Traditional retirement accounts foolish with the US tax structure?

[RosieTR]

I'm not sure I'm thinking about this correctly so I thought I would ask. Here's my conundrum:
-currently in the US, capital gains are taxed at 15%
-income is taxed at a progressive rate with various deductions etc but go much higher than 15%
-traditional retirement accounts (trad-IRAs, 401/403/457s) are withdrawn prior to taxes but the income received when taking those benefits are taxes as regular income
-Roth IRAs are taxed as income initially but then no further taxes are due on the earnings

Given all this, wouldn't it make sense to forgo the traditional retirement accounts and save first in Roths and second just as regular savings? Or maybe I'm thinking of this wrong since the trad accounts are not taxed for years so effectively taxed less over their whole existence than plain, taxable capital gains which would be taxed at 15% each year.
I have to set up my retirement accounts at work and hopefully when DH gets a job we will revisit this whole thing so wanted to explore all this.

[uji]

My understanding, for what it's worth:

If your tax rate will be lower after retirement, then Traditional IRA makes sense: you don't pay the taxes until your rate is lower (after retirement). If you can afford to pay the taxes now, Roth makes sense since that money -- and whatever it earns -- will never be taxed again. I guess if your tax rate now is hugely more than it will be after retirment, then Roth makes less sense.

Also, only long-term (over one year) capital gains are taxed at 15%; short-term (less than one year) is taxed as income. Also all the rates -- including IRA exemptions -- are all controlled by Congress and can be changed any time.

[ApatheticNoMore]

Two confounding factors:
1) 401k matches - it may make sense to put in enough to get these if applicable
2) it sometimes helps for tax purposes to keep income "low". The only way I know to actually keep taxable income low, is using the 401k. For instance there may be certain tax breaks you only qualify for if your income falls below a certain point (for instance one I have actually taken because it does not depend on itemizing - lifelong learning credit). Also due to AMT concerns I've made a regular IRA decrease my taxes even more than it would normally, because I fell low enough in income to qualify. But frankly at this point the math probably becomes too complex to even justify the game playing. It's just sometimes I have been doing my taxes and said "whew, there but for the grace of 401k go I ...." and my income would have been too high to get tax breaks.

Without confounding factors: if your tax rate will be the same or higher at retirement the Roth definitely makes sense. If your tax rate is the same it makes sense because you are least didn't pay taxes on the gain. If you anticipate your tax rate will be higher it makes even more sense. If you are thinking decades down the road tax rates will almost certainly be higher for everyone, so even if you earn less income in retirement your tax rate will probably be higher. Yea I think Roths make sense.

As for a regular investment account, this gets a lot more tricky. Is the fund trading within the fund? If so you could have all sorts of short term gains to pay taxes on at full income tax rates. Some of them wouldn't even be real gains (like ok the mutual fund as a whole doesn't make any money this year say, but you still find yourself paying taxes on "gains" for some internal trading done within it). If you invest in an index fund and hold then I guess you don't pay taxes until retirement. But any mutual fund doing a lot of churn can get very complex. At that point you probably want to look at funds that are managed with an eye toward taxes.

Of course the government can change the rules at any time (decide to tax the gains on Roths, etc.). If you think this can't happen, you really aren't paying attention. But it is impossible to actually figure this in one's calculations as it is entirely unpredicatable, so it should probably be left out just for that reason.

[Rogar]

I am a conservative investor and it sometimes burns me that out tax structure encourages us to be speculators in stocks rather than savers in fixed income investments.

But that aside, you might consider that a diversified retirement portfolio will have both fixed income investment such as bond fund, stable value funds, or whatever, along with equities. Since interest income is taxed as regular income, it especially makes sense to have fixed income investments in a retirement fund like a 401k, where interest is tax differed.

[herbgeek]

I'm assuming that when you (OP) mention "regular savings", that you mean a savings account at a bank. Regular savings are taxed as ordinary income, not at capital gains rate.

