Tax-Efficient Investing Strategies

Tax-Effective-Investing

You can increase your savings through tax-efficient investing.  Tax-efficient investing is the process of maximizing your after-tax investment returns by buying your invested assets in the “best” account from a tax perspective.  You may have savings in a taxable account and/or in one or more types of tax-sheltered retirement accounts.  Your investment returns are taxed differently depending on the type of account in which you hold your invested assets.  In this post, I’ll provide a quick overview of the taxes applicable to each type of account (since I cover taxes on retirement plans in much greater detail in this post) and provide guidelines for how to invest tax-efficiently.

The strategy for tax-efficient investing differs from one country to the next due to differences in tax laws so I’ll talk about tax-efficient investing strategies in the US in this post and in Canada in my next post.

Types of Investment Returns

I will look at four different types of investments:

  • Individual stocks with high dividends
  • Mutual funds
  • Exchange-traded funds (ETFs)
  • Bonds

I will not look at individual stocks with little or no dividends.  The returns on those stocks are essentially the same as the returns on ETFs and are taxed in the same manner.

The table below shows the different types of returns on each of these investments.

Distributions by Investment Interest Dividends Capital Gains Capital Gain Distributions
High dividend stocks           x          x
Mutual Funds          x          x          x
ETFs          x
Bonds          x          x

Cash Distributions

Interest and dividends are cash payments that the issuers of the financial instrument (i.e., stock, fund or bond) make to owners.

Capital Gains

Capital gains come from changes in the value of your investment.  You pay taxes on capital gains only when you sell the financial instrument which then makes them realized capital gains.  The taxable amount of the realized capital gain is the difference between the amount you receive when you sell the financial instrument and the amount you paid for it when you bought it.  Unrealized capital gains are changes in the value of any investment you haven’t yet sold.  If the value of an investment is less than what you paid for it, you are said to have a capital loss which can be thought of as a negative capital gain.

Mutual Funds

Mutual funds are a bit different from stocks and ETFs.  They can have the following types of taxable returns.

  • Dividends – A mutual fund dividend is a distribution of some or all of the dividends that the mutual fund manager has received from the issuers of the securities owned by the mutual fund.
  • Capital gain distributions – Capital gain distributions are money the mutual fund manager pays to owners when a mutual fund sells some of its assets.
  • Capital gains – As with other financial instruments, you pay tax on the any realized capital gains (the difference between the amount you receive when you sell a mutual fund and the amount you paid for it) when you sell a mutual fund.

Tax Rates

The four types of distributions are taxed differently depending on the type of account in which they are held – Taxable, Roth or Traditional.  401(k)s and Individual Retirement Accounts (IRAs) are forms of retirement accounts that can be either Roth or Traditional accounts and are discussed in more detail in in this post.

Accounts other than Retirement Accounts

I’ll refer to accounts that aren’t retirement accounts as taxable accounts.   You pay taxes every year on dividends and realized capital gains in a taxable account, whereas you pay them either when you contribute to or make a withdrawal from a retirement account.  The table below shows how the different types of investment returns are taxed when they are earned in a taxable account.

Type of Investment Return Tax Rates
Interest Same as wages
Dividends, realized capital gains & capital gain distributions ·         0% if dividends, capital gains & capital gain distributions are less than $38,600 minus wages minus income from other sources.

·         15% up to roughly $425,000.

·         20% if higher

For many employed US residents (i.e., individuals with taxable income between $38,700 and $157,500 and couple with taxable income between $77,400 and $315,000 in 2018), their marginal Federal tax rate wages and therefore on interest is likely to be 22% or 24%.

In a taxable account, you pay taxes on investment returns when you receive them.  You are considered to have received capital gains when you sell the financial instrument.

Roth Retirement Accounts

Before you put money into a Roth account, you pay taxes on it.  Once it has been put into the Roth account, you pay no more income taxes regardless of the type of investment return unless you withdraw the investment returns before you attain age 59.5 in which case there is a penalty.  As such, the tax rate on all investment returns held in a Roth account is 0%.

Traditional Retirement Accounts

You pay income taxes on the total amount of your withdrawal from a Traditional retirement account at your ordinary income tax rate.  Between the time you make a contribution and withdraw the money, you don’t pay any income taxes on your investment returns.

After-Tax Returns by Type of Account

To illustrate the differences in how taxes apply to each of these four financial instruments, I’ll look at how much you would have if you have $1,000 to invest in each type of account at the end of one year and the end of 10 years.

Here are the assumptions I made regarding pre-tax investment returns.

Annual Pre-tax Investment Return % Interest Dividends Capital Gains
Stocks 0% 3% 5%
ETFs 0% 0% 8%
Mutual Funds 0% 3% 5%
Bonds 4% 0% 0%

Mutual funds usually distribute some or all of realized capital gains to owners.  That is, if you own a mutual fund, you are likely to get receive cash from the mutual fund manager related to realized capital gains in the form of capital gain distributions.  Whenever those distributions are made, you pay tax on them.  For this illustration, I’ve assumed that the mutual fund manager distributes all capital gains to owners, so they are taxed every year.

Here are the tax rates I used for this illustration.

