Author Topic: Max your 401k vs put in just enough to get into lowest tax bracket possible  (Read 9764 times)

Hoosier Daddy

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All,

I was hoping you could help me understand if I am missing something: is there any reason you would want to max your 401k contributions instead of find out what is the lowest tax bracket you can get into and then contribute just enough to stay in that progressive tax bracket? I make 53k a year and can stay in 15% tax bracket but don't need to put in 18k to do it with exemptions and standard deduction thus is there any reason I should max the 401k instead of just pay the 15% tax and get my money out?

Cheddar Stacker

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If you can max a traditional 401k, and a traditional IRA, you might qualify for this:

http://www.irs.gov/Credits-&-Deductions/Individuals/Retirement-Savings-Contributions-Credit-Savers-Credit

There are other reasons as well and I'm sure others will chime in. Even if you get down to 15% tax, you might be able to go much lower once you retire and pay an effective tax rate of 0-10%.

thd7t

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Being at the top of the 15% tax bracket and being at the bottom of the 25% bracket isn't that different.  Why wouldn't you contribute as far as you can and lower your tax burden as far as possible? 

RexualChocolate

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You also have to remember that you only ever pay taxes once on IRA/401k money as income tax.

You skip all of the capital gains taxes on appreciation.

dandarc

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Underlying the question is the assumption that 15% is a good, low tax rate to pay.  As often is the case, that depends.

If you're spending 20K / year, and currently in a state with an income tax, and your long-term plan is to keep spending about that, and to move to a no-income-tax state when you retire, then 15% federal + whatever state tax is likely a high tax rate to be paying, compared to what you'll pay on withdrawal.

If on the other hand, you expect your income to go up considerably, and plan to inflate your spending as well, then paying the 15% tax today could be a great deal.  Maybe you're a doctor and this 53K is your resident salary.  Couple years from now, you're expecting to make 6 figures as an attending.

And as Cheddar points out, the saver's tax credit might be within reach for you, which adds value to the traditional 401K / IRA side of the equation.  Of course if you're married or have kids, other credits might already have your federal income tax down to 0 or less.  Everything is specific to your situation.

ShoulderThingThatGoesUp

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Getting a guaranteed 17% boost on money by not paying 15% on it is pretty good.

nereo

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You also have to remember that you only ever pay taxes once on IRA/401k money as income tax.

You skip all of the capital gains taxes on appreciation.

This.  Besides the fact that the money goes in tax-free, one of the biggest bonuses is that the money grows tax-free.  In the beginning that's not a big deal, but when your 401(k) balance is in the six-figure range it is a very big deal.  Cumulatively, you can save tens of thousands this way over a decade or two.

Also, don't forget the power of the roll-over.  Money in a 401(k) can be rolled over into a tIRA or ROTH.  There's even the option of doing a "Mega-Backdoor ROTH' where you can use your 401(k) to contribute $35k into a ROTH, where it will never be taxed again.

To sum up: taxes, taxes, taxes (or lack thereof).  That's the ultimate power of your 401(k).

Hoosier Daddy

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Getting a guaranteed 17% boost on money by not paying 15% on it is pretty good.

I'm missing something... where does the 17% come into play?

Hoosier Daddy

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If you can max a traditional 401k, and a traditional IRA, you might qualify for this:

http://www.irs.gov/Credits-&-Deductions/Individuals/Retirement-Savings-Contributions-Credit-Savers-Credit

There are other reasons as well and I'm sure others will chime in. Even if you get down to 15% tax, you might be able to go much lower once you retire and pay an effective tax rate of 0-10%.

My tax credit would be close, but I could get $200 lol. I appreciate you sharing this; $200 is still $200 lol.

Hoosier Daddy

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Underlying the question is the assumption that 15% is a good, low tax rate to pay.  As often is the case, that depends.

If you're spending 20K / year, and currently in a state with an income tax, and your long-term plan is to keep spending about that, and to move to a no-income-tax state when you retire, then 15% federal + whatever state tax is likely a high tax rate to be paying, compared to what you'll pay on withdrawal.

If on the other hand, you expect your income to go up considerably, and plan to inflate your spending as well, then paying the 15% tax today could be a great deal.  Maybe you're a doctor and this 53K is your resident salary.  Couple years from now, you're expecting to make 6 figures as an attending.

