The Taxable Account As A Roth Substitute

by: FinancialDave
Summary

If you don’t have a Roth account you can look to your taxable account as a substitute.

Investors are still looking for ways to improve their retirement income.

You must be knowledgeable about the math involved when considering using a taxable account to supplement your retirement.

Source: Google from Retirement Planning website

This is a follow-up to an article I wrote last year that received a lot of attention called The Risk Of The Roth IRA Revolution II, which you can find by clicking this link. The previous article dealt with comparing various sizes of Roth accounts vs a tax-deferred IRAs. In the end, a strong case could be made that most people don’t need much of a Roth at all from the mathematical point of having more spendable income in retirement. In this article, I will compare substituting a taxable brokerage account in place of the Roth to see how much similarity there is. If you are concerned your spendable money in retirement is marginal, you certainly want to try and maximize it. Like most of my articles, first, we must understand what the optimal condition is before we can decide whether it needs fixing.

Be sure to realize these examples do not consider the effect of state income tax, the non-linearity of the taxation of Social Security, or the effect of increased Medicare premiums, or other nuances that are unique to your own situation. The intent is to just give you a baseline of knowledge. First let us review the details of the previous article, as I will use the same setup in this article.

First is the inflation adjustment of the Social Security payment as well as the inflation of spendable income need by the couple. Secondly, and even more important is the inflation adjustment of the tax brackets and Standard Deduction. I first introduced this in my article titled “ Surviving the Tax Bite in Retirement.” In that article, I used a 2% inflation factor based on the historical data available at the time, but in this article, I have chosen to use 1.5%, in-line with my other inflation factors used and the previous article that I will be comparing these results to. The new standard deduction levels of 2018 will be inflated by $100 per year starting in 2019 as another estimate of what could possibly be expected based on past history. Once again past history is no guarantee but it is important to consider these factors that both make the Roth & taxable account money less attractive in retirement and have usually been neglected by most other authors on this subject.

Reviewing the Ground Rules

First, some definitions and abbreviations are in order:

I will use the term taxable account to indicate what is commonly referred to as a brokerage account funded with after-tax dollars. This account allows you to withdraw your contributions tax-free, however, the earnings portion of the shares you sell could be taxed at a number of different tax rates from your ordinary marginal income tax rate all the way down to zero for some Long Term Capital Gains and qualified dividends if your taxable income is low enough. An important point to interject here is that any investors living in a state with state income tax will most likely have their dividends and long term capital gains taxed as ordinary income. I will use the term IRA to indicate any number of tax-advantaged retirement accounts funded with pre-tax dollars for which you withdraw all contributions and earnings paying ordinary income tax on them at the time of withdrawal. You could find many types of these such as Traditional IRA, Traditional 401k, 403b, SEP-IRA, 457b, SIMPLE IRA, and others. It should be noted that it is possible to have a mix of after-tax and pre-tax dollars in most of these accounts, but when I use the term IRA from now on, I will only be considering these accounts will all pre-tax dollars in them. This article is mainly concerned with contrasting the taxable account and IRA to determine what techniques can be used to maximize your income during retirement. We will then contrast these results to those using the Roth account to see how they are alike or different.

Let’s review the characteristics of the two account types.

Taxable:

Taxes are subtracted from your earnings before being deposited in the account. No age restriction on when you can withdraw your money or on how much money you can add in any one year. When shares are sold within the account you will receive your contribution (known as your cost basis) tax-free but will be subject to tax on the earnings in a range from zero up to your ordinary marginal income tax rate. Tax planning flexibility – Since there are no forced withdrawals by age, you have more tax-planning flexibility during retirement. There is also tax planning flexibility from the fact that you can specify which tax-lot of shares you want to sell which can control the amount of earnings, or capital gains you need to realize with the sale. If the owner of the brokerage account dies, the cost basis of the shares owned is all stepped-up to current market value essentially eliminating all capital gains up to that point in time for the person who inherits the account.

IRA:

Tax deferral on contributions during working years will lower your taxable income while working and can increase some tax-credits. Increasing tax-credits could actually allow you to save more. In most cases, withdrawals do not start prior to age 59.5 because a penalty would be due unless an exception applies. The required minimum withdrawals [RMD] must begin prior to April 1st of the year after you turn 70 ½, but can be withdrawn as early as the year you turn 70 ½. The RMD for any year after the year you turn 70 ½ must be made by December 31 st of that year. If these are not made you can incur a 50% penalty on any amount not taken that was due. Inherited IRAs have a complete set of RMD tables and rules which will not be discussed here.

There are many other nuances to the above two types of accounts and even within different types of taxable or IRA accounts, most of which can be found in the IRS publication 590, which has now been split into two parts – pub 590-A (contributions) and pub 590-B (distributions).

In this article, I will use the same specific details and tax brackets as used previously with the one additional tax bracket for the Long Term Capital Gains [LTCG] in the taxable account. I will also study the same 3 tax brackets, which were the 12%, 18%, and 25% during the accumulation years and the actual tax brackets based on the retirement spending during retirement.

