[Editor’s Note: I’m doing a free webinar especially for emergency physicians Tuesday evening at 8 Eastern/5 Pacific. RSVP here!]
I am often asked about whether or not it is smart to invest in Variable Annuities (VA) and invest after-tax money inside retirement accounts like a non-deductible IRA contribution. The alternative, of course, is to invest in a regular old taxable, non-qualified, brokerage or mutual fund account. It turns out that the answer is “it depends.” Before we get into running the numbers, however, there are a few comments that should be made.
First, with regards to after-tax money in retirement accounts, if you’re going to convert that money to Roth (tax-free) money any time soon such as with an annual Backdoor Roth IRA or a Mega Backdoor Roth IRA, that’s a good idea.
Second, all of these options are inferior to both tax-free retirement accounts or a tax-deferred retirement account. You don’t need to run any numbers to know that. In fact, perhaps the best way to think about a tax-deferred retirement account is to consider it to be two different accounts.
- The first is your account; it is exactly like a Roth (tax-free) account. It grows tax-free and comes out tax-free. Basically, it is sheltered from taxation.
- The second is a “government” or “tax” account. This is simply money that you are investing on behalf of the government and will turn over at the same time you withdraw money from your tax-free account. In most cases, you even get to take a little bit of the government account and move it to your account, making it an even better idea. But the general idea is that this money grows tax-protected and gains are tax-free.
Once you wrap your head around that concept, it’s a lot easier to understand what is going on. But don’t bother with a taxable account or a Variable Annuity if you haven’t maxed out ALL retirement accounts you are eligible for — including individual 401(k)s for side gigs, cash balance plans, HSAs, a personal and spousal Backdoor Roth IRA, etc.
Third, Variable Annuities are an insurance product and it is generally a bad idea to combine investing and insurance. By doing so, you tend to get crummy, expensive insurance and crummy, expensive investments. Insurance companies love to add on bells and whistles so you can’t compare apples to apples and you end up with features you don’t want or paying too much for features that you do. So in today’s post, we’re simply going to compare a bare-bones Variable Annuity without any special bells or whistles to a simple taxable account.
Fourth, sometimes it can make sense to use a Variable Annuity for a special situation. For example, some people who are dumping their whole life policies exchange the cash value into a VA to preserve their basis, then let it grow back to the basis in the VA before surrendering the VA tax-free and using the money for other purposes such as investing in a taxable account. That’s not what we’re talking about today.
Fifth, variable annuities may provide asset protection in your state. You probably don’t need that protection, of course. Protection is usually much weaker than that available for retirement accounts and even cash value life insurance.
How Does a Variable Annuity Work?
A variable annuity is simply an insurance policy wrapped around an investment. Like a Roth IRA, you fund it with after-tax money. Like a 401(k), when a VA is surrendered/closed, all gains are fully taxable at your ordinary income tax rate. Unlike retirement accounts, you’re basically limited to mutual fund-like sub-accounts and can’t invest in real estate or accredited type investments like you could in a self-directed IRA or 401(k). Like a taxable account, your basis (the initial investment) comes out tax-free. Unlike a taxable account, losses are not deductible, there is no tax-loss harvesting, you can’t donate it directly to charity to avoid taxes, and your heirs do not get a step-up in basis. If you choose to annuitize the VA, the portion of the annuity payment attributable to basis is tax-free and the rest of the payment is taxable at ordinary income tax rates. In addition, the age 59 1/2 rule applies. Unlike cash value life insurance, you can’t borrow against a VA and in a partial withdrawal/surrender situation, the gains come out first instead of the basis.
So basically after-tax money in, tax-protected growth, then gains come out at ordinary income tax rates. In case you’re not paying attention, this is MUCH WORSE than the tax treatment of a Roth IRA and a 401(k), somewhat worse than the tax treatment of whole life insurance, and in some ways worse than the tax treatment of a taxable account. The only tax benefit here is that tax-protected growth. The tax treatment is the same as in a non-deductible IRA.