Type of Income Tax Rate
Ordinary Income – This Year 24%
Dividends 15%
Capital Gains 15%

One-Year Investment Period

Let’s say you have $1,000 in each account.  I assume you pay taxes at the end of the year on the investment returns in your Taxable account.  If you put the money in a Traditional account, I assume that you withdraw all of your money and pay taxes at the end of the year on the entire amount at your ordinary income tax rate.  (I’ve assumed you are old enough that you don’t have to pay a penalty on withdrawals without penalty from the retirement accounts.)

The table below shows your after-tax investment returns after one year from your initial $1,000.  Note that the pre-tax returns are the same as the returns in the Roth row, as you don’t pay income taxes on returns you earn in your Roth account.

One-Year After-tax Investment Returns ($) Stocks Mutual Funds ETFs Bonds
Taxable $68 $68 $68 $30
Traditional 61 61 61 30
Roth 80 80 80 40

The table below shows the taxes you paid on your returns during that year.

Taxes Paid Stocks Mutual Funds ETFs Bonds
Taxable $12 $12 $12 $10
Traditional 19 19 19 10
Roth 0 0 0 0

When looking at these charts, remember that you paid income taxes on the money you contributed to your Taxable and Roth accounts and that those taxes are not considered in these comparisons.  This post focuses on only the taxes you pay on your investment returns.

Comparison of Different Financial Instruments in Each Type of Account

Looking across the rows, you can see that, for each type of account, stocks, mutual funds and ETFs have the same one-year returns and tax payments. In this illustration, all three of stocks, mutual funds and ETFs have a total return of 8%.  It is just the mix between appreciation, capital gain distributions and dividends that varies.  The tax rates applicable to dividends and capital gains are the same so there is no impact on the after-tax return in a one-year scenario.

In all accounts, bonds have a lower after-tax return than any of the other three investments.  Recall, though, that bonds generally provide a lower return on investment than stocks because they are less risky.

Comparison of Each Financial Instrument in Different Types of Accounts

Looking down the columns, you can see the impact of the differences in tax rates by type of account for each financial instrument.  You have more savings at the end of the year if you invest in a Roth account than if you invest in either of the other two accounts for each type of investment.  Recall that you don’t pay any taxes on returns on investments in a Roth account.

The returns on a taxable account are slightly higher than on a Traditional account for stocks, mutual funds and ETFs.  You pay taxes on the returns in a taxable account at their respective tax rates – usually 15% in the US for dividends and capital gains.  However, you pay taxes on Traditional account withdrawals at your ordinary income tax rate – assumed to be 24%.  Because the ordinary income tax rates are higher than the dividend and capital gain tax rates, you have a higher after-tax return if you invest in a taxable account than a Traditional account for one year.  For bonds, the taxes and after-tax returns are the same in a Traditional and taxable account because you pay taxes on interest income in taxable accounts and distributions from Traditional accounts at your marginal ordinary income tax rate.

Remember, though, that you had to pay income taxes on the money you put into your taxable account before you made the contribution, whereas you didn’t pay income taxes on the money before you put it into your Traditional retirement account.

Ten-Year Investment Period

I’ve used the same assumptions in the 10-year table below, with the exception that I’ve assumed that you will pay ordinary income taxes at a lower rate in 10 years because you will have retired by then. I’ve assumed that your marginal tax rate on ordinary income in retirement will be 22%.

Ten-Year After-Tax Investment Returns ($) Stocks Mutual Funds ETFs Bonds
Taxable $964 $931 $985 $349
Traditional 904 904 904 375
Roth 1,159 1,159 1,159 480

Comparison of Different Financial Instruments in Each Type of Account

If you look across the rows, you see that you end up with the same amount of savings by owning any of stocks, mutual funds and ETFs if you put them in either of the retirement account.  The mix between capital gains, capital gain distributions and dividends doesn’t impact taxes paid in a tax-sheltered account, whereas it makes a big difference in taxable accounts, as can be seen by looking in the Taxable row.

In taxable accounts, ETFs provide the highest after-tax return because they don’t have any taxable transactions until you sell them.  I have assumed that the stocks pay dividends every year.  You have to pay taxes on the dividends before you can reinvest them, thereby reducing your overall savings as compared to an ETF.  You have to pay taxes on both dividends and capital gain distributions from mutual funds before you can reinvest those proceeds, so they provide the least amount of savings of the three stock-like financial instruments in a taxable account.

Comparison of Each Financial Instrument in Different Types of Accounts

Looking down the columns, we can compare your ending savings after 10 years from each financial instrument by type of account.  You earn the highest after-tax return for every financial instrument if it is held in a Roth account, as you don’t pay any taxes on the returns.

For bonds, you earn a higher after-tax return in a Traditional account than in a taxable account.  The tax rate on interest is about the same as the tax rate on Traditional account withdrawals.  When you hold a bond in a taxable account, you have to pay income taxes every year on the coupons you earn before you can reinvest them.  In a Traditional account, you don’t pay tax until you withdraw the money, so you get the benefit of interest compounding (discussed in this post) before taxes.

Your after-tax return is higher in a taxable account than in a Traditional account for the three stock-like investments.  The lower tax rate on dividends and capital gains in the taxable account, even capital gain distributions, more than offsets the fact that you have to pay taxes on dividends and mutual fund capital gain distributions before you reinvest them.