[Mangano's Gold]

I'm not sure I'm thinking about this correctly so I thought I would ask. Here's my conundrum:
-currently in the US, capital gains are taxed at 15%
-income is taxed at a progressive rate with various deductions etc but go much higher than 15%
-traditional retirement accounts (trad-IRAs, 401/403/457s) are withdrawn prior to taxes but the income received when taking those benefits are taxes as regular income
-Roth IRAs are taxed as income initially but then no further taxes are due on the earnings

Given all this, wouldn't it make sense to forgo the traditional retirement accounts and save first in Roths and second just as regular savings? Or maybe I'm thinking of this wrong since the trad accounts are not taxed for years so effectively taxed less over their whole existence than plain, taxable capital gains which would be taxed at 15% each year.
I have to set up my retirement accounts at work and hopefully when DH gets a job we will revisit this whole thing so wanted to explore all this.
Your basic point is valid that the earnings in your deferred account will ultimately be taxed at your ordinary rate, but if you had them in some non-deferred brokerage account you would pay mostly 15% (current law). But, generally speaking, you are still better off deferring. The punt is valuable, and you also start with a considerably higher investing base (the taxes you would have paid are being invested).

[RosieTR]

I'm assuming that when you (OP) mention "regular savings", that you mean a savings account at a bank. Regular savings are taxed as ordinary income, not at capital gains rate.

Sorry, that was confusing. I meant investments as savings in non-tax deferred vehicles. Although yeah, that would definitely speak to Rogar's point: if you put $ in stock vs just the bank, you are taxed possibly less. It's a pretty rigged game that favors large corps and wealthy individuals with the argument that they are investments that lead to growth. As we've all seen recently this is true but when the money starts sloshing around the investments get riskier and riskier and eventually lead to bubbles and crashes: internet in ~2001, housing in ~2007/8. Bank deposits made by smaller-income folk would probably still be invested in businesses by way of depositors' money being turned around and lent to small businesses in the community. Another argument favoring small banks (if there are any left!) and credit unions.
That was kind of a tangent, sorry.

I realize the US gov't can change the rules any time, though the political will to start taxing Roths doesn't currently exist IMO. Given that, I suppose hedging ones' bets by contributing to multiple "pots" for retirement/FI3 is not a bad plan. As for what my tax bracket will be when that comes vs what it is now...ha ha if I knew that I'd probably also know exactly where to stick my money.>8)

[iris lily]

For one thing, I don't buy the idea that "you tax rate will be different after retirement." One needs to look at THAT assumption with skepticism, I believe.

We are in the 25% tax bracket and I doubt that will change when we retire.

edited to add: well, I am wrong, sorry! When I look at tax charts today it is almost certain that we will drop down into the 15% tax bracket with retirement income. But still, I think it's good to look at tax rate schedules. There was a time when it seemed to me that the spread was so wide in our bracket that we would not see a reduced tax rate in retirement.

[freein05]

Your tax rate in retirement would only be lower if your income is lower. That may not be a good thing.

[uji]

This is really getting interesting...

For what it's worth my wife and I found it well worth making the decision in advance whether we should aim for same or lower income in retirement. For various reasons, we opted for lower -- the principal one being earlier retirement. We retired early, at a lower income and tax rate about ten years ago, and (so far, knock-on-wood) things have worked out fine.

Again, I recommend considering an inverted budget for retirement: spend more time thinking about what expenses will go away in retirment -- or could be made to go away. For example, early retirement and lower income seemed to work out well for us, except for the mortgage. Then we came up with the thought: Well, suppose we found a place we wanted to be that would allow us to buy a home outright with whatever equity we had in the old one. If we could do that, the lower income would be sufficient. That worked out for us.

So, I say think about this carefully: Do you really need what you make now for retirement? If not, you might be able to retire earlier. Just a thought...

[freein05]

uji makes a good point. You can live on a lower income if you have structured your debt to be lower or in the best case 0. I have always said that one way to retire early or at any time is to have no housing debt. Our income in retirement is a little lower but we have no bills to pay so we actually live better in retirement on a lower income.