General Assumptions

The results are for a married couple both age 70.5 in December of 2018, which is the starting year for the retirement analysis. The result of this is their first RMD will be paid in 2018 on the starting IRA balance at the end of 2017. The IRA or taxable account withdrawals required for the year are withdrawn at the start of the year on January 1st. The couple has a combined Social Security income of $40,000 per year, which will be inflation adjusted at 1.5% per year. The couple’s total budget need starts at $100,000 per year and will also be inflation adjusted at 1.5% per year for the 20 years of this study. Whatever taxes are required will need to be added to the budget need to create a total income need for each year. Each couple has saved $10,000 per year for 30 years and gotten an annualized return on those investments of about 7.32%, which translates to a pre-tax IRA balance of $1 million or split-adjusted amounts with varying dollars of taxable account money as detailed in the case outlines below. In the taxable account, a tax drag subtraction from the account will be withdrawn based on an annual 2% dividend and the historical tax rates for dividends over the time span from 1988 to 2017. No sales during the accumulation phase are assumed, but would obviously be another source of tax drag while working. The annualized growth rate of their IRA and taxable investments will be 6% during retirement for all six cases. The tax brackets used to calculate their tax will also be inflation adjusted at a 1.5% rate. The tax year 2018 will be the starting point for the tax tables. Actual tax brackets, standard deductions, and exemptions will be used for all historical years of 1988 to 2018. In the examples studied Social Security will be taxed based on the current IRS Social Security worksheet. No changes to this worksheet are assumed or used. Each retired couple takes the standard deduction which for them starts at $26,600 and increases at $100 per year. Three tax rates for taxable contributions will be studied to contrast how your working tax rate later affects your spendable income when a taxable account is involved. Finally, a comparison will be made to the previous results which used a Roth account rather than the taxable account used in this study.

The three cases will be very much the same as previously studied in which they were able to put their earnings into the taxable account at the below rates:

The money went into the taxable account at 12%. The money went into the taxable account at 18%. The money went into the taxable account at 25%.

Each of the above three cases is broken down into 3 subcases such that the resulting list looks like this:

1a) 100% IRA @ tax-deferred.

1b) 100% taxable @ 12% accumulation.

1c) 97.05% IRA, 2.95% taxable @ 12% accumulation.

2a) 100% IRA @ tax-deferred.

2b) 100% taxable @ 18% accumulation.

2c) 97.21% IRA, 2.79% taxable @ 18% accumulation.

3a) 100% IRA @ tax-deferred.

3b) 100% taxable @ 25% accumulation.

3c) 97.42% IRA, 2.58% taxable @ 25% accumulation.

The Setup

The following tax tables will be used for accumulation in the taxable account:

The below chart is for retirement.

During the accumulation stage, the following will show what happened from a dividend and cost basis standpoint within the taxable account. Below is a view of the 100% taxable account for the 12%, 18%, and 25% case:

A couple of things to point out in the above charts are that the rows for years 1993 to 2000 are hidden to shrink the charts down, but all years are accounted for in the tables. Also of note are the red tax drag amounts which were from years 1988 to 2002 when dividends were taxed as ordinary income.

You might notice that I lowered the salary range on the first investor that was in the 12% bracket. While it would have been hard to be at a marginal rate of 12%, I felt the need to make this the same as the previous as much as possible. So I used 12% for the amount of after-tax money that went into the account however I used actual tax data to calculate the tax on the dividends.

Retirement Years

Results for the IRA accounts which are exactly the same as in the previous article:

As you might have guessed, the working tax rate does not matter to the IRAs as their retirement will always end with effectively $156,400 of after-tax money, or $172,114 of pre-tax money, left to spend after 20 years. As you will find out later on, the tax-deferred IRA is one of the more tax-efficient savings vehicles, for the simple fact that most of the IRA money is spent in the 10% and 12% tax bracket. This is an important point to remember when considering where most of your working savings should go, and as you will see, the higher your working tax rate the more important it will be to stress the IRA over other after-tax accounts, for the average couple.

Results for the 100% taxable account at a 12% tax rate:

In the above case, an interesting thing happens compared to the previous article and that is that the taxable account holds no advantage over the 100% IRA account and that is because some of the Social Security gets taxed due to the Long Term Capital Gains that affect that calculation.

Second, let us look at results when keeping the average tax burden while working at 18%:

In this case, the taxable account runs out of money at age 87.

Finally, let us look at results when keeping the average tax burden while working at 25%:

As can be seen from the above the lack of tax diversity in their savings has caused them a serious setback in their retirement cash flow as they ran out of savings at age 85 and are therefore forced to live only on their Social Security income.

Next, let us review the results when some taxable money is used to keep the investor out of higher tax brackets. In this case, I chose the point similar to the previous article such that just enough taxable account money was saved to keep the investor out of the 22% tax bracket.

This turns out to be a 2.95% taxable account allocation for the 12% accumulator:

In this case, the investor has $19,969 less money left in the IRA as compared to the 100% IRA account because of the effect of the Long Term Capital Gains and dividends.

