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Author: 4inthefamily Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5084  
Subject: Limits rising faster than income Date: 8/23/2007 11:22 AM
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As I have read through posts outlining the path to FIRE, the importance of having taxable accounts has been emphasized. DH and I always figured that we would max out the accounts with tax benefits and then start working on taxable accounts. The last couple of years we have been able to max out both of our Roth IRAs and DH's 401(k) (I don't work), but as the limits have been increasing our income is not keeping pace. In fact, with the limits going up to $5000 each on the Roths next year and $16000 on the 401(k) - we will be struggling to even max out these accounts. Until I go back to work or DH has a significant jump in income (which is unlikely to happen unless he takes a new job), we will be unable to set aside additional money for retirement.

So, here is my question. Would it be prudent for us to start putting some of our money in taxable accounts in lieu of one of the tax advantaged accounts at this time or should we just keeping maxing out what we can and save the taxable accounts for later on? FTR, I am 32 years old.

-4
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Author: VikingErik Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4313 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 11:53 AM
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Four answers, in order of priority:

1. Definitely keep contributing enough to the 401k to get the maximum company matching money. That's an instant guaranteed return of 50% or 100% or whatever the matching ratio is.

2. Definitely keep maxing the Roth IRAs. You can withdraw the Roth principal anytime with no tax or penalty if there's a dire need. The Roth is strictly superior to investing in a taxable account. Either way you pay income tax on the principal up front, but a Roth gives you tax-free earnings for life while a taxable account charges you tax on the earnings every year.

(There is an exception - if you expect to withdraw from the Roth before age 59½. Then the Roth will charge income tax on the earnings while the taxable account will charge lower capital gains rates. But you don't sound like you expect to do this.)

3. Are you planning any major purchases in the next several years (house, car, college) for which you'll want a large amount of non-retirement liquidity? This is the major reason FIRE wannabes establish taxable accounts, beyond the usual emergency fund of 3-6 months living expenses.

4. When it comes to deciding between investing in a 401k without matching or in a taxable account, I think it mostly depends on the quality of the investments available in the 401k plan. Have you got access to low-expense diversified index funds? Or does the plan stick you with underperforming offerings that fill the custodian's pockets rather than yours?

Hope that helps,
- Erik

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Author: 4inthefamily Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4314 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 12:20 PM
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Thanks Erik. This is helpful.

3. Are you planning any major purchases in the next several years (house, car, college) for which you'll want a large amount of non-retirement liquidity? This is the major reason FIRE wannabes establish taxable accounts, beyond the usual emergency fund of 3-6 months living expenses.

We will probably be buying a car in the next 2-5 years. We are saving for this in an ING sub-account and hoping that our 12 year old Saturn holds out long enough. We have quite a bit of equity in our current home and do not plan to move anytime soon.

4. When it comes to deciding between investing in a 401k without matching or in a taxable account, I think it mostly depends on the quality of the investments available in the 401k plan. Have you got access to low-expense diversified index funds? Or does the plan stick you with underperforming offerings that fill the custodian's pockets rather than yours?

There are two funds that are offered that I have our 401(k) split with right now. Half of it is in FUSEX - an index fund with very low expenses and the other half is in DODGX. I have been happy with the expenses and returns of these funds. I've managed to balance out our asset allocation with funds in our rollover IRA and our Roths which are both with Vanguard.

So, from what you have said, I guess that it makes the most sense for us to continue to work with the tax sheltered accounts for the time being.

-4

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Author: warrl Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4315 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 12:39 PM
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So, here is my question. Would it be prudent for us to start putting some of our money in taxable accounts in lieu of one of the tax advantaged accounts at this time or should we just keeping maxing out what we can and save the taxable accounts for later on? FTR, I am 32 years old.

Hm... there can be an argument for tax diversification, as protection against future tax-law changes.... but there is also the fact that they won't make IRAs or 401Ks *worse* than taxable accounts.