Illustration of Tax Deferral Benefit

The ability to compound your investment returns on a tax-deferred basis is an important one, so I’ll provide an illustration.  To keep the illustration simple, let’s assume you have an asset that has a taxable return of 8% every year and that your tax rate is constant at 24% (regardless of the type of account).

The table below shows what happens over a three-year period.

Returns and Taxes by Year Taxable Account Retirement Account
Initial Investment $1,000 $1,000
Return – Year 1 80 80
Tax – Year 1 19 0
Balance – Year 1 1,061 1,080
Return – Year 2 85 86
Tax – Year 2 20 0
Balance – Year 2 1,125 1,166
Return – Year 3 90 94
Tax – Year 3 22 0
Balance – Year 3 1,194 1,260

By paying taxes in each year, you reduce the amount you have available to invest in subsequent years so you have less return.

The total return earned in the taxable account over three years is $255; in the tax-deferred account, $260.  The total of the taxes for the taxable account is $61.  Multiplying the $260 of return in the tax-deferred account by the 24% tax rate gives us $62 of taxes from that account.  As such, the after-tax returns after three years are $194 in the taxable account and $197 in the tax-deferred account.

These differences might not seem very large, but they continue to compound the longer you hold your investments.  For example, after 10 years, your after-tax returns on the tax-deferred account, using the above assumptions, would be almost 10% higher than on the taxable account.

Tax-Efficient Investing for Portfolios

It is great to know that you get to keep the highest amount of your investment returns if you hold your financial instruments in a Roth.  However, there are limits on how much you can put in Roth accounts each year.  Also, many employers offer only a Traditional 401(k) option.  As a result, you may have savings that are currently invested in more than one of Roth, Traditional or taxable accounts.  You therefore will need to buy financial instruments in all three accounts, not just in a Roth.

Here are some guidelines that will help you figure out which financial instruments to buy in each account:

  • You’ll maximize your after-tax return if you buy your highest yielding financial instruments in your Roth.  Because they generate the highest returns, you will pay the most taxes on them if you hold them in a taxable or Traditional account.
  • Keep buying your high-yielding financial instruments in descending order of total return in your Roth accounts until you have invested all of the money in your Roth accounts.
  • If two of your financial instruments have the same expected total return, but one has higher annual distributions (such as the mutual fund as compared to the stocks in the example above), you’ll maximize your after-tax return if you put the one with the higher annual distributions in your Roth account.
  • Once you have invested all of the money in your Roth account, you’ll want to invest your next highest yielding financial instruments in your Taxable account.
  • You’ll want to hold your lower return, higher distribution financial instruments, such as bonds or mutual funds, in your Traditional account. There is a benefit to holding bonds in a Traditional account as compared to a taxable account.  The same tax rates apply to both accounts, but you don’t have to pay taxes until you withdraw the money from your Traditional account, whereas you pay them annually in your taxable account.  That is, you get the benefit of pre-tax compounding of the interest in your Traditional account.

Applying the Guidelines to Two Portfolios

Let’s see how to apply these guidelines in practice using a couple of examples.  To make the examples a bit more interesting, I’ve increased the annual appreciation on the ETF to 10% from 8%, assuming it is a higher risk/higher return type of ETF than the one discussed above.  All of the other returns and tax assumptions are the same as in the table earlier in this post.

Portfolio Example 1

In the first example, you have $10,000 in each of a taxable account, a Traditional account and a Roth account.  You’ve decided that you want to invest equally in stocks, mutual funds and ETFs.

You will put your highest yielding investment – the ETFs, in your Roth account.  The stocks and mutual fund have the same total return, but the mutual fund has more taxable distributions every year.  Therefore, you put your mutual funds in your Traditional account and your stocks in your taxable account.

Portfolio Example 2

In the second example, you again have $10,000 in each of a taxable account, a Traditional account and a Roth account.  In this example, you want to invest $15,000 in the high-yielding ETFs but offset the risk of that increased investment by buying $5,000 in bonds.  You’ll split the remaining $10,000 evenly between stocks and mutual funds.

First, you buy as much of your ETFs as you can in your Roth account.  Then, you put the remainder in your taxable account, as the tax rate on the higher return from the ETFs is lower in your taxable account (the 15% capital gains rate) than your Traditional account (your ordinary income tax rate).  Next, you put your low-yielding bonds in your Traditional account.  You now have $5,000 left to invest in each of your taxable and Traditional accounts.  You will invest in mutual funds in your Traditional account, as you don’t want to pay taxes on the capital gain distributions every year if they were in your taxable account.  That means your stocks will go in your taxable account.

Risk

There is a very important factor I’ve ignored in all of the above discussion – RISK (a topic I cover in great detail in this post).  The investment returns I used above are all risky.  That is, you won’t earn 3% dividends and 5% appreciation every year on the stocks or mutual funds or 10% on the ETFs.  Those may be the long-term averages for the particular financial instruments I’ve used in the illustration, but you will earn a different percentage every year.

If your time horizon is short, say less than five to ten years, you’ll want to consider the chance that one or more of your financial instruments will lose value over that time frame.  With perfect foresight, you would put your money-losing investments in your Traditional account because you would reduce the portion of your taxable income taxed at the higher ordinary income tax by the amount of the loss when you withdraw the money.  Just as the government gets a share of your profits, it also shares in your losses.

