Who Owns Your Money You or the Government or Harvard?

I wrote a response to a forum I infrequently visit about Roth conversion. The math types all were going through their analysis on why it doesn’t really make a difference bla bla bla, but they entirely missed the point of what money is about. You work hard, turn your human capital into value and stash some of that value into an account or two or three. That value doesn’t belong to you. It belongs to you AND the government. How that value is treated is a function of the account type in which you stash that value. If you put it in a post tax account it’s probable ongoing source of income for the government. You pay taxes on the ordinary income to start, stash what’s left and if it generates more value you are taxed again on the new value either as dividend or capital gain. If you loose the government doesn’t charge you for your pain and they give you a credit to charge against future profit. You can stash your value in a TIRA, an account that postpones your payment to the government, but make no mistake part of that value belongs to the government and it’s coming out at the most expensive tax rate, “ordinary income” Pound of flesh time. Ordinary income is progressive. The more you make the higher the “tax rate” not just the higher “the tax”. The effect is a “multiplier” not just a linear “adder” Double the income does not mean double the taxes it means 2.5x or 3x the taxes or more if you start adding surcharges and taxing cliffs. The third place you can stash your value is a Roth. With a Roth you square with the government once and then they leave you alone. You can withdraw without a progressive tax burden of either TIRA or post tax accounts. You can stash value in things like real estate or art or gold but similar tax burdens apply as post tax accounts.

The government has another trick. At age 70 BY LAW they start collecting their money from your TIRA on their schedule and you don’t have any say in it. The calendar rolls over and a predetermined increasing % of your TIRA must be extracted. The % extraction is progressive i.e. a multiplier. In addition as the distribution increases the tax increases as a multiplier because the tax code is progressive, so it’s multiplier times multiplier and you don’t have a thing to say about it. The government is nice and they don’t start this extraction till 70 so you’ll probably expire before your money expires but none the less the government is coming for their money at their leisure not yours. IRA like accounts are marketed such that you can stash value and avoid a high tax rate you may pay on the value immediately in order to subject yourself to the double multiplier effect later and the bet is your tax rate will be lower in your old age so the net result is you MAY pay less but then again you MAY not. It’s a bet! The control variable is the size of the amount of value in the TIRA.

The tax deferment is a middle class perk used to incentive retirement saving. As you make more the incentive disappears, in other words if you’re rich you get soaked today instead of in your old age. At some point the government realized this was a pretty good way to fleece the middle class so they set up a million “tax deferred” vehicles each with it’s peculiar tax treatment and extraction methodology and spending rules. Save for college? No problem 529b, can only be used to transfer wealth from you to something “accredited” Oh happy day if you’re a university. Jr gets drunk for 4 years on your nickel and Harvard’s tuition goes up at slightly above the rate of market return because that’s how much is in your 529b and they want the whole shooting match and you think what a fine deal. Your money grew for 20 years tax deferred just so Harvard could gobble it up, but you didn’t save enough and wound up with a student loan anyway and Jr graduates with a piece of paper and a hangover and a payment schedule, and you feel bad like somehow you failed. NEWS FLASH it was rigged against you. 529b’s are Harvard’s friend not your friend. The point being these tax deferred accounts are not necessarily your friends, yet how many times have your read “max out your tax deferred accounts it’s a no brainer”? You have to think through the liabilities and who benefits in the end.

Value is good for one thing: keeping you comfortable and alive, from your point of view. From the governments point of view your value is good for funding itself under penalty of law, and given the debt the sooner the better! So lets say you followed conventional wisdom and maxed out your retirement accounts. You did well and have a big wad in tax deferred money. You can max out something just shy of 80K/yr in tax deferred accounts. In 25 years you will own 3M+ of tax deferred money! At a 4% WR that’s $10K/mo baby plus SS to boot! Hubba Hubba! So you retire at 62 and take 80% of SS (say 25K) plus your $10K. Your accounts make 6%. 10K/mo is slightly above RMD on $3M. Your tax bill is $17,600 on your netted out TIRA + SS income of $141K/yr or 12.5 cents on the dollar You hit age 70 and the RMD for 8 years into retirement is 164K plus your SS net so your income is 185K and your tax $27,299 or 14.8 cents on the dollar.   At age 75 your haul is 240K and your tax $40,419 or 17 cents on the dollar.