A few priority notes is all I'll offer:
* Definitely get maximum employer matching on the 401K
* After that, you're probably better off maxing out the Roth IRAs first, as opposed to maxing out the 401K first.
* If you have tax-sheltered AND non-sheltered investment accounts, and you do long-term buy-and-hold investing AND short-term trading, prefer to do the short-term trading in tax-sheltered accounts and the long-term investing in unsheltered accounts. (This is of course the opposite of the advice you get from the government and your 401K plan advisers.) However this preference is not in itself compelling enough to suggest that you should open new accounts or change investment strategies.

The other thing I'll mention is that for the EARLY retiree, the most accessible (considering IRS penalties and taxes, and how to avoid them) locations for investment money are usually:

best) an unsheltered account (no penalties, no special taxes)
2) a 457 plan account (no penalties once you are no longer with that employer - no age restriction)
3) a conventional IRA (72(t) plan avoids penalties)
4) a 401K or 403B plan account (roll over to conventional IRA)
5) a Roth IRA (72(t) plan avoids penalties, but withdrawals of earnings are taxable before a certain age)
6) A Roth 401K which I've occasionally - but not often - heard about (roll over to Roth IRA)

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Author: aj485 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4316 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 12:46 PM
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(There is an exception - if you expect to withdraw from the Roth before age 59½. Then the Roth will charge income tax on the earnings while the taxable account will charge lower capital gains rates. But you don't sound like you expect to do this.)

And of course, there are exceptions that can mitigate taxes on the exception.....You are allowed to withdraw the contributions you made to your Roth at any time without penalty or tax. And there is the first time homebuyer's exception, being disabled, and SEPP (Substantially Equal Periodic Payments), etc. See IRS publication 590 for details: http://www.irs.gov/pub/irs-pdf/p590.pdf

AJ

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Author: MadCapitalist Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4317 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 12:51 PM
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...but there is also the fact that they won't make IRAs or 401Ks *worse* than taxable accounts.

That's an opinion, not a fact. Low dividend and capital gains rates from a taxable account could be preferable to much higher ordinary tax rates from distributions from a tax-deferred account, especially if they crank up ordinary tax rates, which isn't unreasonable with the ridiculous Medicare and Social Security liabilities that are accruing. Of course, it is also possible that they will not renew the favorable tax rates for dividends and capital gains.

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Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4318 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 1:02 PM
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>> Hm... there can be an argument for tax diversification, as protection against future tax-law changes.... but there is also the fact that they won't make IRAs or 401Ks *worse* than taxable accounts. <<

Really? Dividends and long-term capital gains are capped at a 15% federal tax rate in a taxable account, but if realized in an TIRA or 401K plan would eventually be taxable at the marginal rate (often 25% or more)?

What you said may be true more often than not, but it isn't an absolute.

#29

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Author: decath Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4319 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 1:09 PM
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So, here is my question. Would it be prudent for us to start putting some of our money in taxable accounts in lieu of one of the tax advantaged accounts at this time or should we just keeping maxing out what we can and save the taxable accounts for later on? FTR, I am 32 years old.

-4


I've always been partial to max the tax preferred methods (IRA's and 401ks) as you have. But I suspect it would be wisest to have a balanced approach since we don't know what the tax laws will be changed in the future.

In my family's case, I've always maxed the 401k and Roth IRA with my income. When we have had extra income or a small windfall come our way, I've added to the taxable investments.

If your 401k balance is considerably larger than your Roth IRA and taxable investments, you may want to consider cutting back on contributing to it and instead put that money into the taxables.

decath

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Author: VikingErik Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4320 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 1:13 PM
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And of course, there are exceptions that can mitigate taxes on the exception.....You are allowed to withdraw the contributions you made to your Roth at any time without penalty or tax. And there is the first time homebuyer's exception, being disabled, and SEPP (Substantially Equal Periodic Payments), etc. See IRS publication 590 for details: http://www.irs.gov/pub/irs-pdf/p590.pdf

An SEPP 72(t) plan does not avoid tax on earnings in a Roth. It does avoid the 10% penalty.

http://www.fairmark.com/rothira/taxfree.htm

An SEPP 72(t) withdrawal doesn't fill any of the "qualified distribution" conditions at the bottom of the page. The earnings are taxable.