The caution is that financial instruments with higher returns also tend to be riskier.  If, in the US, you put your highest return investments – the ETFs in my example – in your Roth account, their value might decrease over a short time horizon.  In that case, your after-tax loss is the full amount of the loss.  If, instead, you had put that financial instrument in your Traditional account, the government would share 24% (your marginal ordinary tax rate) of the loss in my example.

In conclusion, if you plan to allocate your investments using the above guidelines, be sure to adjust them if your time horizon is shorter than about 10 years to minimize the chance that you will have to keep all of a loss on any one financial instrument.

Traditional vs Roth Retirement Plans

The difference between Roth vs Traditional plans for retirement is primarily about tax rates. Other differences relate to when you can or must withdraw your savings.  With one exception, the same withdrawal rules apply to both 401(k)s and Individual Retirement Accounts (IRAs), so I’ll refer to both 401(k)s and IRAs collectively as Roth and Traditional plans.  In this post, I will:

  • Describe the four different combinations of tax-advantaged retirement savings plans in the US.
  • Provide information about contribution limits.
  • Talk about the major differences between Roth vs Traditional plans.
  • Give you the nuts and bolts of the tax considerations so you can make an informed decision as to where to put your retirement savings.

Key Take-Aways – Roth vs Traditional Plans

While there are several differences between Roth vs Traditional plans, some of which may be important to some of you, the biggest difference has to do with when you pay taxes on the money you have saved.  As will be explained below, you pay taxes before you put money in a Roth plan and you don’t pay taxes on Traditional plan money until you withdraw it.

Characteristics that make a Roth plan a better option than a Traditional plan for you include:

  • Your salary and spending are likely to go up a lot before you retire.
  • You anticipate having a lot of taxable income in retirement, such as from a part-time job, a pension or savings not in a tax-sheltered retirement plan.
  • The expectation that tax rates will increase.

If none of these characteristics apply to your situation, a Traditional plan is likely to be better for your than a Roth plan.

Mechanics of Tax-Advantaged Retirement Savings Plans

In the US, there are two types of tax-advantaged retirement savings plans, each with two variations.

Types of Plans

The two types of plans are:

  • Individual Retirement Accounts (IRAs). An IRA is an account that you establish on your own at a bank, brokerage house or other financial institution that offers IRAs.  You make contributions to your IRA and can select one of many different choices for investments.  Allowed investment classes include stocks, bonds, real estate, mutual funds, ETFs, money market and other savings accounts and annuities, among other.
  • 401(k)s. A 401(k) is usually an employer sponsored plan, though you can open an individual 401(k) if you are self-employed. You can contribute a portion of your salary to the 401(k).  Many employers will match some or all of your contribution.  In a 401(k), you are restricted to the investment options offered by your employer, usually mutual funds and ETFs.

Two Variations

The two variations of each of IRAs and 401(k)s are Roth and Traditional plans.  When you set up an IRA, you have the choice of designating it as a Roth vs a Traditional IRA.  Your employer (or you if you have an individual 401(k)) determines whether to offer a Roth vs a Traditional plan. For information about the types of investments that are best held in each type of account, check out this post.

Maximum Contributions

For 2019, the maximum combined contribution to all of your IRAs combined is $6,000, plus another $1,000 if you are 50 or older.  The maximum combined contribution to your 401(k) plan is $19,000 ($25,000 if you are 50 or older).  The 401(k) contribution limits apply to money you deposit in your 401(k) and excludes any funds contributed by your employer.

Major Differences between Roth vs Traditional Plans

There are four major differences between Roth vs Traditional plans.

  • Roth contributions are restricted if your income is high, as discussed below.
  • You pay a penalty on any withdrawals you make from Traditional plans before the year in which you turn 59.5.
  • There are required minimum distributions on all plans except Roth IRAs.
  • The timing of paying taxes on the money in Roth and Traditional plans is different.

Restrictions on Roth Contributions

If your modified adjusted gross income is more than a certain threshold ($137,000 for single taxpayers in 2019, $193,000 for taxpayers who are married filing jointly), the tax law does not allow you to put as much in a Roth IRA and, if your income is high enough, do not allow you to directly contribute to a Roth IRA. However, you can contribute to a Traditional IRA and then very quickly transfer the money to a Roth IRA.  This transfer is called a “roll over.”  If you fall in this category, I suggest talking to your tax advisor or broker to make sure the process follows the IRS rules.

Early Withdrawal Penalty on Traditional Plans

If you withdraw money from your Traditional retirement plan before the year in which you turn 59.5, you will have to pay income taxes on the withdrawal (see below for more) and you will have to pay a tax penalty equal to 10% of your withdrawal amount.

With a Roth plan, you can make withdrawals at any time without paying a penalty, as long as you are either at least 59.5 or you made contributions in each of the previous five years.  If you are younger than 59.5, you can withdraw your contributions without paying any tax, but will pay taxes on any investment earnings (interest, dividends or appreciation) on your contributions.  I’ve read in some places that the every withdrawal is assumed to be a mix of your contributions and earnings, but I read the IRS web site as saying that you are assumed to withdraw your contributions first and then any earnings. If you want to make withdrawals before you are 59.5, I suggest talking to a tax advisor to make sure you understand the tax consequences.

