The Bogleheads' Guide to Retirement Planning (28 page)

As an illustration, consider Professor Young, who takes advantage of his low tax rate. Professor Young is a 30-year-old assistant professor at a state college who earns $45,000 per year. He expects to earn a higher income later in his career when he becomes a full professor. His college enrolled everyone in the 403(b) plan by default with a 6 percent employee contribution and a 3 percent matched contribution. Professor Young is in the 15 percent tax bracket, with adjusted gross income of $42,300. His AGI is reduced by the $2,700 contribution to the college 403(b) plan.

Professor Young expects to be in the 25 percent marginal income tax bracket in the future and when he retires. He has invested his 403(b) with a low-cost investment provider, and as long as he is in the 15 percent bracket, a Roth IRA is better for him than an unmatched contribution to the 403(b).

The cost of a Roth IRA is easy to compute. It is the expense of the investments, compounded over the number of years you hold the fund. The effective cost of a tax-deductible investment must also include the tax benefits of the deduction and the taxes paid later.
Table 10.2
gives examples of the cost comparison, illustrating why an investor who expects to retire in a higher tax bracket should prefer a Roth over an unmatched 401(k), while an investor who expects to retire in a lower tax bracket should usually prefer a 401(k) unless the 401(k) has higher costs which negate the tax advantage. To estimate the cost difference, compound the difference in expenses for as long as you stay with the employer; an extra 1 percent a year is a cost of 10 percent if you leave the employer in 10 years and then roll over the 401(k) to an IRA.

As an illustration, consider Frank and Francis Frugal, who minimize their costs. A married couple, both 45 years old, Frank works for the U.S. government, and Frances works at a hospital. Each earns $90,000 a year. Their state tax bracket is 6 percent, and they expect to retire in the same state. Frances has a mediocre 403(b) plan.

Their first investing priority is to get the employer matches. Frank and Frances both get a match on the first 5 percent they contribute to their TSP and 403(b) plans. Frank has a health savings account (HSA) as part of his health insurance and adds his own money to contribute the maximum to the account. (See Chapter 4 for a discussion of health savings accounts.) Frank and Frances can be in either the 25 percent or 28 percent marginal tax bracket, depending on how much they reduce their income with retirement contributions and deductions. After accounting for state taxes, they are in the 29.5 percent or 32.3 percent combined marginal income tax bracket. They plan to retire in the 25 percent tax bracket in the same state and plan to take the standard deduction in retirement, so they will be in a 31 percent bracket. Since these brackets are close, they should prefer to save in the lowest-expense plans.

Frank’s TSP charges 0.02 percent a year in expenses and is a great deal. That is better than the low 0.2 percent on their Roth IRAs and much better than the 1.0 percent expenses on Frances’s 403(b). Based on all this information, if they have $15,000 to save after getting the matches and HSA contribution, they should contribute the maximum allowed to Frank’s TSP, which is an additional $12,000, and then contribute $3,000 to a Roth IRA. This is their most advantageous allocation, based on current taxes and fees.

Taxable accounts are any accounts that are not tax-free or tax-deferred, and they include general investment accounts, brokerage accounts, savings accounts, money market accounts, certificates of deposit, and any other form of account that is funded with after-tax money and is subject to income tax or capital gains tax each year. The tax treatment is detailed in Chapters 2 and 3. You should consider investing in taxable accounts as part of your retirement plan if you have exhausted the previous options. It is unlikely that you will want to invest for retirement in taxable accounts if you still have tax-deferred options, even if they are poor. If a taxable account loses 30 percent to taxes, a 401(k) charging 1.5 percent a year in extra expenses is still worth more after tax, unless you expect to stay with the employer for more than 20 years.

If you invested money in a taxable account before reading this book and realizing that you may have made a mistake, or if you invested a windfall inheritance or a large bonus in your taxable account, you may be wondering if it’s worth transferring this money to tax-advantaged accounts over time. Any tax you pay on capital gains will be much less than the tax you’ll save by getting the money into tax-deferred accounts. This strategy assumes you are not currently able to maximize all tax-advantaged retirement accounts available to you or your spouse, using your current income. This strategy involves immediately making the maximum annual contribution to your IRA.

Most 401(k) plans let you contribute 100 percent of your salary to your 401(k), up to the plan limit, but prohibit transferring funds from non-401(k) accounts. You could immediately change your payroll deductions to maximize all contributions to employer-sponsored retirement accounts. By doing this, and using taxable money to cover your daily living expenses, you are effectively transferring the taxable money into your tax-advantaged 401(k) account. Your spouse can do the same, halving the time it takes to transfer the money to tax-advantaged accounts. When the taxable money is gone, reset all retirement account deductions back to levels that can be supported by your income.

As an example, after Professor Young made the plan in the previous section, his grandmother died, leaving him $100,000 in taxable money. He wants to use this money for retirement savings. He should temporarily hold the inheritance in a taxable account and max out both his Roth IRA and 403(b). He would then withdraw enough from the taxable account every year so he can continue to max out the retirement accounts.