And as Cheddar points out, the saver's tax credit might be within reach for you, which adds value to the traditional 401K / IRA side of the equation.  Of course if you're married or have kids, other credits might already have your federal income tax down to 0 or less.  Everything is specific to your situation.

Thank you. Because of this post I maxed out my contributions; Didn't think of it this way. Well put!

MDM

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My tax credit would be close, but I could get $200 lol. I appreciate you sharing this; $200 is still $200 lol.
Only $200?  Assuming the $53K in the OP and MFJ w/ 2 exemptions (based on the 15% bracket in the OP):

  $53,000 gross
- $18,000 401k
   ---------
  $35,000 AGI

- $12,600 std. deduct.
- $  8,000 exemptions
    ---------
  $14,400 Taxable income

  $  1,440 Tax
- $  2,000 Saver's Credit
    ---------
            $0 Federal tax

How close is this to your situation?


Cheddar Stacker

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Getting a guaranteed 17% boost on money by not paying 15% on it is pretty good.

I'm missing something... where does the 17% come into play?

2% employer match maybe?

MDM, I think OP is single. $36k ish to meet the top of the 15% bracket. 53k - 10k (exemption/deduction) - 7k 401k contributions would get him there.

MDM

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MDM, I think OP is single. $36k ish to meet the top of the 15% bracket. 53k - 10k (exemption/deduction) - 7k 401k contributions would get him there.
Certainly possible.

MDM

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My tax credit would be close, but I could get $200 lol. I appreciate you sharing this; $200 is still $200 lol.
Yes, only $200 if filing single w/ 1 exemption - perhaps I also read too much into the plural "exemptions" in the OP:

  $53,000 gross
- $18,000 401k
- $  5,500 IRA
   ---------
  $29,500 AGI

- $  6,300 std. deduct.
- $  4,000 exemption
    ---------
  $19,200 Taxable income

  $  2,419 Tax
- $     200 Saver's Credit
    ---------
   $ 2,219 Federal tax

Hoosier Daddy

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My tax credit would be close, but I could get $200 lol. I appreciate you sharing this; $200 is still $200 lol.
Yes, only $200 if filing single w/ 1 exemption - perhaps I also read too much into the plural "exemptions" in the OP:

  $53,000 gross
- $18,000 401k
- $  5,500 IRA
   ---------
  $29,500 AGI

- $  6,300 std. deduct.
- $  4,000 exemption
    ---------
  $19,200 Taxable income

  $  2,419 Tax
- $     200 Saver's Credit
    ---------
   $ 2,219 Federal tax

yes this is what I was thinking. However my financial planning never includes bonuses, which I got this year, thus my income will be about $60k actually. Then I think I am going to put my money in a Roth IRA so that way I can live off of the contributions for 5 years until my roth pipeline kicks in during ER.

Thank you all so much for the help!
« Last Edit: May 12, 2015, 06:53:06 PM by Hoosier Daddy »

Eric

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You also have to remember that you only ever pay taxes once on IRA/401k money as income tax.

You skip all of the capital gains taxes on appreciation.

This.  Besides the fact that the money goes in tax-free, one of the biggest bonuses is that the money grows tax-free.  In the beginning that's not a big deal, but when your 401(k) balance is in the six-figure range it is a very big deal.  Cumulatively, you can save tens of thousands this way over a decade or two.

There is no extra growth because it's tax free.  The only difference is the tax rate now vs the tax rate then.  If the tax rates are the same, then the amount is the same.

Contribute $18K/year pre-tax with 7% growth per year is $248,696 after 10 years.  Take off 15% in taxes and you're at $211,392
$18K/year taxed at 15% is $15,300, contribute $15,300 per year post-tax with 7% growth per year and viola, $211,392

Sure there's some tax nuances, but the math doesn't care when the tax amount is applied. (This assumes a 15% tax bracket or lower for one, as then capital gains are not taxed)

However, the vast majority of us will be in a lower tax bracket when retired.  That's where the savings comes from and why we should max 401ks now to delay taxes until later.  But it has nothing to do with the actual delay, only the change in tax brackets.
« Last Edit: May 12, 2015, 11:31:17 PM by Eric »

ShoulderThingThatGoesUp

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Getting a guaranteed 17% boost on money by not paying 15% on it is pretty good.

