[beanmaestro]

To put “your rent is not wasted” in perspective, I’ll share the situation my wife and I are in. We pay $1700 in rent up here in Santa Barbara, but would have to cough up $5000 a month for an acceptable house (my wife demands a proper garden). We’re sitting on a nice down payment, but right now we’re saving $50k (including 401k, Roth, etc) a year, and growing our $100k+ down payment. When we pull the trigger, we’ll only be able to save about $15k/year, and the down payment stops growing money. When my wife stops working to make babies and eggplants, I’ll be docking my savings to keep my 401k match… All that roughly adds up to at least $50k/year incentive to keep renting. So, looked at in a certain way, my $21k annual rent pays for a roof and a yard and $50k of cash. Meanwhile, my landlord lost $30k of paper equity on the house this year. Pretty good deal, eh?

Now, if housing prices were going up, I’d be happy to give that up… that’s what the money is for, after all. But as long as prices are nominally flat, we’re doing much better renting. So for me, it isn’t a question of whether prices are falling yet, but whether they’re likely to grow 6%/yr anytime soon. And the answer to that is obviously not.

[beanmaestro]

To put “your rent is not wasted” in perspective, I’ll share the situation my wife and I are in. We pay $1700 in rent up here in Santa Barbara, but would have to cough up $5000 a month for an acceptable house (my wife demands a proper garden). We’re sitting on a nice down payment, but right now we’re saving $50k (including 401k, Roth, etc) a year, and growing our $100k+ down payment. When we pull the trigger, we’ll only be able to save about $15k/year, and the down payment stops growing money. When my wife stops working to make babies and eggplants, I’ll be docking my savings to keep my 401k match… All that roughly adds up to at least $50k/year incentive to keep renting. So, looked at in a certain way, my $21k annual rent pays for a roof and a yard and $50k of cash. Meanwhile, my landlord lost $30k of paper equity on the house this year. Pretty good deal, eh?

Now, if housing prices were going up, I’d be happy to give that up… that’s what the money is for, after all. But as long as prices are nominally flat, we’re doing much better renting. So for me, it isn’t a question of whether prices are falling yet, but whether they’re likely to grow 6%/yr anytime soon. And the answer to that is obviously not.

[beanmaestro]

You also forgot the 401k deduction. If you’re paying a mortgage, there’s a good chance you’re only putting enough in your 401k to get a match, and not using the $15.5k ($31k for couples) limit. And even if you can use most of that deduction, are you missing out on Roth contributions to do so?

[beanmaestro]

You also forgot the 401k deduction. If you’re paying a mortgage, there’s a good chance you’re only putting enough in your 401k to get a match, and not using the $15.5k ($31k for couples) limit. And even if you can use most of that deduction, are you missing out on Roth contributions to do so?

[beanmaestro]

Well, okay, let’s take your above scenario, but I’ll use a 30% marginal tax rate, since this seems more accurate for us.

I start with $30k in cash, and $100k in a 401k/Trad IRA.

Scenario 1:
Convert the $100k to a Roth IRA, pay the $30k in taxes.
Wait 25 years at 10% annual return, balance 1083k

Scenario 2:
Keep the $100k in 401k, put the $30k in an index fund
401K: Wait 25 years at 10% annual return, balance 1083k
Index fund: Wait 25 years at 8.5% after-tax return, balance $231k
Total: $1314k before taxes. An average tax of 17.6% will result in a wash. For comparison, if my my wife and I only needed to withdraw enough to pay our current bills, we’d be looking at around a 10% average tax.

Analysis: I’m not convinced my average taxes would necessarily be that high in 25 years. Even if marginal rates are up, I’ll only be withdrawing what I need to pay my bills, I’ll have a house to write off, and I can tap my normal Roth each year to reduce exposure to the nasty tax brackets. And the $231k has already been partially taxed, and will owe less than full cap gains tax when it’s redeemed.

Now, the clever way around this is to do these conversions in a year when you are intentionally unemployed, so your marginal tax rate is very low for the conversion to Roth. Then you pay almost no tax at all. You just have to hope that you can find a job when the year is up.

Of course, this all assumes we’ll have a tax structure that faintly resembles our existing system. The house write-off might not exist. There might be an extra deduction for the elderly. We might have a flat tax, or a VAT tax instead. There may be no cap gains tax, or it may be treated just like income. We might live in burbclaves that don’t care about 1040’s and Roths and just collect a flat head tax.

So, on balance, it’s probably good to put more than $4k a year into Roth-type accounts, but I’m far from sold on doing this with a large chunk of it. And I’m still curious about the rules for accessing converted principal.

[beanmaestro]

Well, okay, let’s take your above scenario, but I’ll use a 30% marginal tax rate, since this seems more accurate for us.

I start with $30k in cash, and $100k in a 401k/Trad IRA.

Scenario 1:
Convert the $100k to a Roth IRA, pay the $30k in taxes.
Wait 25 years at 10% annual return, balance 1083k

Scenario 2:
Keep the $100k in 401k, put the $30k in an index fund
401K: Wait 25 years at 10% annual return, balance 1083k
Index fund: Wait 25 years at 8.5% after-tax return, balance $231k
Total: $1314k before taxes. An average tax of 17.6% will result in a wash. For comparison, if my my wife and I only needed to withdraw enough to pay our current bills, we’d be looking at around a 10% average tax.

