Tax Free Asset Mechanics

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jreese30306
Posts: 1
Joined: Fri Apr 09, 2010 11:58 pm

Tax Free Asset Mechanics

Post by jreese30306 »

Are tax free assets 'grown' at the average asset rate posted as the "Return - Average" on the Summary Input page? I assume this is the case.

If so, how would I address having a large amount of assets in say, a Tax Free Muni Fund - that earns less than the "Return - Average" rate.

Thanks.
jimr
Posts: 821
Joined: Thu Feb 28, 2008 6:48 pm

Re: Tax Free Asset Mechanics

Post by jimr »

Hello,

Your assumption is correct that all portfolio assets share the same rate of return parameters. In each year of each simulation run, a single portfolio return is generated (using a random function and the return & std dev). That single return is applied to all 3 portfolios (taxable, tax free, tax deferred) for that year.

The simulation would be more accurate if returns were generated independently for each portfolio type. I've added a note to implement this capability in the additional inputs section next time I'm in the code.

In the meantime, you could play around with other inputs to try to simulate the rate of return differential. Increasing the investment tax rate will result in a lower rate of return for taxable investments. Increasing the income tax rate (assuming you don't have other taxable retirement income) would have the same effect as lowering the rate of return on tax deferred assets.

Hope that helps...

Jim
katelara
Posts: 1
Joined: Sat Jan 18, 2014 4:01 am

Re: Tax Free Asset Mechanics

Post by katelara »

wonderful tool! Anyone on this forum can point me how to deal with college saving plans (e.g. 529). Those accumulate tax free and distributions for tuition and room and board are tax free. I can see how I can put college expenses into the tool, but how can I add contributions and distributions from a 529 plan. Those will only apply over some defined period (hopefully 4 years).

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Last edited by katelara on Thu Jan 08, 2015 4:56 am, edited 4 times in total.
jimr
Posts: 821
Joined: Thu Feb 28, 2008 6:48 pm

Re: Tax Free Asset Mechanics

Post by jimr »

Hi Kate,

Thanks for posting. There are a couple of ways to handle this, but there isn't any one exact perfect answer.

One approach is to lump college savings in with taxable savings and just accept the inaccuracy of the tax handling differences. If your 529 balance is $50k, you could inflate it by a little to account for this inaccuracy and enter a balance like $55k or so. You could make a similar adjustment for planned 529 contributions. The amount of the adjustment you'd make is dependent on how many years away college expenses are. If they start within a few years, you probably don't need to make any adjustments.

Another possibility is to omit both the 529 and the college expenses you expect it to fund from your plan. In this case, you'd make a separate estimate of your expected future college savings (considering future savings and investment gains) and then make an estimate of your total estimated college expenses adjusted for inflation. In the planner, you'd only enter the college expenses that won't be covered by your future college savings.

This is definitely guess work, but it's important to understand that the retirement planning process is all about estimation, and there are many unknowns and many estimation errors in the mix. The planner is designed to help reduce those estimation errors, but as you can see, it doesn't handle everything.

To help you feel better about your estimates, try a planner run with some rough guesses from one or both of the approaches above, then double your estimate and run the planner again. If you did the first approach, double your expected 529 balance. If you did the second approach, double the expected out-of-pocket college expenses. As you do this, notice how much the change in the estimate impacts your plan's probability of success. My suspicion is that even a big error in your estimate for these expenses won't have a major impact on your plan's chances for success. If that's true, then you probably don't need to worry about being super precise. OTOH, if you notice a big difference in your plan's probability of success as you adjust these college expense assumptions, that's a sign that this is important and deserves extra effort to get the estimate as accurate as possible.

I hope this is helpful and please don't hesitate to post a followup.

Jim
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