Required Minimum Distributions

All tax-advantaged retirement accounts, except Roth IRAs, have minimum distribution requirements. By April 1 of the year in which you turn 70.5, you need to start withdrawing money from these accounts.

The amount you need to withdraw is the balance at the beginning of the year divided by your life expectancy, as calculated by the IRS.  The same life expectancy is used for everyone, based on their age, except people whose sole beneficiary is their spouse and their spouse is more than 10 years younger.  For most people, your life expectancy, according to the IRS web site, in the year you turn 70.5 is 27.4 years. So, if you have $50,000 at the beginning of that year in a Traditional IRA or any 401(k), the minimum withdrawal would be $1,824.  The penalty for not making the minimum withdrawal is very steep – 50% of the amount that you were required to withdraw but didn’t!

Even though I am retired and able to start withdrawing from my retirement savings, this minimum distribution requirement difference between a Roth IRA and the other accounts has not seemed important to me, as I assume I will need to withdraw money from my other retirement plans to support my expenses.  I may change my mind as I get older and have to start making withdrawals, as these withdrawals may increase my taxes more than necessary if I have other funds available to cover expenses.

Dollars and Cents of Taxes

The biggest difference between Roth vs Traditional retirement plans is the way they are taxed. 

Taxes on Contributions

Briefly, Roth contributions are made with after-tax money, while Traditional contributions are made with pre-tax money.  After-tax money means that you have already paid income taxes on the money you contribute. Pre-tax money means that you do not pay income taxes on the money when you contribute it.

In practice, you can deduct the amount of any contributions to Traditional plans from your income on your tax return, but you don’t get to deduct Roth contributions.  The amount of your wages reported by your employer on your W-2 has usually already been reduced for contributions you have made to a Traditional 401(k).  There is a specific line on your tax return for Traditional IRA contributions.

Taxes on Withdrawals

You do not pay any taxes on withdrawals from Roth plans, but you do on Traditional plans.  Just the opposite of when you contribute the money.

Comparison

If the tax rate applicable to your contributions and withdrawals (a lot more on that in a minute) were the same, it wouldn’t matter whether you put your money in a Traditional vs Roth plan!   For a Traditional plan, you contribute the amount you have available, earn a return and withdraw it after paying taxes.  That is:

Money in Traditional plan = Contribution x (1 + compound investment return) x (1 – tax rate)[1]

For a Roth plan, you start with the amount you have available, pay taxes on it, contribute what you have left, earn a return and withdraw it.  That is:

Money in Roth plan = Contribution x (1 – tax rate) x (1 + compound investment return)

Because you can change the order of the terms when multiplying (the associate property for math geeks like me), these two amounts are equal as long as the applicable tax rate when you make your contribution is the same as when you make your withdrawal.

What You Need to Know About Taxes

The Federal government and most states tax your income.  There is a small handful of states with no income tax.  Because state income taxes vary so widely, I will focus only on Federal income taxes.  If you want more information about your state income taxes (and you’ll want to know at least a bit about them for your decision-making process), I suggest visiting your state’s web site or contacting your tax advisor.

The Federal income tax system is very complicated.  In this post, I will focus on aspects of the calculation that impact your choice between Traditional vs Roth retirement plans.  As with state income taxes, if you have questions about your specific situation, I suggest you contact a qualified tax advisor.

There are two steps in calculating your Federal income tax.

  1. Calculate your taxable income.
  2. Determine the taxes that apply to your taxable income.

Taxable Income

Your taxable income is the sum of all sources of income minus your deductions.  

Income

The most common sources of income include:

  • Wages
  • Interest and dividends, other than those from US Government bonds
  • Capital gains and losses
  • Pension income and withdrawals from retirement plans, other than Roth plans
  • A portion of your social security benefits, as discussed in this post
  • Self-employment income
  • Alimony

Reductions and Deductions

These amounts are reduced by a number of items, including the following:

  • Contributions to Traditional retirement plans
  • Contributions to Health Savings Accounts
  • Alimony paid
  • Some student loan interest

The total of your income excluding this amounts is called your Adjusted Gross Income.

You can then choose to either itemize your deductions or use the standard deduction.  The standard deduction is $12,000 if you file individually and $24,000 if you file jointly with your spouse.  (There are also separate thresholds for most aspects of the tax calculation for married filing separately and head of household.  I will not provide the specifics for these filing statuses.  You can find more information at www.irs.gov.)

Itemizing your deductions is quite complicated.  Briefly, here are the most common deductions:

  • Medical expenses, but only the portion that exceeds 7.5% of your adjusted gross income
  • State and local income and property taxes, up to $10,000
  • Some or all of your mortgage interest
  • Charitable donations

People usually use the standard deduction unless their itemized deductions are higher than the standard deduction in which case they use their itemized deductions.

Taxable income is adjusted gross income minus deductions.

Calculating Your Taxes

For most people, the regular tax rates are applied to your taxable income.  People with high incomes and especially those with a large amount of deductions have to calculate a second tax called alternative minimum tax. According to the Tax Policy Center, a very small percentage of people with income between $200,000 and $1 million and about 10% – 15% of people with income more than $1 million will pay the alternative minimum tax. I am going to assume that most of you are not subject to the alternative minimum tax, so will not discuss it here.

