How about another mental exercise on taxes? I usually enjoy Christine Benz’s articles on Morningstar, and When Taxes Collide With Your Asset Allocation was no exception. She presents the following scenario:
Let’s say a 65-year-old woman is prepping her portfolio for retirement. Her assets are ultra-streamlined, with a $500,000 Roth IRA account containing stocks and $500,000 in a traditional IRA portfolio consisting of bonds.
Is her asset allocation:
a) 50% bonds and 50% stocks
b) Heavier on stocks than bonds
c) Both of the above statements are true.
The basic premise of the article is that because she has to pay taxes on withdrawals from her Traditional IRA accounts at ordinary income tax rates, while not owing any taxes on her Roth IRA accounts, the woman effectively has more exposure to stocks than bonds. I agree that taxes are an important facet to consider.
However, Benz makes a quick assumption that her federal income tax rate is 25%. Here we meet the difference between marginal and effective overall tax rates, as well as the difference between gross and taxable income, in our progressive tax system. While the woman’s marginal tax rate may be 25%, unless she has a lot of outside income, her effective tax rate on those bond withdrawals would be much less. In fact, my wife and I would like to pay zero taxes in retirement with a similar portfolio.
How? Let’s say we are a couple both age 65 as in the example, which is over 59.5 we can start taking withdrawals without penalty. We have no pensions to rely upon. Like above, we have $500,000 in Roth IRA and $500,000 in Traditional IRA. With 401k plan rollovers and regular IRA contributions, this is not unrealistic. With a 4% withdrawal rate that is $40,000 a year, let’s say $20,000 from both.
What taxes do we owe? The $20,000 Roth IRA withdrawal is tax free. Now onto the $20,000 Traditional IRA withdrawal. Well, since this isn’t earned income, you won’t have to pay any payroll taxes like Social Security and Medicare taxes. For 2012, the standard deduction for a married filing joint couple is $11,900 plus $1,150 per person for being 65+ and the personal exemption is $3,800 per person. That adds up to $21,800. That’s more than $20,000, so our taxable income is zero! In fact, the first $17,400 of taxable income is taxed at the 10% bracket, so your total withdrawals could total up to $39,200 and still owe an overall percentage less than 5%.
As always, there are things that could skew the math. You might have a pension. There’s also the possibility of state income taxes, although if we take California the effective tax rate would less than 1%. Finally, Social Security benefits could create a greater tax liability, although it might be wise if you’re healthy to defer Social Security until age 70 to maximize the payout of what is effectively an inflation-adjusted lifetime annuity.
When you contribute to a Traditional IRA, you take the tax break upfront and pay taxes later. When you contribute to a Roth IRA, you pay taxes now and take withdrawals tax-free after age 59.5. Keep in mind this example when choosing as by carefully mixing the two, your effective tax rate in retirement may be lower than you think.