Tax and Personal Finance Nerds needed! Investment method comparison spreadsheet

Hey All - I was reminded of the work I did on this for my own understanding about a year ago. Please check my method and understanding. Note this is all based on current law and I cannot predict the future changes in that arena.

OK. My goal was to compare what you can do with a dollar, and what place it would have the best impact. The 4 'vehicles' I compared were: Invest it in a 401k/403b/Traditional IRA, Invest in a Roth account, use the dollar to pay income taxes to convert existing 401k to Roth, and then just a regular investment account. I tried to normalize everything assuming you have access to the same funds/fees/ return rate, etc in all vehicles. I also normalized by saying the investment was an 'after tax dollar' or essentially a dollar from your paycheck. If you invested in the 401k, it would be inflated by the tax savings, so the $1 invested would actually be the pre-tax amount you would be able to invest (more than a dollar). Similarly the roth conversion isn't actually investing anything, it's taking the dollar to pay the required tax to convert pre-tax money to Roth.

Looks like this (you can change the variables on the right and see the results on the bottom of the left):

What we learn is that if your tax rate is the same at withdraw as it is when you deposit, there are differences in total tax paid, but no difference to your bottom line. Perhaps obviously, if you pay more in taxes now than when you withdraw, the 401k is best. And if you pay more taxes at withdraw, then conversion is best.

Also, perhaps less intuitively, if you need to withdraw before age 60 and therefore pay a penalty, the Roth investment account wins (unless maybe you have a large difference in current and future tax rates):

So now that we see the results, let's talk about the methodology (because this is what I want to double check).

401k: If you invest a post tax dollar here, you actually get to invest the pre-tax dollar (assuming you haven't yet hit the annual limit), so I take the dollar and mark it up based on the current tax rate. Money grows at standard growth rate for the number of years between age withdrawn and deposited, and taxes are calculated on the withdrawn tax rate and the entire pre-tax amount. If the age withdrawn is less than 60 there is also a 10% penalty assessed on the gains only.

Roth: If you invest the dollar here, the pre-tax account and post-tax account grown individually. Taxes on withdraw are only calculated on the pre-tax amount. If early withdraw penalty applies, it applies only to the gains.

Convert to Roth: This one is a bit tricky. This is saying you use the $1 to pay taxes on converting existing pre-tax to post-tax (and assuming you have enough pre-tax to convert). So the $1 is not invested. Rather I use the tax rate to figure out how to split the pre-tax amount into pre and post tax accounts. From there i follow the Roth methodology.

Standard: Should be simple. The pre-tax account stays, and there is no post tax account, but there is a separate 'pre-capital-gains' account. You'd pay withdraw tax rate on the pre-tax amount and you'd pay capital gains rate on the gains in the 'pre-capital-gains' account. The early withdraw penalty only hits the pre-tax balance only.

Question: Does the early withdraw penalty apply 'before' the taxes are calculated or 'after'? ie are you taxed on the amount before penalty or after?

In conclusion, this isn't the whole story, as it doesn't even start to get into the RMD discussion. It also leaves out investment vehicles like your primary residence (essentially a roth because it is post-tax money that is not subject to capital gains tax). But what we do see is that unless there is a large difference between the tax rate you pay now and the rate you pay later, all methods work out pretty similarly for you.

tl;dr - invest your saved money somehow.

If you want the spreadsheet pm me I can send a copy. Also, please let me know if I've got something wrong or should add something. I'm thinking a feature that let's the user control the withdraw amount would be good, as that absolutely does change the results (if you don't need to withdraw the entire balance).

Can't see the pictures on the network I'm on, so I'll defer commenting on much here, but some general thoughts: 

- If available, you should really be looking into an HSA: https://www.madfientist.com/ultimate-retirement-account/

- Best description of getting the funds early: https://www.madfientist.com/how-to-access-retirement-funds-early/

- Another article on it: https://www.madfientist.com/traditional-ira-vs-roth-ira/

- My way of attacking it is that I believe taxes will never be lower than they are right now. Because of this I am putting everything into Roth accounts (both IRA and 401k, I'm lucky to have that option). If I had a higher income, I would put everything to traditional only until I got below the 22% tax bracket. If I had significantly higher income, I would be maxing accounts, putting towards regular taxable accounts, and not worrying about it too much. 

I think this is your faulty assumption:

if your tax rate is the same at withdraw as it is when you deposit...

Everyone assumes their tax rate will be lower when they withdraw.  Not necessarily true.  It WILL be different, but not necessarily lower.

Robbie said:

Hey All - I was reminded tl;dr - invest your saved money somehow.

 

Good advise. In the next episode you can show us how to save money by not spending it on dumb stuff like fender flares. 

Personal finance is one of my favorite topics. Although it is often a topic people my age think is taboo and don't like to talk about. Often my friends parents really never talked to their children about managing money because they didn't know how to do it themselves.  I'm the go to guy for financial advice in my friend group.  

mtn said:

My way of attacking it is that I believe taxes will never be lower than they are right now. Because of this I am putting everything into Roth accounts (both IRA and 401k, I'm lucky to have that option). If I had a higher income, I would put everything to traditional only until I got below the 22% tax bracket.

 

this x1000.  put everything you can into Roth when you're in a low tax bracket.

Ooooooh....Fender Flares.....  neeeeed....

Andy Neuman said:

Robbie said:

Hey All - I was reminded tl;dr - invest your saved money somehow.