If you do not have any dividend income or capital gains, you can calculate your taxes from tables provided by the IRS. 

Tax Table for Single Taxpayers

Here is the table for single taxpayers for tax year 2018.

Taxable Income is More Than: But Not More Than: Fixed Part of Tax Tax Rate Threshold Above Which Tax Rate is Applied
$0 $9,525 $0 10% 0
9,525 38,700 952.50 12% 9,525
38,700 82,500 4,453.50 22% 38,700
82,500 157,500 14,089.50 24% 82,500
157,500 200,000 32,089.50 32% 157,500
200,000 500,000 45,689.50 35% 200,000
500,000 150,689.50 37% 500,000

Tax Table for Taxpayers Who Are Married Filing Jointly

Here is the table for taxpayers who are married filing jointly for tax year 2018.

Taxable Income is More Than: But Not More Than: Fixed Part of Tax Tax Rate Threshold Above Which Tax Rate is Applied
$0 $19,050 $0 10% 0
19,050 77,400 1,905 12% 19,050
77,400 165,000 8,907 22% 77,400
165,000 315,000 28,179 24% 165,000
315,000 400,000 64,179 32% 315,000
400,000 600,000 91,379 35% 400,000
600,000 161,379 37% 600,000

How to Use Tax Tables

To calculate your taxes from these tables, you:

  • Determine the range in which your taxable income falls.
  • Take your taxable income and subtract the value in the last column.
  • Multiply the difference by the percentage in the second-to-last column.
  • Add the amount in the middle column.

For example, if you are single and your taxable income is $50,000, your tax is

($50,000 – $38,700) x .22 + $4,453.50 = $7,093.50

If you have dividend and capital gain income, the calculations are a bit more complicated as those types of income are sometimes taxed at different rates.

Key Points about Taxes as They Relate to Contributions

Let’s look at a couple of examples to see how Roth and Traditional retirement plans affect your taxes today. 

John’s Contributions

In the first example, John’s sole source of income is wages of $60,000.  He doesn’t have a lot of expenses to itemize, so takes the standard deduction of $12,000.  The table below compare the taxes he will pay if he makes contributions of $5,000 to either a Roth and a Traditional retirement plan.

Traditional Roth Difference
Wages $60,000 $60,000 $0
Deduction for IRA 5,000 0 5,000
Standard Deduction 12,000 12,000 0
Taxable Income 43,000 48,000 5,000
Tax 5,400 6,500 1,100

 

If we take the tax difference and divide by the difference in taxable income, i.e., $1,100/$5,000 = 22%, we get what is known as the marginal tax rate on your IRA contribution. A “marginal” rate is the amount by which the result changes if you make an addition or subtraction to one value in the calculation.  It differs from the average tax rate which would be the total tax divided by taxable income. For the Roth column, the average tax rate is 13.5%.  It is the weighted average of the 10%, 12% and 22% tax rates that are combined to determine your taxes if your taxable income is between $38,700 and $82,500.

The marginal tax rate will be important because it is the tax rate we need to evaluate whether you are better off making a contribution to a Roth or Traditional plan.

Jane’s Contributions

Let’s look at another example.  Jane’s situation is similar to John’s except she makes $90,000.  She also takes the standard deduction and has no other income. 

Traditional Roth Difference
Wages $90,000 $90,000 $0
Deduction for IRA 5,000 0 5,000
Standard Deduction 12,000 12,000 0
Taxable Income 73,000 78,000 5,000
Tax 12,000 13,100 1,100

Her marginal tax rate is also 22% (=1,100/5,000), calculated using the differences in the table above.

Key Points about Taxes as They Relate to Withdrawals

The key focus of the Roth vs. Traditional decision is how the marginal tax rate compares at the time contributions are made with the marginal tax rate at the time withdrawals are made.  So, now we will look at what John’s and Jane’s situations might look like if they were retired and making withdrawals.  For this part of the illustration, we will assume that there hasn’t been any inflation or changes in tax rates between now and the time they retire.

We will assume John’s Social Security benefit is $2,000 per month and he has expenses (including income taxes) of $60,000 a year in retirement.  His Social Security totals $24,000, so he needs an additional $36,000 from his retirement accounts to cover his expenses.  (He will actually need to withdraw more from a Traditional account to cover the taxes on his Social Security benefits and withdrawals, but I will ignore those for now as they add a lot of complication without having much impact on the conclusion.)

John’s Withdrawals

Let’s look at John’s tax calculation in his retirement.  As a reminder, a portion of your Social Security benefits become taxable if the value in the Test Sum row is greater than $25,000.  For more details on this calculation, see my post on Social Security benefits.

Traditional Roth Difference
Social Security benefits $24,000 $24,000 $0
Taxable Withdrawal 36,000 0 36,000
Test Sum = 50% of SS + Taxable Withdrawal 48,000 12,000 36,000
Taxable SS benefit 16,400 0 16,400
Adjusted Gross Income 52,400 0 52,400
Standard Deduction 12,000 0 12,000
Taxable Income 40,400 0 40,400
Tax 4,828 0 4,828

John’s marginal tax rate in retirement is 12% (=$4,828/$40,400).  He is better off if he contributes to a Traditional retirement plan, as he would reduce his taxes at a 22% marginal rate when he makes his contributions with the Traditional plans as compared to reducing his taxes at a 12% marginal rate when taking his withdrawals with the Roth plans.  That is, a Traditional plan is better if the marginal tax rate when you withdraw the money is less than the marginal rate when you contribute it.