To make matters worse, a VA has additional costs, which can be highly variable, and available investments can be terrible. Companies like Vanguard and TIAA-CREF have generally low costs and some good investments, but even there the higher costs create a drag on returns. For example, take a look at some common Vanguard funds versus the equivalent variable annuity.
As you can see, the VA wrapper decreases returns by 0.27-0.42% per year.
Bear in mind that some retirement accounts and some brokerage/mutual fund companies also have additional costs which should be added in when making comparisons like these. But since a Vanguard taxable mutual fund account and a Vanguard IRA don’t, I’ll be ignoring those costs today.
Mutual Funds vs Variable Annuities
Taking your kids mountain biking is more of a consumption item than an investment, but it is far more fun than trying to figure out what to do with a VA you never should have bought.
So the comparison here is basically weighing the additional expenses and the additional taxes at surrender of a VA against the benefit of avoiding taxation of dividends and capital gains distributions on a growing investment in a taxable account.
Bear in mind I am completely ignoring the tax benefits of tax-loss harvesting, leaving appreciated shares to heirs for a step-up in basis, or the use of appreciated shares for charitable donations, which makes taxable investing substantially more tax-efficient, especially when you combine the tactics as I do. I am also assuming the very highest tax brackets for both ordinary income (37%) and for capital gains (20%), and for PPACA taxes (3.8%), which is higher than most docs are in now and will be in during retirement. I will also ignore state taxes for the sake of simplicity.
Total Stock Market – A 5 Year Period
Let’s start with a very tax-efficient investment (Total Stock Market) and a very short time period (5 years.) Let’s assume a return of 8% per year. Current yield on Total Stock Market is 1.90%, almost all of which is taxed at qualified dividend rates and long term capital gains rates. Let’s assume I put $10,000 into the mutual fund and $10,000 into the VA. We’ll also make the simplifying assumption that the entire distribution is paid at year end, which is obviously not the case but should make little difference.
The TSM Mutual Fund
After five years of growing at 8% and paying taxes along the way, the fund is worth $14,364.
However, now taxes must be paid. Gains are taxed at 23.8%. The initial $10K is not taxed, but neither are the reinvested distributions since they are also part of the basis. The distribution in year one was $205.20, but $48.84 went to the taxman so only $156.36 was invested. Let’s add up all the basis.
So you have $14,364.06 with a basis of $10,908.42. So if you sell the entire investment, you will owe 23.8% * ($14,364.06-$10,908.42) = $822.44 in taxes leaving you with $14,364.06 – $822.44 = $13,541.62
The TSM Variable Annuity
The math for the VA is much simpler. It grew at 8% minus the 0.38% tax drag, or 7.62%. After 5 years, you get
=FV(7.62%,5,0,-10000) = $14,436.60.
If you now surrender it, the basis is $10,000, so $4,436.60 is taxable at your ordinary income tax rate plus PPACA tax for a total of 40.8%. Remember this is investment income, not earned income, so you get to pay 3.8% in PPACA tax, not 0.9%.
$14,436.60 – (40.8% * $4,436.60) = $1,810.13
Total after tax = $14,436.60 – $1,810.13 = $12,626.47.
That is $13,541.62-$12,626.47 = $915.15 less than you would have in the mutual fund, or about 6.76% less money.
Clearly, with this very tax-efficient asset class and this short 5 year time period, the VA was a dumb idea that cost you money.
Total Stock Market – A 50 Year Period
Now that I’ve shown my work, let’s speed this up a bit. In this section, I’d like to demonstrate the benefit of additional tax protected growth. Instead of holding this investment for 5 years, let’s hold it for 50 before liquidating it.
After 50 years, your $10,000 investment in a taxable TSM mutual fund is now worth $373,913, of which $85,752 is basis. So after tax, you have $305,331.