- Erik

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Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4321 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 1:15 PM
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>> I've always been partial to max the tax preferred methods (IRA's and 401ks) as you have. But I suspect it would be wisest to have a balanced approach since we don't know what the tax laws will be changed in the future. <<

For the most part I agree. But I also believe in diversifying retirement assets so you can more easily minimize your taxes and keep yourself in the lowest tax rates possible.

For example, using today's rates, if I were retired and had all three types of retirement plans (401K/TIRA, Roth IRA and taxable), I might pull from the 401K/TIRA as much as I could until I exhausted the 15% bracket. At that point I'd start drawing from the Roths and/or taxable accounts so additional income would not be taxed, thus helping me avoid the 25% bracket. If I put all my eggs in the 401K/TIRA basket, I might have to withdraw in the 25% bracket to get the same amount of income.

#29

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Author: warrl Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4322 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 1:21 PM
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>> Hm... there can be an argument for tax diversification, as protection against future tax-law changes.... but there is also the fact that they won't make IRAs or 401Ks *worse* than taxable accounts. <<

Really? Dividends and long-term capital gains are capped at a 15% federal tax rate in a taxable account, but if realized in an TIRA or 401K plan would eventually be taxable at the marginal rate (often 25% or more)?


There are definitely possibilities, involving long-term gains, where you might be better off investing in a non-sheltered account as opposed to a CONVENTIONAL (not Roth) IRA or 401K.

... but that is true under the current tax law, and besides, it's rather a special case.

Further the Democrats and the media have somehow convinced the populace that:
* IRAs and 401Ks are for ordinary people
* dividends and capital gains are something that only happen to rich people

Because of that, and with the noises I hear coming out of the leeches in Congress, the single most likely income-tax increase is on long-term capital gains and qualifying dividends. Quite possibly eliminating the special treatment altogether, so that the government profits from inflation in yet another way.

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Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4323 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 1:23 PM
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>> Because of that, and with the noises I hear coming out of the leeches in Congress, the single most likely income-tax increase is on long-term capital gains and qualifying dividends. Quite possibly eliminating the special treatment altogether, so that the government profits from inflation in yet another way. <<

I agree this is a reasonable possibility, and the "deal" on long term gains and dividends may be eliminated or at least watered down...but since we don't know the future I think it's best to hedge one's bets overall.

Besides, even if the Dems eliminated these provisions in 2009 or beyond, there's no saying they couldn't be reinstated a few years later.

#29

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Author: warrl Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4324 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 1:32 PM
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Besides, even if the Dems eliminated these provisions in 2009 or beyond, there's no saying they couldn't be reinstated a few years later.

Personally I think that, to be really accurate about it, they SHOULD eliminate the break for long-term capital gains and dividends...

... and allow you to increase your basis to compensate for inflation.

Of course, that would require a lot more calculation.

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Author: decath Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4325 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 2:27 PM
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For example, using today's rates, if I were retired and had all three types of retirement plans (401K/TIRA, Roth IRA and taxable), I might pull from the 401K/TIRA as much as I could until I exhausted the 15% bracket. At that point I'd start drawing from the Roths and/or taxable accounts so additional income would not be taxed, thus helping me avoid the 25% bracket. If I put all my eggs in the 401K/TIRA basket, I might have to withdraw in the 25% bracket to get the same amount of income.

#29


I'm pretty well diversified between the 3 areas, thanks to a good chunk of moonlight earnings that I stuffed into a SEP-IRA and some taxable investments back in the 90's and early 2000's. Those investments were in a few health care stocks that were largely unaffected by the market collapse. Yet, my 401k got hosed big time.

This argument kind of reminds me of the healthcare debate that rages a lot on both RECF and RELE. We don't know if we will move towards socialized HC or more market solutions based. It makes it hard to plan for the future. You just have to make reasonable choices on the here and now and be flexible as things change.

decath

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Author: whyohwhyoh Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4326 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 2:41 PM
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An SEPP 72(t) withdrawal doesn't fill any of the "qualified distribution" conditions at the bottom of the page. The earnings are taxable.