Jane’s Withdrawals

Now we will look at Jane’s situation in retirement.  In her profession, most people she knows get significant raises between her age and retirement.  She anticipates that her salary will be more than $150,000 (before inflation) when she retires. With her higher income, her monthly Social Security benefit will be $3,000 or $36,000 a year.  Jane expects to have gotten accustomed to her higher salary so has estimated that she will have $120,000 a year in expenses.  She plans to save some money in taxable accounts (i.e., not in tax-advantaged retirement accounts) and will get a pension from her employer. These two amounts contribute $44,000 a year to her retirement income.  She will need to withdraw $40,000 from her retirement savings accounts to cover her expenses. Her tax calculation in retirement is as follows:

Traditional Roth Difference
Social Security benefits $36,000 $36,000 $0
Taxable Withdrawal 40,000 0 40,000
Other Taxable Income 44,000 44,000 0
Test Sum = 50% of SS + Taxable Withdrawal 102,000 62,000 40,000
Taxable SS benefit 30,600 23,800 6,800
Adjusted Gross Income 114,600 67,800 46,800
Standard Deduction 12,000 12,000 0
Taxable Income 102,600 55,800 46,800
Tax 18,914 8,216 10,698

Her marginal tax rate in retirement is 23% (=$10,698/$46,800).  In her case, her marginal tax rate in retirement is higher than when she makes her contributions, so she is better off putting her contributions in a Roth retirement plan.  That is, it is better for to pay the taxes at the lower rate before she contributes money to a Roth plan than to pay the taxes at a higher rate on Traditional plan withdrawals in retirement. 

How John’s and Jane’s Situations Differ

Jane’s situation differs from John’s in two ways:

  1. Her retirement expenses are expected to be much higher than her current salary, pushing her into a higher tax bracket in retirement than she is in today.
  2. She is funding some of her retirement expenses with other sources of income that are taxable which causes the marginal tax rate on her Traditional withdrawals to be higher than if all of her non-Social Security income were from her retirement plans.

How Taxes Have Changed

It is pretty clear that your spending when you retire would have to be much higher than your current income before a Roth retirement plan would be preferred under the current tax structure.  However, the tax structure changes frequently so it is impossible to know your marginal tax rate in retirement.  To shed some light on how much tax rates might change, I’ve compiled information from this site on historical tax rates.

Marginal Tax Rates Over Time

The graph below shows the marginal tax rate for four different taxable income levels: $40,000; $60,000; $100,000 and $200,000.  I adjusted these four amounts for inflation from 2018 back to each year shown in the chart. For example, the Social Security wage adjustment from 2000 to 2018 is 1.565.  I therefore looked up the marginal tax rate in 2000 for $25,559 (=$40,000/1.565) when creating the $40,000 line in this chart.

Tax rates prior to 1985 were much higher than they are today.  They were fairly constant from 1985 to 2014 with a few ups and down primarily at the higher income levels.  In 2015, the marginal tax rates for all but the $60,000 level in the chart increased. The increase for the $40,000 level brought the tax rate for people at that income to its highest level ever. In 2018, all of the tax rates decreased.

For people with taxable income in the $60,000 to $100,000 range, current tax rates are about as low as they have been in the past 35 years.  There is also a common sentiment that those with higher incomes should pay even higher taxes than they currently do.  Given the current financial condition of the Federal government, it seems more likely than not that tax rates will go up, making Roth plans more attractive.  One possible exception is people with lower incomes, e.g., at or below the $40,000 threshold in the graph, as their tax rates are high by historical standards.

How to Decide

Here are some guidelines you can use to decide whether a Roth or a Traditional plan is better for you. Characteristics that make a Roth plan better include:

  • Your salary and spending are likely to go up a lot before you retire.
  • You anticipate having a lot of taxable income in retirement, such as from a part-time job, a pension or savings not in a tax-sheltered retirement plan.
  • An expectation that tax rates will increase.

One suggestion I have seen that is interesting is to put some of your retirement savings in each of a Roth and a Traditional plan which you can do as long as the total doesn’t exceed the limit on contributions.  In this way, a portion of your retirement savings is protected from large increases in tax rates, but you still have the benefit of reducing your taxes now. This approach is similar to what I did. All of my 401(k) savings is in Traditional plans, while my IRA savings is all in a Roth plan.


[1]Here is a quick explanation of the (1 – tax rate) term in these formulas.  The pre-tax value is Contribution x (1 + compounded investment return) which can be thought of as Contribution x (1 + compounded investment return) x 1.  The tax on that amount is equal to Contribution x (1 + compounded investment return) x tax rate.  To get the after-tax return, we subtract the tax from the pre-tax value.   When we pull out the common term and group them (i.e., apply the distributive property of multiplication over subtraction for you math geeks), we get Contribution x (1 + compounded investment return) x (1 – tax rate).