In the VA, your $10,000 investment grew to $393,232, of which $10,000 is basis. So after tax you have $236,874. That’s $144,249 or 22.4% less!
What?! That’s not even close. How can that be? Well, it turns out with a very tax-efficient investment, you’re better off in a taxable account than even a cheap VA, no matter what the time period. And that’s ignoring tax-loss harvesting, donations to charity, and the step-up in basis.
Eliminating the VA Costs (Investing in a Non-Deductible IRA)
But what if you eliminate the costs of the VA. Let’s say you are investing in a Total Stock Market Fund inside a non-deductible IRA. Is that worth it? I mean, you will probably get some asset protection there and perhaps you can do a Roth conversion of those dollars down the road, but we’re just talking from a tax savings standpoint assuming you are never able to do a Roth conversion.
The 5 Year Comparison
We know TSM in taxable after 5 years is worth $13,542.
Inside an IRA, it would grow at 8% each year and then after 5 years, all gains would be taxed at 40.8%. It grows to $12,778. So no, at 5 years, the non-deductible doesn’t make sense. But what about at 50 years?
The 50 Year Comparison
After 50 years, TSM in taxable is worth $305,331.
Inside an IRA, it would grow to be $469,016 before tax and $281,738 after tax. So no, even after 50 years, it doesn’t make sense unless you can somehow do a Roth conversion or get into a lower tax bracket at withdrawal. How much lower? Well, at 50 years, your tax bracket would have to be at least 6% lower. At 5 years, it would have to be at least 15% lower.
A Less Tax Efficient Investment
Let’s demonstrate it now for a less tax-efficient investment. We could look at bonds, but it gets kind of tricky because if this high tax bracket investor were going to invest in bonds in taxable, she would use a muni bond fund and we wouldn’t be comparing apples to apples. So let’s take a look at REITs. Remember REITs are required to pay out at least 90% of their earnings each year as distributions and these are taxed at ordinary income rates. We’ll assume 100% is paid out for the sake of simplicity. They are now eligible for the Section 199A deduction, however. So 20% of that distribution is tax-free.
REITs – A 5 Year Period
After 5 years, the mutual fund has grown to $12,873, of which it is ALL basis. (Remember all earnings are paid out and taxes are paid each year on this investment.
After 5 years, the VA has grown to $14,410 before tax and $12,611 after tax.
The taxable account is ahead, but only by $12,873-$12,611= $262, or about 2%.
REITs – A 50 Year Period
After 50 years, the mutual fund has only grown to $124,922. Note how much lower that is than TSM at 50 years ($305,331). This is why it is important to invest in tax-efficient mutual funds in a taxable account, even with the new 199A deduction.
By contrast, the VA has grown to $232,587, or $107,665 (86%) more. Clearly, the advantage of tax-protected growth has overcome the costs of the VA with this tax-inefficient asset class.
The Breakeven
So where is the breakeven? It turns out it is about 13 years. At 13 years, the REIT mutual fund is worth $19,281 and the REIT VA is worth $19,385. Note that without the VA wrapper costs (i.e. in a low-cost non-deductible IRA) the break even is in year one.
What about investments with intermediate tax-efficiency? Some mutual funds are less tax-efficient than TSM but more tax-efficient than REITs. Does it make sense to put those into a VA or a nondeductible IRA? You just have to run the numbers but realize you’re going to have to leave it in the VA for decades for it to work out. The more tax-efficient, the longer. Due to the lower costs (and potential conversion) of the IRA, you would need less time there.
The Bottom Line
There are a few conclusions that can be reliably drawn from these calculations.
- First, it does not make sense to buy even a low-cost VA in order to shelter a very tax-efficient asset class from taxation.
- Second, it does not make sense to invest in a tax-efficient asset class inside a non-deductible retirement account unless you expect to be able to do a Roth conversion (and the sooner the better) or have a significantly lower marginal tax rate at withdrawal.
- Third, for a very tax-inefficient investment that you are going to hold for multiple decades, it is probably worth using a low-cost variable annuity.