I'm missing something... where does the 17% come into play?

For $100 of salary in the 15% bracket, ordinarily you'd get $85, right?

But if you put it into your 401k, you get (100-85)/85 = 17.6% more.

I think that's the right way to calculate it.

nereo

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This.  Besides the fact that the money goes in tax-free, one of the biggest bonuses is that the money grows tax-free.  In the beginning that's not a big deal, but when your 401(k) balance is in the six-figure range it is a very big deal.  Cumulatively, you can save tens of thousands this way over a decade or two.

There is no extra growth because it's tax free.  The only difference is the tax rate now vs the tax rate then.  If the tax rates are the same, then the amount is the same.

Contribute $18K/year pre-tax with 7% growth per year is $248,696 after 10 years.  Take off 15% in taxes and you're at $211,392
$18K/year taxed at 15% is $15,300, contribute $15,300 per year post-tax with 7% growth per year and viola, $211,392

Sure there's some tax nuances, but the math doesn't care when the tax amount is applied. (This assumes a 15% tax bracket or lower for one, as then capital gains are not taxed)
Eric - what about dividends?  Either I really have a hole in my understanding or you pay taxes on all dividends in normal investment accounts but not in a 401(k).  So if you have a 401(k) with $250k that earns $6,000 in dividends per year, you will pay $0 in taxes each year.  That same amount in a normal investment account would result in an extra $900 in taxes (assuming 15% if you are in the 25% tax bracket.  If you are in a lower income bracket it might very well be $0 and this is all mute).
Cumulatively after a decade or so the non tax-deferred investment account may rack up ~$10k in taxes (assume some growth) while the 401(k) would rack up exactly $0.   Correct?

zolotiyeruki

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Eric - what about dividends?  Either I really have a hole in my understanding or you pay taxes on all dividends in normal investment accounts but not in a 401(k).  So if you have a 401(k) with $250k that earns $6,000 in dividends per year, you will pay $0 in taxes each year.  That same amount in a normal investment account would result in an extra $900 in taxes (assuming 15% if you are in the 25% tax bracket.  If you are in a lower income bracket it might very well be $0 and this is all mute).
Cumulatively after a decade or so the non tax-deferred investment account may rack up ~$10k in taxes (assume some growth) while the 401(k) would rack up exactly $0.   Correct?
For normal investment accounts, qualified dividends and long-term capital gains are actually taxed at 0% if you're in the 15% tax bracket or lower.  So as long as you keep your income low when you're using that income, it's like a Roth (i.e. no taxes on withdrawal) but better (you can withdraw at any time).
« Last Edit: May 13, 2015, 03:22:25 PM by zolotiyeruki »

Cheddar Stacker

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This.  Besides the fact that the money goes in tax-free, one of the biggest bonuses is that the money grows tax-free.  In the beginning that's not a big deal, but when your 401(k) balance is in the six-figure range it is a very big deal.  Cumulatively, you can save tens of thousands this way over a decade or two.

There is no extra growth because it's tax free.  The only difference is the tax rate now vs the tax rate then.  If the tax rates are the same, then the amount is the same.

Contribute $18K/year pre-tax with 7% growth per year is $248,696 after 10 years.  Take off 15% in taxes and you're at $211,392
$18K/year taxed at 15% is $15,300, contribute $15,300 per year post-tax with 7% growth per year and viola, $211,392

Sure there's some tax nuances, but the math doesn't care when the tax amount is applied. (This assumes a 15% tax bracket or lower for one, as then capital gains are not taxed)
Eric - what about dividends?  Either I really have a hole in my understanding or you pay taxes on all dividends in normal investment accounts but not in a 401(k).  So if you have a 401(k) with $250k that earns $6,000 in dividends per year, you will pay $0 in taxes each year.  That same amount in a normal investment account would result in an extra $900 in taxes (assuming 15% if you are in the 25% tax bracket.  If you are in a lower income bracket it might very well be $0 and this is all mute).
Cumulatively after a decade or so the non tax-deferred investment account may rack up ~$10k in taxes (assume some growth) while the 401(k) would rack up exactly $0.   Correct?

