Sep 05

Back in July, I wrote a post “Loving That Roth” where I discussed why the Roth account was a great deal for a select portion of savers. I went on to discuss how few people could save their way into a higher tax bracket and that the use of a Roth 401(k) should be considered very carefully as it would ignore the lower rate most of us will retire into. A fellow blogger posting under the moniker jIM_Ohio shares my view, offering his own brief post last month, “The 15% tax retirement account“. As I look at Jim’s post, I realize its brevity is its strength. I tend to offer much data to support my views and often that obfuscates the issue at hand. To the other extreme, I offer the article, “Thinking About a Roth 401k Think Again” from the Journal of Financial Planning.

The JFP article closes with “Those properties [of Roth compared to traditional 401(k)] indicate that for most moderately affluent wage earners, today’s marginal tax rates and the associated government subsidy for retirement contributions are likely to markedly exceed effective tax rates tomorrow, when that subsidy must be cashed out.”

Anyone interested in the Roth vs Traditional 401(k) or IRA discussion should read the article from JFP, and decide how to approach their own situation. As I’ve stated prior, their are few absolutes in financial matters. When I shared my thoughts in one forum and suggested that Roth was appropriate for maybe 5% of people currently working, I was told that the particular forum only contained a selection of high income people who saved above average, that most of that group would benefit from Roth. It reminded me of surveys that showed that 10% of people believed they were in the top 1% of earners. And all of their children were above average.


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Aug 22

Some time ago, in an article titled Social Insecurity, I wrote about what I call Phantom Tax Rates. To understand this, one first must understand what one’s Marginal Tax Rate is. A single person, after taking his exemption, and deductions, will pay 10% of the amount up to $16,050, then 15% from $16,050 to $65,100, then 25% from $65,100 up to $131,450. Let’s stop there. The Phantom Tax Rate comes into play when there is either a phase out of deductions or phase in of other income. In the case of Social Security, when half of your Social Security benefits plus other income exceed $25,000 ($32,000 if married filing joint) your benefits start to become taxable, until 85% of your benefits are fully taxed. This create a graph that looks as follows;

While we would expect a 15% rate from $16,050 right to $65,100, instead we find that for each $1000 of income (or IRA withdrawals for the person for whom this chart applied) that the incremental tax is as high as $462.50.

In another situation, the adoption credit is phased out for AGIs between $174,730 and $214,730, and in the case I’ve been alerted to, the taxpayer loses $11,600 on the next $40,000 of income due to this phaseout. This loss, plus his marginal rate of 25% total 54.13%. My advice to him was to defer income if possible to 2009, which he will. By deferring that $40,000 worth of income he will pay $26,600 less tax this year, and just $10,000 when he receives this income in 2009.

When it comes to taxes, nothing is simple. When planning, it’s best to get a copy of TurboTax and run a few ‘what-if’ scenarios to best understand the impact of any financial changes you may incur.

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Mar 24

For my first post of this year I wrote an article titled, “Can you save too much, pre-tax?” This is a topic that comes up frequently as one decides whether to choose a Traditional (pre-tax) IRA vs a Roth IRA. I recently had some dialog with another blogger and it’s clear to me that the decision is not so clear cut. Ideally, one makes a deposit pre-tax and withdraws it at a lower rate some time later. But as Mark (the other blogger) reminds me, a Roth has many benefits that shouldn’t be ignored:

  1. You can withdraw the original deposits at any time with no tax or penalty, as I suggested in my Roth magic post.
  2. A Roth has no RMDs (required minimum distribution) requirement, which forces withdrawals when they may not be needed or wanted due to other considerations.
  3. The accounts pass through one’s estate with less impact to estate tax as the funds are denser, and received by the beneficiary with no income tax upon withdrawal.

I think for any retiree there is likely an ideal mix, so they might draw funds from their pre-tax accounts (IRA and 401(k)) and use Roth withdrawals to avoid getting sent into the next bracket or be subject to the Social Security Tax Trap. The issue today is that we can’t know that mix two or three years out, let alone 20 or 30. What I do know, and I hope Mark agrees, is that this decision follows the shape of the Laffer Curve. I know with certainty that 100% of one’s savings in pre-tax accounts misses the benefits I share above. 100% in Roth accounts will miss the benefit of the zero bracket I discussed at length in my article cited and linked above. I don’t know the ideal mix, but I’d suggest this: The lower your savings rate, the more you’ll see the benefit of pre-tax savings, a diligent saver may be best served by leaning toward the Roth savings. A Wall Street Journal article titled “A Cool Million No Longer Buys You a Luxe Retirement” helps back up my position as it states that only the richest 2% of Americans have saved more than $1 million. One would need to be in this exclusive group to even begin worrying about higher taxes on the their retirement savings. I hope to get some feedback, as others’ opinions always help me to see a different side of the issue.


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