- Fourth, for a very tax-inefficient investment, it is worth using a no-cost non-deductible IRA for any length of time.
What do you think? Do you use a VA? Why or why not? What about a nondeductible IRA? Comment below!
Another great post on how these products are much less beneficial than their salesmen/women realize. I don’t disagree with you in any way but was curious how sensitive this is to the very low dividends (and accompanying lower tax friction) we have today? Also, do you know why Vanguard has a higher expense charge for these funds when they are in an annuity? Does this reflect actual management/accounting costs or are they benchmarking to industry standards on annuity charges as a multiple of the non-annuity charge?
I used today’s yields in my analysis.
Jim, we have used no load low cost VAs for at least three additional reasons:
1) We have a client receiving a large amount of alimony for the next decade who doesn’t want to pay taxes on investment income (has substantial after tax assets) and who will be in a much lower bracket at the end of the alimony period.
2) We have several clients who have terminated large whole life policies with significant embedded gains-we have rolled these over with a 1035 exchange and are letting the investments grow there.
3) most commonly, we are using them for large after tax investments for single physicians as an asset protection vehicle.
1. It certainly does that.
2. Another great use of a VA.
3. Very state dependent.
In the analysis above, it is rare that you would sell and take all the money out at once, no? At age 70.5, you might take the RMD, but not the entire amount of money out (and have it taxed). We will have to engage the FI physician to do an analysis that way. Invest in a TIRA, accumulate money, and then take the RMD until age 90—then see who wins. FI physician, are you game?
I’m game, but I’m trying to wrap my head around why you would have a non-deductible IRA without converting it to a Roth. I guess when you have a large deductible IRA and don’t want to mess around with pro-rata or roll it into a 401k… And I assume you want to compare it to a brokerage account. What asset allocation do you want–this will determine how much difference there will be. As Jim points out, if we just use tax-efficient funds there won’t be much of a difference!
What I find ironic about VA’s is that the “average” investor does better in high-cost VA’s than they do investing their own money. Why? Because the surrender charges keep them from pulling their money out at the wrong time! So, stupidity trumps high fees every time… but of course there are no average investors reading this blog.
For the reasons you mention. Some docs have a large built up capital gains and are in a high tax bracket. And, they did not do the backdoor Roth yearly (by mistake). They don’t want to get stuck with a large tax bill. Not all plans allow for a roll in. Perhaps use the same example as the WCI, but at year 70.5, the investor takes the RMD, while the rest of the portfolio grows. Each year the doc takes the RMD to live on. Each year the doc sells some of the TSM to live on. The physician passes away at 90. Who wins then?
Ok, I took a 40-year-old and put 10k in a brokerage account or a non-deductible IRA. Invested in TSM earning 7% with 2% yearly dividends.
With other income, expense, inflation, etc assumptions, at the end of 50 years he or she had:
Brokerage plan age 40: 10k in brokerage
Age 65: 3,325,682
Age 90: 7,149,297
Non-deductible IRA Plan age 40: 10k in TIRA
Age 65: 3,285,590 in brokerage 58,074 in TIRA total 3,340,664
Age 90: 7,136,417 in brokerage 100,368 in TIRA total 7,236,785
So after 50 years you have 87,488 more with a non-deductible TIRA where you only take out RMDs compared to just putting it in a brokerage account.
This is not quite fair to WCI as we are have an effective tax rate of 6.2% in retirement and RMDs start at 2,437 a year and are only 8,697 at age 90 so, as you see above, much of the TIRA is taxed minimally (due to no other always taxable money in the above example) and the buck remains tax-deferred despite RMDs.
I’ll come up with another example where there is a 401k in addition to make retirement taxes and RMDs more realistic. Take me a couple days to polish it up.