At 76 you get cancer and you beat it! But it takes 4 years at and extra $100K/yr expense. Your RMD at age 80 is 284K plus you had to take out an extra 100K so your tax that year on $384K is $78,500 or 20 cents on the dollar. Now your wife gets cancer and in 5 years she beats it at 100K/yr so at age 85 your pulling 482K out of the TIRA with a tax of $111,800 for 24 cents on the dollar. 

Back when you were 65 you could have pealed off a million or two at a lower tax rate doing a Roth conversion. 250K/yr conversion (1M) would have cost you 17 cents on the dollar and then your done. Your TIRA would RMD at a far lower rate. 120K at age 70 with a 10 cents on the dollar tax  at 75 $165K with 14 cents on the dollar at 80 $210K income with 15.7 cents on the dollar tax and at 85 $261K income at 17.4 cents tax You and your wife still get cancer and you still beat it but you pay the extra from the Roth tax free and enjoy lower taxes on your TIRA distribution as well.

That’s the real advantage of Roth conversion is you are prepaying for disaster coverage and tax free growth as opposed to tax deferred growth at a relatively low rate. In addition if you die your wife is left with paying single rates on her taxes so in her 86th year the 2M + 1M Roth payout would cost her on a 261 K RMD income 23 cents on the dollar On a 3M TIRA the RMD would be 397K and 28 cents on the dollar  

So the calculation is colored by how the money is used and how rapidly it is needed. TIRA retirement is about doling out small aliquots of money and letting the “interest” pick up the slack. If bad things happen and you’re TIRA you are locked in with no flexibility. The government is coming for their money.

4 Replies to “Who Owns Your Money You or the Government or Harvard?”

  1. So how should we invest?
    I think I follow this and agree, but I’m not sure.
    I have 529 accounts and get an annual tax credit. I’ve been happy with that so far.
    I have Roth IRAs and a Roth 401K. Most of my investing is outside of tax-favored accounts.
    So that’s all good, right?

  2. Hi WD.

    Rule 1: If the government gives you a “special deal” it’s for their benefit. Welfare is to get votes. SS is to get votes, as in accumulate power, 25 trillion in debt is to ward off revolution. France decided to raise taxes and they burned the place down.

    So let’s take the case of “college”. The market grows at 4%, which means a 529 grows at 4% College cost grew at 4% over inflation. Coincidence? If you don’t have a 529 we got a special loan deal a 4.5% to 7% but once in you can’t go bankrupt. Pay me now, pay me later you get a 4 year drunk and a piece of paper, I get all the loot. We got the government to give you a “tax write off” to entice you to save and then send us all the money. Sound about right? In the mean time you need $1M of life insurance just in case so Warren Buffet gets his cut too.

    When I adopted my daughters I did it differently. My state offered 120 credits hours of tuition and fees for $22,500 at any state school from U of F on down the line. So I bought each of them “college”. Their choices were limited but not really since chemistry is chemistry. and I let the school eat the inflation. I could have died the next day after the check cleared and college was paid for. I cheated Warren out of his money. The next year after I bought the tuition I put $20K into a UGTM in “low cost Vanguard index funds”. A UGTM does not grow tax free but if you do it right the taxes are trivial. At 18 the money becomes theirs, but I didn’t tell them about the money I just used it for their benefit. The 20K grew over 19 years to about $75K and I spent down the money about $15K/yr or $1200/mo. The money was growing while I was spending just like a retirement. My kids always had everything they needed in college, spent a semester abroad, vacations, electronics, clothes etc. Upon graduation I took what was left and bought a car for them to get their life started. So college cost me $42,500 each and my kids came out cum laude, are employed and debt free. Each of them has side gigs that make money and know how to manage their money. The best part was I never had to tell them no. When they wanted something, the want was reasonable and affordable. The plan was in place from age 3 and self sustaining. If I needed to I could add some money at the end or not buy a car etc as the plan would at least pay most of the cost even in a down economy. The plan wasn’t over funded or underfunded but properly funded and it wasn’t over risked or under risked but properly risked and had risk management contingencies built in. The plan was retirement practice. The tuition was like SS a subsidy funded by the school. I paid in 22,500 and got a lot more back. The UGTM was like a portfolio. It paid out a little bit each year while it continued to grow and funded their lives without affecting my cash flow. The end game and contingencies were planned before I spent the first dollar. I was not impressed with the “tax deferred” 529 boilerplate.

    In my opinion to retire you need 6 accounts

    1. Taxable account
    2. Roth account
    3. TIRA especially matched IRA
    4. Tax loss harvest
    5. SS
    6 HSA

    Each of these has a different tax treatment and allows you freedom to maneuver in retirement, and allows different optimization.