 

Good advise. In the next episode you can show us how to save money by not spending it on dumb stuff like fender flares. 

 

Personal finance is one of my favorite topics. Although it is often a topic people my age think is taboo and don't like to talk about. Often my friends parents really never talked to their children about managing money because they didn't know how to do it themselves.  I'm the go to guy for financial advice in my friend group.  

I will absolutely not be recommending to skimp on fender flares.

Andy Neuman said:

 Often my friends parents really never talked to their children about managing money because they didn't know how to do it themselves. 

Everything I've learned had to be through outside sources like Youtube or articles and lots and lots of Googling. My dad, who's 47 or 8, never taught me anything about managing money, just spending it.

If I knew how important saving money and investing was when I first got out of high school, I'd be a lot better off than what I am currently when it comes to my retirement accounts.

In reply to mtn :

As always a very helpful reply. Thanks!

I don't have an HSA because my wife has employer converage that is amazing and cheap. I do have the option of getting an HSA through my own work, but then I would not be covered by her insurance. 

I at first wrote the HSA idea off because of not being on the excellent insurance, but I may rethink that.

Robbie said:

In reply to mtn :

As always a very helpful reply. Thanks!

I don't have an HSA because my wife has employer converage that is amazing and cheap. I do have the option of getting an HSA through my own work, but then I would not be covered by her insurance. 

I at first wrote the HSA idea off because of not being on the excellent insurance, but I may rethink that.

It is hard to comprehend. Even though I consider personal finance to be among my favorite topics of research and conversation, and had done a ton of research into it, I did NOT understand it at all until I had $1M (before insurance, $10k after) in hospital bills staring at me. Just because it is the ultimate account does not mean it is the best strategy for your family - in hindsight, it would have been a better strategy for us if I had used it when I first could have, but that was in hindsight only. Presented with the same facts when I was, I would have done the same thing. 

I see it as the best of both worlds. It is a pre-tax (or tax deductible if not done through your employer). It can be invested in stocks/bonds/mutual funds, like an IRA. There is currently no time limit on how long you can wait to make a claim, so theoretically if you're extremely good at keeping records you can save all  your reciepts and then cash them all in at once - thus, the contributions and the growth are both tax free, with no age limit. And, once you hit 65, it acts like an IRA and you can get distributions from it! Those distributions though would be taxed as income.

Obviously this would not make sense if you never have any health expenses, and if you plan on retiring early, but we've now hit our out of pocket expenses - which are more than the annual HSA limit - 2 years running. So for me at least, it makes plenty of sense.

Robbie said:

Question: Does the early withdraw penalty apply 'before' the taxes are calculated or 'after'? ie are you taxed on the amount before penalty or after?

To the best of my knowledge: The penalty applies equally to each and every un-taxed dollar withdrawn. That means pre-tax contributions, pre-tax growth, and post-tax growth. Only the dollars you've already paid taxes on (Roth contributions/conversions) can be withdrawn penalty free.

However: If you trigger the early withdrawal penalty when withdrawing early, you're doing it wrong anyway.

AngryCorvair said:

mtn said:

My way of attacking it is that I believe taxes will never be lower than they are right now. Because of this I am putting everything into Roth accounts (both IRA and 401k, I'm lucky to have that option). If I had a higher income, I would put everything to traditional only until I got below the 22% tax bracket.

 

 

this x1000.  put everything you can into Roth when you're in a low tax bracket.

What is the plan when you hit the 24% bracket? I just realized I'm in that this year, but just barely. Does it really make that big of a difference?

In reply to z31maniac :

Because Roth contributions are made with post-tax dollars, they have their strongest purchasing power when you're in a low bracket, ie in 10% bracket that $1.00 post-tax cost you $1.10 pre-tax.  But if you're in the 30% bracket that same post-tax dollar cost you $1.30.  I guess you're winning as long as your withdrawals would put you in a higher bracket than you were in when you made the deposits.

z31maniac said:

AngryCorvair said:

mtn said:

My way of attacking it is that I believe taxes will never be lower than they are right now. Because of this I am putting everything into Roth accounts (both IRA and 401k, I'm lucky to have that option). If I had a higher income, I would put everything to traditional only until I got below the 22% tax bracket.

 

 

this x1000.  put everything you can into Roth when you're in a low tax bracket.

What is the plan when you hit the 24% bracket? I just realized I'm in that this year, but just barely. Does it really make that big of a difference?

You're going to have to make that determination for yourself. I'd recommend making a spreadsheet like Robbie's to make your decision, but it ultimately comes down to the same questions:

• Do you expect your income to go up or down in retirement?
• Do you expect the income tax rate to go up, or stay the same/decrease in retirement? Don't forget that if you get married, your tax rate will likely decrease. 

I could make the argument either way, but you should really figure it out using your own numbers to figure it out. I'm still inclined to think that taxes will go up. If I were to put myself in your shoes, I would probably go with the traditional with the intention of converting it to Roth via the conversion ladder. That way you can have some control over the taxes.

I would expect my income to go down, taxes to go up, and plan on getting married in the next 1-2 years. 

I suspect in reality, the best thing at this point is to get some debt paid off and just start hammering my 401k (I do contribute enough to get the match), the ESPP, and the HSA.

In reply to z31maniac :

The easy button for uncertainty is to hedge your bets with both traditional and Roth type accounts. If you're getting the full company match already, max out a Roth IRA next before increasing 401k contributions.