Investment Options in Retirement Savings Plans

All investment decisions are a trade-off between risk and reward. In this post, I’ll focus on how risk and reward affect your decision among the investment options in your employer-sponsored retirement plans.

If you look at returns over very long periods of time, well diversified, riskier investments tend to produce higher returns with lower risk. For most of these investments, “a very long period of time” is somewhere between 10 and 30 years. That doesn’t mean that the riskiest investments will always outperform the less risky investments in every 10 or 20 year period, but, if you look at enough of them, they generally will on average.

When I Take More Risk

Very briefly, three characteristics I use to help decide whether I want to lean towards a more or less risky investment are:

    • With only a small amount to invest, I will tend to be purchase less risky investments than if I have a larger amount because I have less of a cushion and I want to protect it.
    • When I know I will need the money very soon, I invest in less risky investments (or possibly keep it in a savings or checking account). With longer time periods, riskier investments have more time to recover if they have a large decline. If I need the money soon, I might not have enough money for my purchase if the values declined.
    • If I have almost as much money as I need for a purchase that isn’t going to be made for a while (for example when I had enough money saved for my children’s college education), I will purchase less risky investments as I don’t need a high rate of return to meet my objectives and also want to protect my savings.

    If you aren’t comfortable with the concept of risk, I suggest looking at my post on that topic.

    Common Choices

    Commonly available investment options in employer-sponsored retirement plans are listed below. I have put them in an order that roughly corresponds to increasing risk.

    • Money market funds – Money market funds invest in what are considered short-term, liquid (easily sold) securities. They are similar to, but slightly riskier than, interest-bearing savings accounts.
    • Stable value funds – A stable value fund usually buys and sells highly-rated corporate or government bonds with short to intermediate times to maturity. The return on a stable value fund is the sum of the changes in the market value plus the coupon payments on the bonds held by the fund.   Because stable value funds tend to buy bonds with shorter times to maturity than typical bond mutual funds, they often have lower returns and be less risky.
    • Bond Mutual Funds – Bond mutual funds buy and sell bonds. The return on a bond mutual fund is the sum of the changes in the market value plus the coupon payments. Although they don’t track exactly, the market values of bonds tend to go down when interest rates go up and vice versa.
    • Large Cap Equity Mutual Funds – These funds buy and sell stocks in large companies, often defined as those with more than $10 billion of market capitalization (the total market value of all the stock it has issued).
    • Small Cap Equity Mutual Funds – These funds buy and sell stocks in smaller companies.
    • Foreign Equity Mutual Funds – These funds buy and sell stocks in foreign companies. Every foreign equity fund is allowed to define the countries in which it invests.   You’ll want to look to see in what countries your fund options invest to evaluate their level of risk.
    • Emerging Market Equity Mutual Funds – These funds buy and sell stocks in companies in countries that are considering emerging markets. Morocco, the Philippines, Brazil and South Africa are examples of currently emerging markets.

    Other Choices

    Some employers offer index funds which are variations on equity mutual funds. An index fund’s performance tracks as closely as possible to a major stock market index. The Dow Jones Industrial Average, the Standard & Poors (S&P) 500 or the Russell 2000 are examples of indices. The first two indices have risk and return characteristics somewhat similar to large cap equity mutual funds. The Russell 200 is more closely aligned with a medium or small cap equity mutual fund.

    Increasingly, employers are offering Target Retirement Date Funds as an option. The fund manager not only selects the individual securities that will be owned by the fund, but also chooses the mix between equities and bonds.   In theory, the number of years until the target retirement dates for that fund determines the mix of investments. For example, a fund with a target retirement date range of 2021 through 2025 might be invested more heavily in bonds than a fund with a target retirement date range of 2051 through 2055. People who are close to retirement are often more interested in protecting their investments (i.e., want less risk). On the other hand, people who don’t plan to retire for many years are often more willing to take on additional risk in exchange for higher returns. You can accomplish the same mix yourself using bond funds and equity funds, but some people prefer to let the fund manager make that decision.

    Some employers allow or require you to invest in company stock in their defined contribution plans. Many of these employers consider an investment in the company’s stock as an indication of loyalty. I view it as a very risky investment option. I discuss the benefits of diversification in this post. If your investment portfolio is diversified, it means that a decline in value of any one security will not adversely impact the total value of your portfolio too severely. If you purchase your employer’s stock, you are investing in a single company rather than investing in the larger number of companies owned by a mutual fund. In a really severe situation, you could lose your job and the stock value could drop significantly, leaving you with much smaller savings and no salary. As such, you take on much less risk if you select a mutual fund than company stock.

    How I Decided

    As I made my 401(k) investment selections, I thought about what other investments I had, if any, and used the 401(k) choices to fill in the gaps. That is, I used my 401(k) investment selections to increase my diversification. When I was young, I selected two or three funds that had US exposure to each of small and large cap equities. As I had more money both in and out of my 401(k), I still selected two or three funds, but invested in at least one fund with foreign or emerging market exposure to further diversify my holdings.

    Fine Print

    As a reminder, I am not qualified to give investment advice for your individual situation. Nonetheless, I can provide insights about the types of investment options I’ve seen in employer-sponsored retirement plans. I’ll describe the characteristics of most of these investment vehicles in more detail in later posts, but want to touch on them now as many of you will be making employee benefit elections before then.