    Let’s say you want to Roth convert. To do that you want no income so all of the taxes you pay go to the cost of conversion. To live on no income you need cash to pay for your hamburgers and to pay those conversion taxes. To get cash you need to sell some appreciated stock from the Taxable, but that generates cap gain tax. You take some tax loss and mix it with your cap gain and get your cash tax free. It takes 20 years to bring this plan to fruition. You have to invest and tax loss harvest but in 20 years there is ample opportunity to do that.

    Why Roth convert? TIRA’s are forced to RMD and the government wants their money on their schedule. If you play with the schawb RMD calculator you see big TIRA spins off big RMD and therefore big taxes. Small TIRA spins off small RMD and small taxes so if you optimally move some TIRA at a low tax rate (while living on cash) to the Roth, later on your taxes due to RMD remain in the low bracket for a long time. Maybe not forever but say 15 – 20 years. In addition by being in a low bracket if you die your wife stays in a lower bracket. Planning the Roth conversion goes back to step 1 funding the taxable and doing the TLH.

    Why own a Roth beside lowering your tax bill? It acts as insurance against extraordinary expense. Everybody is going to die and dying can be quite expensive and if there are 2 spouses the cost is 2x. Sandra Day O’Conner retired from the supreme court to take care of her husband who had Alzheimer’s. Alzheimer’s is about a 12 year disease and those 12 years need to be funded. She’s 85 now and her husband is dead and she was just diagnosed with Alzheimer’s. If you’re a woman and you live to 65 your chance of living to 90 is 30% and to 100 1.5% so she has a good chance of living 10 years into her disease, so just like the UGTM for my kids a Roth can provide a long term pay down for your old age. In my opinion this account is considered separately in the portfolio from you’re WR money, and should be left to grow untouched over decades. If you don’t use it, good deal. If you do use it, good plan. You don’t need to convert everything just enough so it can grow nicely. There is an optimized trade off between now taxes and future taxes but if insurance is the point tax optimization is less important.

    What’s your WR money? That comes from taxable, SS, and residual TIRA allowed to RMD. If you analyze the tax code people with small RMD’s are pretty much left alone by the government. If you’re married filing jointly you can make $104K/yr and still be in the 12% bracket including deductions and your average tax rate on $104K is only 8.5 cents on the dollar. SS is taxed at 85% so if your SS is say $50K you are taxed on $42.5K leaving $61.5K to be filled until the next tax bracket. SS does go up with inflation and RMD goes up on an increasing schedule so eventually you will inflate your way into the next bracket but it can take a long time say 15 years depending. So you make your $42.5k your first year and you have say 600K left in the TIRA. You leave the TIRA in bonds since you need some bonds in your portfolio and bonds provide steady low interest growth. I read the average middle class retiree retires with about $600K in an IRA so the tax code is likely designed to not gouge this guy. If you have 4M in the TIRA get ready to be gouged. VBMFX paid a little over 4% for the long term so I use 4% as the rate of return for the schwab calculator. The first year a 600K TIRA RMD at 4% pays out about 23K taxable and SS pays out 50K of which 42.5 is taxable so your net tax liability is 65.5K and you gross income is 73K, Your tax on that 73K income is $4287 or 5.8 cents on the dollar. Lets say you have 2M in your taxable account and you want 100K to live on, that means you have to take $27K out of the taxable to get up to 100K (73K + 27K) Since cap gain on that 27K is zero while in the 12% bracket you’re WR from the taxable is 27K/2M or 1.35% and you’re net net tax bill on that 100k of income is 4.2 cents on the dollar. Each succeeding year you come closer to moving to a new bracket and a little higher taxes but it takes a long time. Let’s say you need a new car at 30K so you take 30K additional out of taxable for 57K or a one time WR of 2.85%! Big whoop. Once you move to the 22% bracket the TLH kicks in and you still withdraw your taxable tax free until that TLH runs out. If you did it right you’re dead long before that happens. In my case over 30 years of investing, I TLH’d about 500K and still have 250K left. I sold about $600K of appreciated stock and turned it into cash to live on while I Roth convert and wrote off $120K of taxes. I TLH’d another 20K last week. I’ve converted 250K of an eventual $1M which is not part of my WR calculation but is insurance.