Sorry, Federal tax is 13% and state tax 6% so effective tax rate in retirement is 19%. And should be “bulk” not buck above. Though it is hunting season here and the bucks are tax free too…
Thanks FI Physician. I think Jim’s last bullet point of the article is an important one. It is nice to have a tax protected space for tax inefficient items. Tax diversification is hard to beat, especially as one commenter pointed out the rules can change any time. I think we beat this horse to death, as usual.
Ha! Now the horse is beat to death! Here is the example with the 401k added to increase taxable income in retirement. It is also a cool example of why you use a 401k as there is an extra $2M after 50 years if you do!
https://www.fiphysician.com/non-deductible-ira-vs-brokerage/
Posted this one your blog article:
First,
I don’t think your first line is an accurate representation of the conclusions of my article which were, and I quote:
“it does not make sense to invest in a tax-efficient asset class inside a non-deductible retirement account unless you expect to be able to do a Roth conversion (and the sooner the better) or have a significantly lower marginal tax rate at withdrawal….for a very tax-inefficient investment, it is worth using a no-cost non-deductible IRA for any length of time.”
Second, I don’t follow your math at all. You’re saying you put $10K into a taxable account at 40 and somehow magically by age 65 it’s worth $3.3 Million despite only earning 7% a year? That would require a rate of return of 26%.
Third, your argument is that there will be “more money left in the tIRA due to the fact that you’re only taking out RMDs.” I’m sure that is true. But that does NOT mean that you have more money to spend by taking that approach. Because those dollars in the tIRA are NOT worth the same as the dollars in the brokerage account, especially to heirs who will get the step-up in basis at death.
That said, the longer the money grows tax protected, the more advantageous the IRA approach will be. But for a very tax efficient investment, it still may never overcome the effect of being able to withdraw earnings at the lower LTCG rate. Certainly for a less tax efficient investment it’ll eventually come out ahead.
But it’s really a non-issue for most because they should be doing a Backdoor Roth IRA instead of non-deductible IRA contributions. This is really a discussion for a tiny subset of the physician population and the main point of my article was that investing in variable annuities wasn’t really a great idea.
WCI,
Sorry I misrepresented your point about non-deductible IRAs. It wasn’t my intention to do so. I think we both agree that investing in variable annuities isn’t a good move for most.
In my example, there was ongoing investment in the brokerage account yearly in addition to the lump sum funding at 40. I’m sorry I didn’t make the clear, but she had to have funds to retire with at some point, so I was just looking at what 10k does in the non-deductible IRA vs in the brokerage account. And of course you are correct that taxes are owed on the IRA and not on a brokerage account at death.
I think the point is that pulling all of the non-deductible IRA out in a lump sum at 40.8% taxes is about as realistic as my example is realistic…. but as we both agree tax protection is good.
Thanks for reading,
FiPhysician
I agree most docs would not withdraw money at 40.8%. I should have included a more complete example using a lower tax rate, although I did allude to it with this comment- “So no, even after 50 years, it doesn’t make sense unless you can somehow do a Roth conversion or get into a lower tax bracket at withdrawal. How much lower? Well, at 50 years, your tax bracket would have to be at least 6% lower. At 5 years, it would have to be at least 15% lower.”
So if you, like many docs, are going to be facing marginal tax rates of 22% or 24% in retirement, that tax-deferral aspect of a non-deductible IRA or even VA can overcome the effect of having to withdraw at ordinary income tax rates. However, it should be acknowledged that in those situations, you are likely to also have a lower LTCG/qualified dividend rate in the taxable account, maybe even 0%. So you have to run the numbers. And again, I’m ignoring other benefits of a taxable account- flexibility, step-up in basis at death, ability to tax loss harvest, ability to use appreciated shares for charitable donations etc. For example, in my 7 figure taxable account I have no shares that I have held for more than a year and so they all have quite high basis relative to value. I routinely flush out all the capital gains with large charitable contributions. I’ve also harvested $75K+ in losses in the last year. That makes my taxable account incredibly tax-efficient. For someone like me, that VA/NDIRA is almost never going to make sense despite my high tax bracket.
