Notes from "Two Key Concepts for Wealth Management and Beyond" Financial Analysts Journal.
Tax deferred accounts are like partnerships in which the investor owns (1-t) of the partnership principal and the government owns the remainder, where t is the marginal tax rate when the funds are withdrawn. The government shares in both the return and the risk of assets held in taxable accounts.
A dollar of pretax funds in a tax deferred account is less valuable than the same amount in a Roth. The type of account in which an asset is held affects the portion of the asset's risk borne by the investor and returns received by the investor (due to taxes).
Tax deferred accounts (TDA): 401k, 403b, Individual IRA, SEP, SIMPLE.
Tax exempt accounts: Roth, 529.
In an estate planning context, a tax exempt account analogue is making a taxable gift that would trigger an imminent transfer tax in exchange for not paying a transfer tax upon the donor's death.
A tax deferred account is analogous to a limited partnership in which the investor is like the general partner and owns (1-t) of the partnership interest, and the government is the limited partner and owns t of the partnership interest. As the general partner, the investor gets to decide where the funds are invested and when they are withdrawn subject to RMD. The investors true economic interest in a tax deferred account is 1-t. The after tax value of the tax deferred account grows tax exempt, not tax deferred. The individual investor receives 100% of pretax returns and bears 100% of the risk on after tax funds in a TDA.
The government shares in both the risk and return on assets held in taxable accounts. Investors bear less than 100% of the risk and receive less than 100% of the returns in taxable accounts.
The difference between the risk and return sharing characteristics of a tax deferred account and a taxable account is driven by the difference in the tax base of the two structures. Tax liabilities for tax deferred accounts are a proportion of principal value. Tax liabilities for taxable accounts are based on incremental returns.
You've got to look at TDA on their present after-tax value to get asset allocation right. An after tax portfolio optimization procedure will simultaneously solve both the asset allocation and asset location decisions. Result: hold bonds in retirement account and stocks in taxable account. The best assets to hold in the taxable account are those that make the best use of the preferential long term gains tax treatment, ie. equities. Also, in an after tax optimization environment, a larger portion of stocks are allocated in the portfolio.
The present value of the future tax liability is smaller for high risk assets than for low risk assets. Although the future value of the tax liability of a TDA is likely to be greater when the account is invested in stocks, the tax liability must be discounted at a higher rate which exactly offsets its higher future value and nullifies the notion that locating assets with higher expected returns in TDAs shelters the investor from paying more taxes.
Choosing the proper savings vehicle simply reduces to comparing the marginal tax rate today with the expected marginal tax rate when funds are withdrawn. If the prevailing tax rate when funds are withdrawn is less than the tax rate when they are invested, the TDA will accumulate more after tax wealth than the tax exempt account, et vice versa.
Contribution limits effectively allow an investor to shelter a larger investment of after tax funds in a Roth 401k as compared to a regular 401k. Contribution limits favor the use of Roth 401ks.
Rule of thumb: an individual who expects to have a 25% tax rate during retirement should, in general, convert sufficient funds to take this year's taxable income to the top of the tax immediately below 25%.
The government's partnership interest and risk sharing roles also manifest themselves in optimal withdrawal strategies. As a rule of thumb, you should withdraw funds from the taxable account before the retirement accounts. The proper way to view the effective tax rate is that it is zero for funds held in TDAs and Roths and positive for funds held in taxable accounts. By retaining funds in retirement accounts as long as possible, you will receive a higher after tax rate of return. Some exceptions to the rule: if taxable assets have a very low cost basis; if you have a short life expectancy (it would not make sense to realized capital gains when they could have been avoided due to the step up basis on death); when there is opportunity to withdraw funds from the TDA in retirement when your marginal tax rate is less than the rate at which you contributed funds (ie. due to large charitable contributions, large medical expenses). In retirement withdrawals from taxable accounts are taxed at the capital gains level and should be supplemented with withdrawals from retirement accounts up to the marginal tax rate at which TDA contributions were made.
Remember, the size of the government's partnership interest in a TDA is determined by the tax rate and not by the timing of the withdrawal.
A combination of TDAs and tax exempt accounts in retirement can be advantageous because it provides the flexibility necessary to design the optimal withdrawal mix in the then prevailing tax environment.
Related to the gifting assets now or bequeathing them later issue: Foregoing the gift of an asset that would trigger an transfer tax in favor of a bequest that would trigger an estate tax upon the donor's death is analogous to investing in a TDA. Conversely, opting for a bequest in lieu of a gift is analogous to investing in a Roth.
Asset Location: individuals should locate lightly taxed securities in taxable accounts and heavily tax securities in retirement accounts to the greatest degree possible, while maintaining their risk return preference.
Choice of Retirement vehicle: in general, if the marginal tax rate in retirement is expected to be lower than this year's tax rate, then the individual should save in a TDA.
IRA-Roth conversion: if this year's marginal tax rate is lower than the expected retirement withdrawal tax rate, it pays to convert funds to a Roth account this year. The optimal conversion amount would push an investor to the top of the tax bracket just below their estimated marginal tax rate in retirement.
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