Analysis: I’m not convinced my average taxes would necessarily be that high in 25 years. Even if marginal rates are up, I’ll only be withdrawing what I need to pay my bills, I’ll have a house to write off, and I can tap my normal Roth each year to reduce exposure to the nasty tax brackets. And the $231k has already been partially taxed, and will owe less than full cap gains tax when it’s redeemed.

Now, the clever way around this is to do these conversions in a year when you are intentionally unemployed, so your marginal tax rate is very low for the conversion to Roth. Then you pay almost no tax at all. You just have to hope that you can find a job when the year is up.

Of course, this all assumes we’ll have a tax structure that faintly resembles our existing system. The house write-off might not exist. There might be an extra deduction for the elderly. We might have a flat tax, or a VAT tax instead. There may be no cap gains tax, or it may be treated just like income. We might live in burbclaves that don’t care about 1040’s and Roths and just collect a flat head tax.

So, on balance, it’s probably good to put more than $4k a year into Roth-type accounts, but I’m far from sold on doing this with a large chunk of it. And I’m still curious about the rules for accessing converted principal.

[beanmaestro]

Makes sense. My only concern is that it seems that this transfer is making a tax wager that your *marginal* tax rate now will be lower than your *average* tax rate in retirement, when you may very well have less (relative) income and more deductions than you do now.

Although I agree income taxes will probably go up, I have trouble believing they would go up that much. For instance, we now pay marginal (state + fed) income taxes of 34% vs. average taxes of about 20%. Now, this might be a fantastic idea if I leave my job and take a year off, allowing the conversion at a very low tax rate, but it seems dubious at the full rate.

[beanmaestro]

Makes sense. My only concern is that it seems that this transfer is making a tax wager that your *marginal* tax rate now will be lower than your *average* tax rate in retirement, when you may very well have less (relative) income and more deductions than you do now.

Although I agree income taxes will probably go up, I have trouble believing they would go up that much. For instance, we now pay marginal (state + fed) income taxes of 34% vs. average taxes of about 20%. Now, this might be a fantastic idea if I leave my job and take a year off, allowing the conversion at a very low tax rate, but it seems dubious at the full rate.

[beanmaestro]

Interesting… How does accessing the principal of Roth conversions work? As I mentioned above, my big hang-up with a huge 401k are the tax penalties involved in getting to it before turning 60 (or whatever the age is in a few decades).

I’m interested to hear more about this since I still have $30k with my previous employer and have been debating what to do with it.

[beanmaestro]

Interesting… How does accessing the principal of Roth conversions work? As I mentioned above, my big hang-up with a huge 401k are the tax penalties involved in getting to it before turning 60 (or whatever the age is in a few decades).

I’m interested to hear more about this since I still have $30k with my previous employer and have been debating what to do with it.

[beanmaestro]

You don’t mention kids, your age, housing or any specifics, so I’ll just tell you what my wife and I do…

My priorities are as follows:
1. 401k’s up to the max match (4% of salary in my case)
2. Roth IRA’s up to $4k limit
3. 401k’s up to $15.5k limit
3. Taxable Vanguard funds (saving for down payment)

Getting the match is obvious. Then I favor the Roth over the rest of the 401k because I can pull money from it for a down payment in a couple years, whereas the 401k money is stuck there for a few decades. Then I split the remainder between the 401k and taxable funds, for the same reason. In your case (high tax bracket), you might tilt the balance more toward 401k.

Right now, I’m fairly certain our 401k’s will be overkill if we consistently max them out, and I’d rather have a good deal of money where I can get to it before retirement. Yes, we’ll pay taxes, but do you really want to be 50, ready to retire early, only to have millions of dollars you can’t touch for a decade?

[beanmaestro]

You don’t mention kids, your age, housing or any specifics, so I’ll just tell you what my wife and I do…

My priorities are as follows:
1. 401k’s up to the max match (4% of salary in my case)
2. Roth IRA’s up to $4k limit
3. 401k’s up to $15.5k limit
3. Taxable Vanguard funds (saving for down payment)

Getting the match is obvious. Then I favor the Roth over the rest of the 401k because I can pull money from it for a down payment in a couple years, whereas the 401k money is stuck there for a few decades. Then I split the remainder between the 401k and taxable funds, for the same reason. In your case (high tax bracket), you might tilt the balance more toward 401k.

Right now, I’m fairly certain our 401k’s will be overkill if we consistently max them out, and I’d rather have a good deal of money where I can get to it before retirement. Yes, we’ll pay taxes, but do you really want to be 50, ready to retire early, only to have millions of dollars you can’t touch for a decade?

[beanmaestro]

I suppose I have to agree. That doesn’t mean we’ll forgive Bush Sr for having children.

[beanmaestro]

I suppose I have to agree. That doesn’t mean we’ll forgive Bush Sr for having children.

[beanmaestro]

Guys, guys, ease off on the gloating, and rearrange the priorities. I wake up smiling every morning because I’m snuggling with my lovely wife. I try to limit the “hey, this renting stuff is making me rich” to once or twice a month.

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