Reviewed. Thanks FI Physician for the analysis. The one thing I like about economics is that it is a social science. Charlie Munger says economists have “physics envy.” It all depends on the clients personal situation and the assumptions that are made. Appreciate the discussion.
I love how FIphysician said “What I find ironic about VA’s is that the “average” investor does better in high-cost VA’s than they do investing their own money. Why? Because the surrender charges keep them from pulling their money out at the wrong time! So, stupidity trumps high fees every time… but of course there are no average investors reading this blog.”
I’m not sure though that “stupidity” would describe the average investors pulling out, but rather it’s not knowing your risk tolerance. The surrender fees forces the average investor to increase their risk tolerance, and therefore a VA makes sense it seems from a behavioral standpoint.
Jim, any comment on using a VA maybe if you don’t know your risk tolerance, or if your risk tolerance may be somewhat conservative where your asset allocation is mostly tax inefficient bonds? Or if you have a spending problem and the VA locks at least a portion of your retirement portfolio from being touched? Just from my understanding of a VA, it seems that it might makes sense to pay higher fees based on psychology rather than math.
RACELARI –
Thanks for “softening” my mention of stupidity. You are right it is not stupidity; perhaps ignorance of a complicated system where job one of the financial industrial complex is to obfuscate and confuse so the average investor thinks they need high priced assistance.
A better understanding of risk tolerance and the fact that the market corrects and has recessions regularly is needed before investing on your own. And even that doesn’t help when VTSAX is down 40%!!!
A comment on your behavioral VA thoughts: Using a VA with 2-3% fees and 7-10 year surrender period is worse than a 1% AUM fee-only “here take my money and manage it because I don’t want to think about it” attitude. So, I think a fee-only advisor might make sense in that setting, vs a fee-based guy who will not only sell you the expensive VA but manage it for you too!
If your asset allocation calls for more bonds than you have room for, then a IOVA might be right for you.
I hear similar argument a lot from whole life insurance guys- investors are so dumb that even things that are bad for them and overly expensive are worth it if it can keep them investing something. I find it insulting as an investor. If the problem is you don’t save enough, you don’t have an aggressive enough asset allocation, you don’t stay the course etc then why not address the problem instead of finding some cockamamie work-around solution.
yup, definitely better to avoid these VA’s given the fees if trying to use a vehicle’s rules to protect youself from pulling out in a bear market. I have sort of a related question regarding more traditional retirement accounts. Is there any data on putting all of your equity portfolio in a 401k/403b in order to increase your risk tolerance? here me out- I find that the penalties for pulling out of a tax deferred account forces me to NEVER want to pull that money out before the age of 59 1/2. Thus I would see myself in a bear market tolerating a much more aggressive, even 100%, equity portfolio, given in a bear market not only would I have the pain of huge losses, but additional pain of the penalties.
Jim, I read your “bonds go in taxable” post with interest, but I think it’s worth mentioning the psychology of risk tolerance when you throw in the possible huge penalties of tax deferred accounts is another reason bonds go in taxable. I could see myself in a bear market pulling out much more easily if my equities were in taxable.
dude, is Jason Zweig around on this forum? This is right up his alley!
Sure, that’ll keep you from pulling the money out, but it won’t keep you from exchanging it for a bond fund.
And the age 59 1/2 rule is pretty easy to get around anyway: https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
Make sure you read the follow-up to that asset location post: https://www.whitecoatinvestor.com/my-two-asset-location-pet-peeves/
I exchange emails with Jason but I don’t know that he spends much time reading my blog.
This is the sort of post that I thoroughly enjoy. Gets right at the key issues. As it happens I have a modest Vanguard VA that I opened at work before I figured out how to use after tax contributions for a mega backdoor Roth. So unlike the previous commenters, mine was not especially strategic. In fact, I remember being conflicted about the VA vs. taxable at the time and defaulted to deferring taxes. (Too bad I didn’t have this post to check my assumptions!) It is only about $60 K or so, and I plan to hold it until my tax rate drops in retirement in about three years and cash it all then.