That's correct, but all withdrawals from the 401k are taxed at ordinary rates. In Eric's example, that would be 15%, same as the dividend tax rate you used. So it's a wash still if the tax rate stays at a flat 15%. It will never do that, but his statement is still fact. The timing of the tax is irrelevant, only the rate matters in the analysis.

beltim

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This.  Besides the fact that the money goes in tax-free, one of the biggest bonuses is that the money grows tax-free.  In the beginning that's not a big deal, but when your 401(k) balance is in the six-figure range it is a very big deal.  Cumulatively, you can save tens of thousands this way over a decade or two.

There is no extra growth because it's tax free.  The only difference is the tax rate now vs the tax rate then.  If the tax rates are the same, then the amount is the same.

Contribute $18K/year pre-tax with 7% growth per year is $248,696 after 10 years.  Take off 15% in taxes and you're at $211,392
$18K/year taxed at 15% is $15,300, contribute $15,300 per year post-tax with 7% growth per year and viola, $211,392

Sure there's some tax nuances, but the math doesn't care when the tax amount is applied. (This assumes a 15% tax bracket or lower for one, as then capital gains are not taxed)
Eric - what about dividends?  Either I really have a hole in my understanding or you pay taxes on all dividends in normal investment accounts but not in a 401(k).  So if you have a 401(k) with $250k that earns $6,000 in dividends per year, you will pay $0 in taxes each year.  That same amount in a normal investment account would result in an extra $900 in taxes (assuming 15% if you are in the 25% tax bracket.  If you are in a lower income bracket it might very well be $0 and this is all mute).
Cumulatively after a decade or so the non tax-deferred investment account may rack up ~$10k in taxes (assume some growth) while the 401(k) would rack up exactly $0.   Correct?

That's correct, but all withdrawals from the 401k are taxed at ordinary rates. In Eric's example, that would be 15%, same as the dividend tax rate you used. So it's a wash still if the tax rate stays at a flat 15%. It will never do that, but his statement is still fact. The timing of the tax is irrelevant, only the rate matters in the analysis.

Nereo's point is that if you pay a tax on dividends or capital gains, then it is a big deal, even if the starting and ending tax rates are the same.  If you have the tax at an intermediate stage, you don't benefit from that growth.  I think you understand this, but for anyone else following along, here's a simplified example:
In a 401k:
Start with a $10,000 balance.  Receive a dividend of $300.  Reinvest the dividend.  Market goes up another 10%.  You're left with (10000+300)*1.1 = 11,330.
After 25% taxes you have .75 * 11330 = 8497.50

In a taxable account
:
Start with an $7,500 (in this example the investor is in the 25% tax bracket).  Receive a dividend of $225, pay taxes of .15*225 = 33.75.  Reinvest the 225 - 33.75 = 191.25.  The market goes up another 10%, giving you a balance of (7500 + 191.25) * 1.10 = 8460.37.  Owe capital gains tax of .15*(8460.37-7691.25) = 115.37.  Final balance is 8460.37 - 115.37 = 8345.

With more years and more intermediate steps the effect gets bigger.

Jeremy E.

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My tax credit would be close, but I could get $200 lol. I appreciate you sharing this; $200 is still $200 lol.
Yes, only $200 if filing single w/ 1 exemption - perhaps I also read too much into the plural "exemptions" in the OP:

  $53,000 gross
- $18,000 401k
- $  5,500 IRA
   ---------
  $29,500 AGI

- $  6,300 std. deduct.
- $  4,000 exemption
    ---------
  $19,200 Taxable income

  $  2,419 Tax
- $     200 Saver's Credit
    ---------
   $ 2,219 Federal tax
What is this $4,000 exemption and how can I get it, and also why is the std. deduction only $6,300?

dandarc

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The only reason I'm aware of that you wouldn't be entitled to at least 1 exemption is if you're being claimed as a dependent on someone else's return.  Standard deduction is only 6300 because OP is single.

http://www.forbes.com/sites/kellyphillipserb/2014/10/30/irs-announces-2015-tax-brackets-standard-deduction-amounts-and-more/

Bob W

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Put in just enough and then build your real estate rental empire.

MDM

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What is this $4,000 exemption and how can I get it, and also why is the std. deduction only $6,300?
For exemption, depending on which form you filed, what did you have on the following?
 - 1040: Line 42
 - 1040A: Line 26
 - 1040EZ: Line 5

For std. deduction, what do you think it should be for a single filer?  ...for MFJ?

Jeremy E.