I have to disagree. Qualified SEPP withdrawls are tax free and penalty from a Roth IRA. Your link doesn't discuss SEPP options. This one does, and I'm sure there are many more.

http://www.investopedia.com/university/retirementplans/rothira/rothira3.asp

--
whyohwhyoh

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Author: warrl Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4327 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 3:53 PM
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I have to disagree. Qualified SEPP withdrawls are tax free and penalty from a Roth IRA. Your link doesn't discuss SEPP options.

The IRS's link http://www.irs.gov/publications/p590/ch02.html#d0e10379 DOES mention SEPP - but not in the right place to support your claim. SEPP withdrawals from a Roth IRA are usually taxable.

There is an additional 10% tax that can be applied - SEPP withdrawals dodge THAT.

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Author: whyohwhyoh Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4328 of 5084
Subject: Re: Limits rising faster than income Date: 8/23/2007 5:27 PM
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The IRS's link http://www.irs.gov/publications/p590/ch02.html#d0e10379 DOES mention SEPP - but not in the right place to support your claim. SEPP withdrawals from a Roth IRA are usually taxable.


I stand corrected. Taxes are due on SEPP withdrawls from a Roth IRA.

--
whyohwhyoh

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Author: vickifool Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4329 of 5084
Subject: Re: Limits rising faster than income Date: 8/24/2007 10:55 AM
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Personally I think that, to be really accurate about it, they SHOULD eliminate the break for long-term capital gains and dividends...

... and allow you to increase your basis to compensate for inflation.

Of course, that would require a lot more calculation.


I definitely agree, but....

The official "inflation" number is subject to government manipulation. AND

I think that inflation calculation would be seriously beyond the capabilities of most people not at the Fool. (We are an exceptionally math-capable bunch.)

AND I don't think the government really wants the average person to think about inflation that much.

Vickifool

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Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4330 of 5084
Subject: Re: Limits rising faster than income Date: 8/24/2007 11:05 AM
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>> The official "inflation" number is subject to government manipulation. AND

I think that inflation calculation would be seriously beyond the capabilities of most people not at the Fool. (We are an exceptionally math-capable bunch.)

AND I don't think the government really wants the average person to think about inflation that much.
<<

Yup. The government has a vested interest in cooking the books where inflation is concerned. As long as their payout in pensions, Social Security, TIPs and I-bonds goes up with inflation, they have every reason to use inflation calculations that don't keep up with the inflation that a typical household "feels".

#29

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Author: foolkath Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4331 of 5084
Subject: Re: Limits rising faster than income Date: 8/24/2007 11:40 AM
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At 32 our family was similar to yours. We were FI at 52 . My kids were entering college. Ages 18 and 19. We did not qualify for financial aide because of our savings outside of retirement accounts. We eventually exhausted the taxable accounts paying for reasonable colleges. We continued to add to the tax exempt and allowed then to grow. The kids have graduated loan free. The only thing that stops us from retiring is health care. We work way less now, mostly for the health insurance. We travel lots.My husband enjoys the half time work. He wants to retire in full at 62. (at least for now) We will see what our health care options will be then. But for now, we are FI and choose to work for health care.And almost all our savings are in tax deferred.

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Author: warrl Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4332 of 5084
Subject: Re: Limits rising faster than income Date: 8/24/2007 1:31 PM
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AND I don't think the government really wants the average person to think about inflation that much.


Which is similar to why one of my other big tax-related suggestions - to eliminate all forms of indirect and withheld tax payment, replacing them with actual checks written to the government and due on election day - will never catch on.

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Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4333 of 5084
Subject: Re: Limits rising faster than income Date: 8/24/2007 1:54 PM
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>> Which is similar to why one of my other big tax-related suggestions - to eliminate all forms of indirect and withheld tax payment, replacing them with actual checks written to the government and due on election day - will never catch on. <<

Yep. Think about all the property tax revolts there are out there. Even people who pay a lot more in federal and state income taxes -- or state sales taxes, even -- tend to focus on property taxes. I suspect this is because the true cost of government isn't hidden by paying a few bucks here and a few bucks there when making purchases, or having hundreds of dollars withheld from your paycheck before you see the proceeds.