[RosieTR]

Ha ha, we'll have zero debt whenever we can get rid of the Phoenix house. That will likely be a few years but we're not in a position yet to consider FI3 anyway, so my goal now is to lower expenses where possible and increase savings. I think our tax bill might be lower in retirement, but looking at decades' worth of time is a little more difficult to predict. Someone, somewhere will have to pay for the debt/deficit that the US is incurring, and frankly it's likely to be me. Boomers have a huge generation and the political clout that goes with that. Those of us born in the crappy economy of the 70s are not so lucky. Employment will probably go up for us as we have experience and the Boomers won't work *forever*, but I expect taxes will have to go up. I actually learned some math in school :-) I'm not bitter about that because hey, we all got ourselves into this mess and I actually like many of the government services that taxes pay for, such as roads, public works, drinkable water, reliable electrical grids, etc. The fact that the Mitt Romneys and Warren Buffets of the world are paying less tax than I am, well, that's another story and something to be bitter about.
Back to topic, though-having lower income in retirement if it's not going to happen fairly soon does not necessarily mean lower taxes. Having some of my retirement income as a Roth vs a 401K may mean lower taxes though also not a given. However, neither is capital gains outside of tax-deferred accounts. I don't have any of the latter, though I suppose I should start on that. Whenever we do manage to sell the Phoenix house it will very likely be a capital loss but I don't know if I can offset capital gains from stocks with capital losses on property. Any thoughts?

[Spartana]

uji makes a good point. You can live on a lower income if you have structured your debt to be lower or in the best case 0. I have always said that one way to retire early or at any time is to have no housing debt. Our income in retirement is a little lower but we have no bills to pay so we actually live better in retirement on a lower income.

This is how I retired early (age 42). Paid off house, no debt so therefor was able to live on a small income. The small income meant I was in a very low tax brackett - currently zero percent (YAY!!!). Some of my income is tax free (my very small military/VA disability pension is totally tax free and my state pension (also very small because I started collecting it at age 50) is partially tax free) and the rest is in tax deferred things that will only be counted as taxable income based on the amount I withdraw each year. Again, that won't be much because I only need a little bit of money to live on.

[Spartana]

For one thing, I don't buy the idea that "you tax rate will be different after retirement." One needs to look at THAT assumption with skepticism, I believe.

We are in the 25% tax bracket and I doubt that will change when we retire.

edited to add: well, I am wrong, sorry! When I look at tax charts today it is almost certain that we will drop down into the 15% tax bracket with retirement income. But still, I think it's good to look at tax rate schedules. There was a time when it seemed to me that the spread was so wide in our bracket that we would not see a reduced tax rate in retirement.

And also remember that the tax brackets change each year too. The amount you can "write off" of the standard deductions and exemptions increases each year by $50 - $100 or so - more if you are 65 or older - and therefore, over the years, that adds up to a higher deduction you can take. For example both the standard deduction and personal exemption for a single filer have gone up $250/each from the 2009 tax year to the 2012 tax year. That's an extra $500 deduction. The standard deduction for married people for 2011 is $11,600 (up by several hundred from 2009) and the personal exemption is $3750/person ($7500 together). So a married couple who don't itemize (and may have nothing to itemize) can write off the first $19,100 of their income this tax year. And that will most likely be much higher by the time you retire. That means the rest of your taxable income could be in the 10% bracket. So that coupled with a potentially lower taxable income stream, may put you in a much lower tax bracket then when you were working. For me, reducing my need for a higher income (but still having fair large assets in tax deferred stuff - 457, Trad. IRA's, saving bonds even) by being debt free has been the biggest factor in my remaining in a low or zero % tax bracket.

[Spartana]

Again, I recommend considering an inverted budget for retirement: spend more time thinking about what expenses will go away in retirment -- or could be made to go away. For example, early retirement and lower income seemed to work out well for us, except for the mortgage. Then we came up with the thought: Well, suppose we found a place we wanted to be that would allow us to buy a home outright with whatever equity we had in the old one. If we could do that, the lower income would be sufficient. That worked out for us.



Getting rid of the mortgage is key to lowering your income needs (and thus lowering your income taxes). I also chose to first pay off my house before quitting work, and then decided to sell it and downsize - still owning a place outright (mortgage free) but having a large chunck of cash to live on while I waited until I was old enough to get my pension (at age 50). I ended up needing MUCH MUCH LESS money in retirement then I thought I would. Just those little things I spent money on like gas and maintenence for the car to commute each day (and having to totally replace the car much sooner then I would when not working), meals out, the daily bagel and coffee out, etc... really added up over the year. Cutting those things out when I retired made a big difference in the amount of income I needed. Yet I still do all the fun stuff people want to do in retirement - like travel. I just do it in a budget way, off season, and for a longer period of time now which reduces the biggest expense of travel - getting there and back!