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What is this $4,000 exemption and how can I get it, and also why is the std. deduction only $6,300?
For exemption, depending on which form you filed, what did you have on the following?
 - 1040: Line 42
 - 1040A: Line 26
 - 1040EZ: Line 5

For std. deduction, what do you think it should be for a single filer?  ...for MFJ?
Sorry my mom did my taxes lol, so I'm still learning the tax code. I'm a head of household though so my standard deduction I believe was $8,950, and I guess I sometimes forget that not everyone is a head of household. This exemption is new to me, I'm sure I've received it but I haven't put it into the excel spreadsheet that I made, I'll go ahead and add it so my calculations are more accurate. thanks

frugalnacho

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This.  Besides the fact that the money goes in tax-free, one of the biggest bonuses is that the money grows tax-free.  In the beginning that's not a big deal, but when your 401(k) balance is in the six-figure range it is a very big deal.  Cumulatively, you can save tens of thousands this way over a decade or two.

There is no extra growth because it's tax free.  The only difference is the tax rate now vs the tax rate then.  If the tax rates are the same, then the amount is the same.

Contribute $18K/year pre-tax with 7% growth per year is $248,696 after 10 years.  Take off 15% in taxes and you're at $211,392
$18K/year taxed at 15% is $15,300, contribute $15,300 per year post-tax with 7% growth per year and viola, $211,392

Sure there's some tax nuances, but the math doesn't care when the tax amount is applied. (This assumes a 15% tax bracket or lower for one, as then capital gains are not taxed)
Eric - what about dividends?  Either I really have a hole in my understanding or you pay taxes on all dividends in normal investment accounts but not in a 401(k).  So if you have a 401(k) with $250k that earns $6,000 in dividends per year, you will pay $0 in taxes each year.  That same amount in a normal investment account would result in an extra $900 in taxes (assuming 15% if you are in the 25% tax bracket.  If you are in a lower income bracket it might very well be $0 and this is all mute).
Cumulatively after a decade or so the non tax-deferred investment account may rack up ~$10k in taxes (assume some growth) while the 401(k) would rack up exactly $0.   Correct?

That's correct, but all withdrawals from the 401k are taxed at ordinary rates. In Eric's example, that would be 15%, same as the dividend tax rate you used. So it's a wash still if the tax rate stays at a flat 15%. It will never do that, but his statement is still fact. The timing of the tax is irrelevant, only the rate matters in the analysis.

Nereo's point is that if you pay a tax on dividends or capital gains, then it is a big deal, even if the starting and ending tax rates are the same.  If you have the tax at an intermediate stage, you don't benefit from that growth.  I think you understand this, but for anyone else following along, here's a simplified example:
In a 401k:
Start with a $10,000 balance.  Receive a dividend of $300.  Reinvest the dividend.  Market goes up another 10%.  You're left with (10000+300)*1.1 = 11,330.
After 25% taxes you have .75 * 11330 = 8497.50

In a taxable account
:
Start with an $7,500 (in this example the investor is in the 25% tax bracket).  Receive a dividend of $225, pay taxes of .15*225 = 33.75.  Reinvest the 225 - 33.75 = 191.25.  The market goes up another 10%, giving you a balance of (7500 + 191.25) * 1.10 = 8460.37.  Owe capital gains tax of .15*(8460.37-7691.25) = 115.37.  Final balance is 8460.37 - 115.37 = 8345.

With more years and more intermediate steps the effect gets bigger.

Won't the payment of dividends reduce the value of your investment proportionally?  So in the first case with $10,000 and a $300 dividend you are left with $9,700 investment and $300 dividend reinvested so $10,000.  Market goes up 10% so you have $11,000 and have to pay tax on all of it.  Withdraw and pay 25% income tax = $8,250

In the second scenario you have $7,500 in a taxable account, get $225 of dividends, and owe 15% of that in taxes (so reinvest 85% of dividend payment back into it) and end up with $7,466.25.  10% market increase yields $8,212.88.  10% capital gains owed on ($8,212.88 - ($7,500 + 0.85*225) = $521.63), which is $52.16.  So total ending value of $8,160.72. 

So I get slightly different numbers, but agree with your point.  The money in the 401k account won't be subject to dividend/capital gains taxes, and that difference will be able to continue to compound in the account.