Next, we will look at a 2.79% taxable account allocation for the 18% accumulator:

In this case, the investor has $19,711 less money left in the IRA as compared to the 100% IRA account because of the effect of the Long Term Capital Gains and dividends.

Finally, we will look at a 2.58% taxable account allocation for the 25% accumulator:

In the above case what is verified is that the investor had $7188 less than if they had left 100% of their savings in the IRA account.

Summary of Results

Below is the summary of all results in tabular form:

First place goes to the 100% IRA account with the next three places going to the retirement accounts in which less than 3% of the earnings were allocated to the taxable account. Finally, in the case of trying to use 100% taxable funds for retirement, only the 12% case did not cause the investor to run out of money but it still ended up with over $81,539 less of spendable income than the 100% IRA account.

In the case of the previous article using Roth funds instead of taxable funds, the results looked like this:

Conclusion

Even though everyone’s tax situation is different, I would hope the takeaway from this article is something that is not often stressed by advisors, other authors, or those commenting on these articles. When deciding just how much tax diversity you should have or can afford, it is important to understand that the taxable and Roth accounts are very much in the same situation as they compare to the IRA. Both have their place but are generally inferior when you don’t have enough IRA funds to fill up the bottom couple of tax brackets. Finally, the taxable account is almost always inferior to the Roth account. The taxable account actually starts out equal to the Roth account on the day you put the money into the account, but once you start paying tax on additional dividends and capital gains, the taxable account is the clear loser.

The reason for the above is also something that is not stressed often enough, but I intend to do a better job of it in the future. While working it is your marginal tax rate that is paid on your taxable or Roth savings that is important. Over your lifetime this number may go up and down so I would use what I call the average working marginal rate. To decide in retirement when it is efficient to spend your taxable or Roth dollars you need to know which tax brackets they are being spent in and the fact that your IRA dollars may span any number of tax brackets from zero to the maximum and that it usually does not make sense to spend those taxable or Roth dollars in a tax bracket lower than the average working marginal rate that was already paid on those Roth dollars. What I have heard too many times is the statement:

“Since my marginal rate in retirement is higher or going to be higher I should put all my effort into minimizing my IRA and RMDs and saving as large of a Roth allocation as I can.”

I would hope by now most can see the shortsightedness of that thinking.

Another statement that I have heard concerning the taxable account is:

“I get a tax break on my dividends in my taxable account so that is where I should put my dividend paying stocks.”

That could not be further from the truth during your accumulation years and in many cases not a good idea during your retirement either. In this study, I used a very low dividend rate of 2% which is quite low by most dividend investors standards. As you might imagine the higher this rate goes the more tax drag you will have on your account.

While RMDs can raise your taxable income and your tax rate in retirement they should not be something that is feared to extremes. In an article I wrote entitled Surviving the Tax Bite of Retirement, I pointed out that over the previous number of years the personal exemption, standard deduction, and the top of each of the tax rate bracket have grown by around 2% per year. With completely revised lower tax brackets for 2018 and the foreseeable future, this has only improved the odds of you having a lower tax bracket in retirement, compared to while you were working. Hopefully, you have learned that this favors the IRA owner and the results are not insignificant. Who would not want 10-20% extra money in retirement or for their beneficiaries? I do understand that on the other end you do not want to be seen as the one who increased someone’s taxes with an inheritance. I personally think it is up to you to educate your heirs and make them see that a little bit of tax on a larger sum of many can in many cases be better than no tax on a smaller pool of money.

In my volunteer work helping people with their taxes each season, there are always cases where having some of their retirement in a tax-deferred IRA could have resulted in some tax-free withdrawals from that IRA, due to their low-income level. For others the converse is also often true – that with at least a small Roth or taxable account it would have been possible to lower how much of their retirement savings go to the taxman. It is never a bad idea, in my opinion, to have taxable, Roth and IRA funds going into retirement. In my case, I was able within the first couple of my retirement years to spend down the inefficient taxable account and use some of that Roth to keep my tax rates reasonable while I paid off a sizable mortgage.

Of Notable Mention

Once again I also want to shout out a special thanks to Bruce Miller, who made my job much easier by providing a tax calculator for the new tax law going forward in 2018 as well as a Social Security tax calculator.

All retirement tax calculations were started from a base of the new 2018 tax law and as I outline, they were inflation adjusted at 1.5% going forward from there. In the case of the historical tax calculations going from 1988 to 2017, for the year 2000 to present I used data from this moneychimp.com site. For older data, I searched some of the archives at the taxfoundation.org website. For standard deduction data, I went to this innovateprofessional.com website and a few other miscellaneous sources to pick up the personal exemption data.

This study is only as good as the data presented from the sources mentioned in the article, my own calculations, and my ability to apply them. While I have checked results multiple times, I make no further claims and apologize to all if I have misrepresented any of the facts or made any calculation errors.

The information provided here is for educational purposes only. It is not intended to replace your own due diligence or professional financial or tax advice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.