No, with property taxes you get one large bill, usually well into four figures, payable all at once. That gets your attention a lot more than $200 in federal income and payroll taxes withheld every week.

#29

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Author: MadCapitalist Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4334 of 5084
Subject: Re: Limits rising faster than income Date: 8/24/2007 1:55 PM
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AND I don't think the government really wants the average person to think about inflation that much.

Which is similar to why one of my other big tax-related suggestions - to eliminate all forms of indirect and withheld tax payment, replacing them with actual checks written to the government and due on election day - will never catch on.


I like that idea. A similar idea that I have always wanted is to have people write a check every month. Both ideas would create awareness of the mammoth amount of taxes that we pay, which, as you suggested, is why our politicians will never go for it.

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Author: warrl Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4335 of 5084
Subject: Re: Limits rising faster than income Date: 8/24/2007 2:02 PM
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Yep. Think about all the property tax revolts there are out there. Even people who pay a lot more in federal and state income taxes -- or state sales taxes, even -- tend to focus on property taxes. I suspect this is because the true cost of government isn't hidden by paying a few bucks here and a few bucks there when making purchases, or having hundreds of dollars withheld from your paycheck before you see the proceeds.

No, with property taxes you get one large bill, usually well into four figures, payable all at once. That gets your attention a lot more than $200 in federal income and payroll taxes withheld every week.


Actually, quite a lot of people pay their property taxes monthly as part of their mortgage payment.

But still there are property-tax revolts.

A few years ago the state of Washington had a license-plate-tax revolt.

I think maybe the defining characteristic is that these taxes are to keep and continue using something you already have, as opposed to taxes on stuff you are just getting. (Not that I think this is actually worthy of a difference in tax treatment.)

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Author: MurrayS Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4336 of 5084
Subject: Re: Limits rising faster than income Date: 8/27/2007 12:33 PM
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For example, using today's rates, if I were retired and had all three types of retirement plans (401K/TIRA, Roth IRA and taxable), I might pull from the 401K/TIRA as much as I could until I exhausted the 15% bracket. At that point I'd start drawing from the Roths and/or taxable accounts so additional income would not be taxed, thus helping me avoid the 25% bracket. If I put all my eggs in the 401K/TIRA basket, I might have to withdraw in the 25% bracket to get the same amount of income.

Of course, you have to factor in your current marginal tax rate. If you're in the 15% tax bracket, maxing out your Roth before a 401k would be a good option.

OTOH, in the 25% tax bracket (current), the Roth is no better tax wise than a 401k assuming similar investments.

If, like me, your in the 28% tax bracket, a 401k still offers a significant tax advantage over a Roth.

The current marginal tax rate is important for the OP to consider when deciding between a Roth and 401k IMHO.

-murray

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Author: TheBreeze Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 4337 of 5084
Subject: Re: Limits rising faster than income Date: 8/28/2007 10:57 PM
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if I were retired and had all three types of retirement plans (401K/TIRA, Roth IRA and taxable), I might pull from the 401K/TIRA as much as I could until I exhausted the 15% bracket. At that point I'd start drawing from the Roths and/or taxable accounts so additional income would not be taxed, thus helping me avoid the 25% bracket. If I put all my eggs in the 401K/TIRA basket, I might have to withdraw in the 25% bracket to get the same amount of income.

OTOH, if you had only the 401K/TIRA accounts, you ought to have more in them than in a Roth. Since you got a deduction when they were originated, you would have more investable assets to have put in. That presumes that the annual limit wasn't your limiting factor, which would add another level of complexity.

I also agree that it's good to have several kinds of investment classes to manage your taxes but also to minimize the amount of social security subject to tax or to anything that would cause you to lose out on any SS money (like the "lose $1 for wach $2 earned" that some people get hit with).

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