However if you lower the tax bracket from 25% to 15%, and the dividends/capital gains from 15% to 0% and you end up with the same value in both scenarios.

The real benefit as I see it though is being able to take that chunk of money that is in the 15% or 25% bracket and avoid taxes completely on the front end, allow those tax savings to grow and compound with your investment, and then withdraw it at a lower (or even 0%) tax bracket on the back end thus avoiding taxes altogether.

As for the ops original question, it would depend on your personal situation and where you expect to be when you start to withdraw that money.  I'm not sure if I understand correctly, but it sounds like the op might have a misconception of how tax brackets are applied and taxes are calculated.  If I contribute just enough money to lower me into the 15% bracket, that means I am still paying 15% on that entire bracket.  Every dollar I am able to shelter still saves me 15 cents of taxes (until I hit the 10% bracket).  Unless you plan to increase your spending significantly once your retire you are almost certainly better off contributing more to a 401k/ira even if it doesn't bump you to another tax bracket.  You still benefit from that reduction in taxes.

beltim

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Won't the payment of dividends reduce the value of your investment proportionally?

So I get slightly different numbers, but agree with your point.  The money in the 401k account won't be subject to dividend/capital gains taxes, and that difference will be able to continue to compound in the account.

Yeah, the numbers are just illustrative and it doesn't matter if you use 10% or 13.4% (that's 1.10/.97).  I just wanted to point out that tax deferment can be a major advantage of retirement plans.

Quote
However if you lower the tax bracket from 25% to 15%, and the dividends/capital gains from 15% to 0% and you end up with the same value in both scenarios.

Of course.  But that's exactly why Nereo specified the 25% tax bracket.  And, of course, don't forget state taxes.  I've paid far more in state income taxes than federal income taxes on my taxable investments, so it's a much bigger issue for me.  And these analyses always seem to forget it (gocurrycracker is the worst offender).

Quote
The real benefit as I see it though is being able to take that chunk of money that is in the 15% or 25% bracket and avoid taxes completely on the front end, allow those tax savings to grow and compound with your investment, and then withdraw it at a lower (or even 0%) tax bracket on the back end thus avoiding taxes altogether.

For very early retirees, sure.  But even if you are a traditional retiree and spend just as much money in retirement as you do during your career, a 401k—traditional or Roth—is a huge advantage because you don't have to pay any intermediate taxes on dividends or capital gains.

frugalnacho

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The real benefit as I see it though is being able to take that chunk of money that is in the 15% or 25% bracket and avoid taxes completely on the front end, allow those tax savings to grow and compound with your investment, and then withdraw it at a lower (or even 0%) tax bracket on the back end thus avoiding taxes altogether.

For very early retirees, sure.  But even if you are a traditional retiree and spend just as much money in retirement as you do during your career, a 401k—traditional or Roth—is a huge advantage because you don't have to pay any intermediate taxes on dividends or capital gains.

Even if you spend more money in retirement you are still taking advantage of this.  Those first tax free dollars you are taking out were the last dollars you earned in some previous year.  The intermediate taxes on dividends and capital gains is small potatoes compared to the fact that you completely avoided income tax on the first $20k or so you pull out each year during retirement. 

beltim

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The real benefit as I see it though is being able to take that chunk of money that is in the 15% or 25% bracket and avoid taxes completely on the front end, allow those tax savings to grow and compound with your investment, and then withdraw it at a lower (or even 0%) tax bracket on the back end thus avoiding taxes altogether.

For very early retirees, sure.  But even if you are a traditional retiree and spend just as much money in retirement as you do during your career, a 401k—traditional or Roth—is a huge advantage because you don't have to pay any intermediate taxes on dividends or capital gains.

Even if you spend more money in retirement you are still taking advantage of this.  Those first tax free dollars you are taking out were the last dollars you earned in some previous year.  The intermediate taxes on dividends and capital gains is small potatoes compared to the fact that you completely avoided income tax on the first $20k or so you pull out each year during retirement.

Not necessarily.  Consider someone who has, say, $1.5 million in a 401k already, and she's trying to decide where to put a $10k investment this year.  Say she's single, and she's in the 25% tax bracket.  Her portfolio is already enough to cover $60k expenses.  Any money she puts into her 401k this year will come out in the 25% tax bracket.

frugalnacho

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The real benefit as I see it though is being able to take that chunk of money that is in the 15% or 25% bracket and avoid taxes completely on the front end, allow those tax savings to grow and compound with your investment, and then withdraw it at a lower (or even 0%) tax bracket on the back end thus avoiding taxes altogether.