    So by planning my end game all the way out till age 90+ and planning for my wife and the likely contingencies like the cost of dying and understanding the tax law and having multiple tax choices by having different accounts, I reduce my tax exposure and avoid the cattle chute of RMD and the fairy tale of “tax deferred growth”. TAX deferred growth works out only with a small RMD. Understanding “all the way out” changes the amount you need to accumulate. Understanding all the way out changes how you view risk and the risk you take in retirement. None of this 100% stocks nonsense for this daddy-o Understanding all the way out gives you a much clearer picture of when you can retire instead of some dumb assed 4 x25 equation. Understanding all the way out means there isn’t much hand waving when it comes to pretend or half assed side gigs that may or may not work and take up all of your retired time even though you “love them’ which is a total BS rationalization anyway. OH I LOVE BEING AN UBER DRIVER! I FEEL SO FREE AND FULFILLED!!

    That’s what I’m doing with my retirement. So far the plan is working exactly according to schedule. I sold my stock last December at the market high. My portfolio is now closed to SORR since nothing else is coming out for 5 years. My cost of Roth conversion is fixed and known and will be about 12 cents on the dollar. I continue to do things like TLH and optimize. It turns out if you Roth convert when the market is down you can convert a larger amount of your stocks at a lower price and wind up saving on the taxes. Buy low, sell high, transfer low. Living on cash reduces my over all AA for the first 5 years of retirement which is desirable and as I spend the cash my AA will gradually glide back up. When I hit 70 Roth conversion will be done, I will RMD and take SS and re-evaluate my situation with regard to my needs at that time. I will probably do that again at 75 or 77 as my wife’s longevity comes into focus, so my portfolio is iterative and not based on 4th grade algebra. In the mean time I track my expenses and I experimented with spending by testing what “belt tightening” felt like and by exploring my bottom baseline expense categories like taxes and insurance. I also have a HSA which I’m using to pay Medicare and there is enough projected to buy about 17 years of medicare for me and my wife all growing tax free (not tax deferred)

    This isn’t to say my plan is THE plan, it’s just to point out following your plan to the end informs your decisions at the beginning, and those decisions decades earlier can make things easier or safer. I only had access to a HSA for a few years for example but when I did have access it was clear a few years of HSA compounded is a useful thing. I stopped funding IRA accounts in my 50’s and started aggressively funding taxable accounts as I hit on the idea of Roth conversion. I was going to convert all of my IRA into a Roth to the top of the 24% bracket which is most tax efficient, but found something smaller had a smaller conversion cost and I could leave more invested in the taxable to grow and RMDing a small TIRA had only a diminishing worsening in my tax situation on going so the opportunity for growth was worth more than a couple extra cents saved on taxes. In this case the TIRA once RMD’d is acting a bit like an annuity. If I didn’t have the TLH it would change the calculation considerably.

    It’s certainly the case retirement is NOT one size fits all. I also analyzed the likelihood of portfolio failure using advanced tools not 4th grade algebra or rearward looking analysis of the past. Plenty to think about for sure.

  3. My eyes popped out when I read that you planned 20 years out. My kids are living in the multiplex I bought when my daughter was 2 years old. They are certainly living my plans for them now.

    I often plan 20 years out. If you do, you start to study the risks much better.

    I also have hundreds of thousands in tax loss harvesting. It allowed me to take out a piece of real estate more tax efficiently.

    And I also tax loss harvest 18K last week. Dang it, we are living sorta parallel lives Gasem.

    Plan till the end I say. No one is getting outta this alive!!!

    1. Hey MB

      What helped was journaling my extended family’s financial history. If you traced their lives like grandparents and great uncles you can tend to see how things play out. I had a couple uncles that RE and had businesses one grandfather that was an executive and built things like shopping centers he wasn’t an owner though so he retired on a pension. My Dad was the only one in the next generation so he got to look after my grand mother and aunt who dies about 90 and he had to dispose of their property. I’m oldest so I was somewhat involved at least in seeing how things were laid out financially and how they lived and died. My job (also my pleasure) is taking care of my Mom so I see how my Dad did his finances. My Bro runs her finances but I run the estate and she retired to my town so we take care of her and are involved with the day to day even though she lives in her own place. The other kids live in UT, so all of that informs as things play out and life isn’t like a Taylor Larimore book. You also get clues as your friends parents pass on. Since I’m a physician a lot of that end of life stuff is shared with me and I can kind of guide them in terms of prognosis and natural history as they navigate their problems. After a while you can start to judge what’s important to think about.

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