Jim, I’m not sure, but for consistency should you not also count the drag of the TSM fee? Although even if the arithmetic answer is yes I suspect that at .04 it is unlikely to make much difference.
I believe I did, but if I somehow forgot, you’re right that it essentially makes no difference being so low.
I like to keep it simple, no VA or any annuity for that matter, asset protection done via umbrella and malpractice insurance.
We have made a lot of investing mistakes over the years which = investing experience.
We purchased 2 VA back in 1996. A few years ago we switched them both to a fixed GIA (general interest account) each paying 4% & 3% and only 1 has a $35 yearly fee given they both are GIA accounts.
The plan is that both of these will go to our kids as part of our estate as we don’t plan on using these tax deferred funds.
Are they any other viable options that can benefit the investor rather than a salesman?
Yes! Don’t use them!! , just put your money in old fashioned taxable brokerage account, great vehicle for inheritance as your kids will enjoy the step up basis.
Yeah I get it… 🙂
Was implying is there anyway to get out of them at this point without either taxing a tax hit or having to tie up the funds for an extended period of time? I think not, however worth seeing what others think.
One additional point to keep in mind is that tax laws will change several times over that 50 year period. I have only been putting money in retirement plans and investments for 25 years. When I started there were no Roth IRA’s and dividends and capital gains were taxed at the same rate as all the rest of your income. There were traditional IRA’s but none of the residents at my institution could deduct our contributions because we were theoretically part of the hospital retirement plan. Except that the plan design made it not very useful for a typical resident. So, variable annuities and non deductible IRA’s were the best options based on the facts at the time.
Over the length of less than a typical career, let alone an investing lifetime, has been the introduction of Roth IRA’s, the elimination of the $100 k income limit for conversion to a Roth, the creation of a special tax rate for capital gains and dividends, the creation of Roth employer retirement vehicles, and a doubling of voluntary tax deferral space for academic & government physicians with the 457b. Then there have been many smaller rate changes with things like the PPACA and lowering of brackets for higher income earners. Then there are the changes in one’s personal life…illness…successful blog…marriage or divorce….
I bring this up because when we are 30, we tend to plan as if the rules are set in stone. I think it is helpful to realize that, while very useful, calculations comparing outcomes over longer time periods may end up giving the wrong answer. So you need to re-evaluate as you go. And, for me, when option A and option B give outcomes in the same ballpark, I choose the one that gives diversification.
Excellent point.
Hey WCI
I understand the broad overarching principles but I have a technical question. For the chart in TSM Mutual Fund, I am confused as to how some columns are calculated. Specifically what is being taxed year to year (i.e where is 52.51 coming from in row 3). I am similarly confused as to how basis is calculated year to year.
I also did not understand how you broke down a tax deferred (traditional) IRA. “It grows tax-free and comes out tax-free” – my understanding is that yes a tIRA grows tax free, but aren’t you taxed when it is withdrawn (aka comes out?) I was flat out lost when you stated “you are investing on behalf of the government and will turn over at the same time you withdraw money from your tax-free account…But the general idea is that this money grows tax-protected and gains are tax-free.” I know that you pay taxes when you withdraw from a tIRA but I don’t know how to reconcile that with your description of a traditional IRA.
Technicalities aside appreciate all you do.
2% yield is $200 in that first year. $200 * 23.8% = $48.84.
Hope that helps.
Yes you pay tax when you withdraw money from an IRA. The paragraph is explaining that a tax-deferred account is really a tax-free account plus a government account. The government account is the tax. The tax-free account is yours.
I thought the account was growing at 8% annually, not 2. Apologies for needing to have it spelled out, as you can tell I’m new at this.
It is growing at 8% annually. But the yield is only 2%. You only pay taxes on the distributions until you sell.