For very early retirees, sure.  But even if you are a traditional retiree and spend just as much money in retirement as you do during your career, a 401k—traditional or Roth—is a huge advantage because you don't have to pay any intermediate taxes on dividends or capital gains.

Even if you spend more money in retirement you are still taking advantage of this.  Those first tax free dollars you are taking out were the last dollars you earned in some previous year.  The intermediate taxes on dividends and capital gains is small potatoes compared to the fact that you completely avoided income tax on the first $20k or so you pull out each year during retirement.

Not necessarily.  Consider someone who has, say, $1.5 million in a 401k already, and she's trying to decide where to put a $10k investment this year.  Say she's single, and she's in the 25% tax bracket.  Her portfolio is already enough to cover $60k expenses.  Any money she puts into her 401k this year will come out in the 25% tax bracket.

Of course, and some of the dollars I extract in retirement I will have to pay the same tax rate as if I just paid taxes on it in the year I earned it.  But the overwhelming majority of those dollars will be at a lower tax bracket for me and for the hypothetical woman you described.  Her $10k investment now might come back out in the 25% bracket (if the market goes gangbusters it might even come out in a higher bracket), but the other $1M she invested is going to come out much lower.  The only way for that scenario of her putting in a $10k chunk and then withdrawing it later in the same tax bracket is if she has already taken advantage of deferring her expensive dollars (like I described). 

beltim

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Of course, and some of the dollars I extract in retirement I will have to pay the same tax rate as if I just paid taxes on it in the year I earned it.  But the overwhelming majority of those dollars will be at a lower tax bracket for me and for the hypothetical woman you described.  Her $10k investment now might come back out in the 25% bracket (if the market goes gangbusters it might even come out in a higher bracket), but the other $1M she invested is going to come out much lower.  The only way for that scenario of her putting in a $10k chunk and then withdrawing it later in the same tax bracket is if she has already taken advantage of deferring her expensive dollars (like I described).

I think we agree and we're just coming to the conversation from different points.  I just wanted to make the point that even if you're not saving any money from a reduction in taxes paid by using a 401k, the tax deferment still saves you money.

As a sidenote, I think most of the population that I'm talking about here is quite un-Mustachian, and receives significant taxable income in retirement from non-savings sources, particular Social Security but also possibly a pension.  The average Social Security benefit completely fills the retirees tax-free space and gets them ~1/3 of the way through the 10% tax bracket, assuming they have enough other income to make Social Security benefits taxable.

MDM

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The only way for that scenario of her putting in a $10k chunk and then withdrawing it later in the same tax bracket is if she has already taken advantage of deferring her expensive dollars (like I described).
Or has other income streams (pension, SS, side job, etc.) to "fill up the low brackets."

Not 100% true but more true than not:
  - The more one has already contributed to traditional, the more Roth makes sense. 
  - The more one has already contributed to Roth, the more traditional makes sense. 

beltim

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The only way for that scenario of her putting in a $10k chunk and then withdrawing it later in the same tax bracket is if she has already taken advantage of deferring her expensive dollars (like I described).
Or has other income streams (pension, SS, side job, etc.) to "fill up the low brackets."

Not 100% true but more true than not:
  - The more one has already contributed to traditional, the more Roth makes sense. 
  - The more one has already contributed to Roth, the more traditional makes sense.

The really crazy scenarios are the ones where a traditional makes more sense now, but potential higher future income may mean that you're better off contributing to a Roth now so that your benefit from a traditional later has even higher value.

Optimization is fun!

MDM

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The really crazy scenarios are the ones where a traditional makes more sense now, but potential higher future income may mean that you're better off contributing to a Roth now so that your benefit from a traditional later has even higher value.

Optimization is fun!

True on all counts!

frugalnacho

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Of course, and some of the dollars I extract in retirement I will have to pay the same tax rate as if I just paid taxes on it in the year I earned it.  But the overwhelming majority of those dollars will be at a lower tax bracket for me and for the hypothetical woman you described.  Her $10k investment now might come back out in the 25% bracket (if the market goes gangbusters it might even come out in a higher bracket), but the other $1M she invested is going to come out much lower.  The only way for that scenario of her putting in a $10k chunk and then withdrawing it later in the same tax bracket is if she has already taken advantage of deferring her expensive dollars (like I described).