We have now reached the lowest priority for your retirement investing: nondeductible IRAs and annuities. They are distinct account types, but their tax treatment is similar: you get no income tax deduction for the contributions, the account grows tax-deferred, and you pay tax on the gains at your full income tax rate when you withdraw the money. This income tax treatment—and the high fees on annuities—make them poor investment choices for most investors. Variable annuities have a variety of options, including some that guarantee a level of return. Some annuities have stable-value funds, which pay a fixed return that is determined every year; others have an option to guarantee a certain minimum return. The single-premium immediate annuities (SPIAs) covered in Chapter 8 are not the same as variable annuities. Do not confuse them.

Taxable accounts are preferable to nondeductible IRAs as long as tax-efficient investments are selected. In a nondeductible IRA, you defer taxes, but when you pay tax on all your gains, you pay the tax at your full income tax rate even on your capital gains rather than the lower capital gains tax rate. This is the potential disadvantage of a nondeductible IRA compared with a taxable account.

A nondeductible IRA might be a reasonable choice if you would otherwise have to hold tax-inefficient investments, such as bonds, in your taxable account. A stock index fund is likely to do better in an ordinary taxable account than a nondeductible IRA.

Variable annuities have the additional significant disadvantage of higher costs. The fees associated with most variable annuities are very high—2 percent fees are common. Even low-cost providers such as Vanguard charge significantly more for their variable annuities than for their comparable mutual funds. In addition, most variable annuities have surrender charges, which force you to either pay the high fees for a long period or pay the annuity provider a fee to compensate them for the high fees you avoided paying by leaving early. A typical surrender charge structure might be 7 percent if you redeem in the first year, decreasing by 1 percent a year until you have already paid 14 percent or more in total annual fees by holding the variable annuity for seven years.

Even a low-cost variable annuity is not likely to cost less than a comparable taxable investment. The only situation in which a low-cost variable annuity might make sense is if you need to hold something tax-inefficient, such as REITs, and you have no way of holding it in one of your other tax-deferred accounts. If you already have a high-cost variable annuity, it may well make sense to pay any surrender fees. The surrender fee is likely to be less than the total cost of staying until the fees go away. Switch to a low-cost provider such as Vanguard or TIAA-CREF, and then invest it the same way you would invest in an IRA. If you have a high-cost variable annuity inside your 401(k) or 403(b), roll it over to an IRA when you leave your employer. Since the rollover doesn’t have to be to another annuity, you’d then have the entire range of low-cost investment options available to you in your rollover IRA.

Susan Saver, age 30, has served eight years in the U.S. Army and is now a captain earning $63,000 a year. Like Professor Young, she expects to make more later in her career. The Army does not match contributions to the TSP. Instead, it provides her with a pension. Therefore, her choice is between unmatched contributions to the TSP and Roth IRA contributions.

Her tax situation has one special consideration. Most military pay in a combat zone is exempt from taxes. Therefore, she is in the 25 percent bracket if she spends most or all of the year in the United States. However, if she spends half the year in a combat zone, she’ll pay only 15 percent on her U.S. pay and 0 percent on her combat pay. Tax-exempt contributions to the TSP work like a nondeductible IRA; she will pay tax at her full tax rate but only on the gains. She won’t retire in a combat zone, so she expects to retire in the 25 percent tax bracket. Her state bracket is 5 percent and will be the same 5 percent in retirement.

When she expects to spend most of the year stateside, she prefers the TSP to a Roth IRA because of the TSP’s lower expenses, since she is in the same tax bracket now as at retirement. If she will be deployed for part of the year, then the Roth IRA becomes the better choice, since she expects to retire in a higher tax bracket than her tax bracket for that year. The Roth IRA is clearly better for tax-exempt pay. If she learns that she will be deployed in November, she will want to make sure to get all her TSP contributions made by October so that they are deductible and then contribute only to the Roth in November or December if she has more to contribute. If she learns that she will be deployed in July, she should max out her Roth IRA while deployed and take the rest of her contributions to the TSP from her taxable pay.

Carefully consider the types of accounts available for your retirement investments and the order in which you choose to invest in those accounts. Taking an employer match and paying down high-interest debts should be easy decisions. Then take full advantage of tax-deductible retirement accounts unless you are in a low marginal tax bracket or the investment options available in that account are very poor. A Roth IRA also deserves serious consideration, especially if you are in a low marginal tax bracket or need additional tax-advantaged investment space to supplement any plans available through your employer. If you are in the fortunate position of contributing the maximum to all available retirement plans and you would like to contribute additional funds for your retirement, you should then contribute to a taxable account. A nondeductible IRA should be considered only if you have a considerable amount of taxable savings. A variable annuity is almost never a good choice.

Social Security is the primary source of income for many retirees in the United States, yet few of us know much about this vast program. How much will your benefits be? When can you start to receive them? Should you apply for benefits as soon as possible? Must you pay income tax on these benefits? What happens to the money deducted from your pay for Social Security? Will the program run out of money, and what happens if it does?