which I find interesting. I own a mutual fund portfolio and have considered the mutual fund fees part of the price that I pay for the fund manager. I had never really considered the tax implications of mutual funds vs regular stocks.
Yeah, this makes me think twice about investing in MFs.
I find it interesting that people are saying in this post tax rates at retirement should be lower when they retire but the entire time I've been on MM the general theme has been people expect to pay a higher tax rate which is why MM tends to want people to max out Roths before maxing out pretax retirement accounts.
The today's dollars/future dollars thing makes a huge difference though, right? Say I have $10,000,000 in future dollars, and have to take $500,000 a year. That's going to be nothing compared to today's $500,000, right? 30 years ago, you got into the highest tax bracket (50%!) with a measly by today's standards $106,000 in income.* Today you get into the highest tax bracket by earning almost 4 times that. I'd imagine the same will occur in retirement and that $500,000 mandatory distribution would be more WAY modest then? Like not 33% modest?
(*Note: the highest tax brackets were higher in the 70s -- along the lines of $200,000, but people in that bracket were paying 70%ish!!!)
Ok if we assume 3% inflation, 500,000 in 30 years will have the buying power of 206,000. That would be an effective tax rate of 24% with no deductions using today's taxes. That is still significantly more than 17%. Plus, tax rates are at an all-time low. Who knows if they will stay that way?
How does state tax figure into this? 401(k) is also pre state tax, right? I only have our 2009 tax return handy, but looking at it, we were in the 33% tax bracket, but once state and local income taxes were factored in, our overall effective rate was 31% (that's with both of us maxing out our 401(k)s, but there may have been some Roth contributions that year). Sadly, very close to the percentage of our federal tax bracket. So I don't get to take advantage of the "still significantly more than 17%" argument.
And yeah, we don't know about tax rates in the future, but that just has to be a big black box, right?
(edited because I quoted the wrong message. and to add stuff
Post by 80sjunkie on Sept 27, 2012 13:01:52 GMT -5
V, yes it is also pre-state tax. That stinks re your effective rate.
I think it is fine that future tax rates be a black box of sorts but given the current economic and political climate my bets are on at least slight increases for HHI folks.