I think we agree and we're just coming to the conversation from different points.  I just wanted to make the point that even if you're not saving any money from a reduction in taxes paid by using a 401k, the tax deferment still saves you money.

As a sidenote, I think most of the population that I'm talking about here is quite un-Mustachian, and receives significant taxable income in retirement from non-savings sources, particular Social Security but also possibly a pension.  The average Social Security benefit completely fills the retirees tax-free space and gets them ~1/3 of the way through the 10% tax bracket, assuming they have enough other income to make Social Security benefits taxable.

We definitely agree.  I just wanted to point out to the noobs that there is an often overlooked benefit of last dollars in, first dollars out that give the early retiree a HUGE tax benefit.  It seems like it is most often overlooked when they reduce it to "i'm in the 15% bracket now, and anticipate being in the 15% bracket when I retire, therefore contributing more to my 401k doesn't give me any advantage".

MDM

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We definitely agree.
Maybe...I hope.

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I just wanted to point out to the noobs that there is an often overlooked benefit of last dollars in, first dollars out that give the early retiree a HUGE tax benefit.
It's "current dollars in now" vs. "those same dollars out later" - correct?  If the first dollars out later are already identified (e.g., prior traditional contributions, or other income) then the dollars in now are coming out at the future marginal rate - are we agreed?

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It seems like it is most often overlooked when they reduce it to "i'm in the 15% bracket now, and anticipate being in the 15% bracket when I retire, therefore contributing more to my 401k doesn't give me any advantage".
Definitely agree if the comparison is vs. taxable.  See previous paragraph for traditional vs. Roth.

frugalnacho

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We definitely agree.
Maybe...I hope.

Pretty sure we do.  I understand what he is saying.

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I just wanted to point out to the noobs that there is an often overlooked benefit of last dollars in, first dollars out that give the early retiree a HUGE tax benefit.
It's "current dollars in now" vs. "those same dollars out later" - correct?  If the first dollars out later are already identified (e.g., prior traditional contributions, or other income) then the dollars in now are coming out at the future marginal rate - are we agreed?

Yes, yes.  If you already have your future low tax brackets filled up with other income sources then you are not the typical early retiree I am speaking of.  Many of the "15%" dollars I am deferring right now will be taken out at 0% or 10%.  That should be true for the majority of early retirees.

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It seems like it is most often overlooked when they reduce it to "i'm in the 15% bracket now, and anticipate being in the 15% bracket when I retire, therefore contributing more to my 401k doesn't give me any advantage".
Definitely agree if the comparison is vs. taxable.  See previous paragraph for traditional vs. Roth.

Yea, you can get all kinds of weird scenarios.  I was mostly addressing the misconception.  I feel like the op might have a misconception about how taxes work.  Stopping as soon as he hit's the 15% bracket might make sense, or it might be a terrible mistake depending on his anticipated spending in early retirement.  He could potentially contribute more and get a 15% savings on that money, which is then taken out in a lower tax bracket in the future, even if a portion of that money ends up being in the 15% bracket at that time.


MDM

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Many of the "15%" dollars I am deferring right now will be taken out at 0% or 10%.
In the best possible way, I hope you are wrong. :)

But that would be good!  Let me explain....  Depending on how much you have already deferred and the rate of return you get on those deferrals and how long the returns compound (and of course future tax brackets and rates), it's possible you have already covered the 0% or even 10% brackets with the future value of those past deferrals.  If so, the dollars being deferred now might be withdrawn at a 15% tax rate.  Or not - depends on your situation.  Not a bad problem to have, if you do....

frugalnacho

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Many of the "15%" dollars I am deferring right now will be taken out at 0% or 10%.
In the best possible way, I hope you are wrong. :)

But that would be good!  Let me explain....  Depending on how much you have already deferred and the rate of return you get on those deferrals and how long the returns compound (and of course future tax brackets and rates), it's possible you have already covered the 0% or even 10% brackets with the future value of those past deferrals.  If so, the dollars being deferred now might be withdrawn at a 15% tax rate.  Or not - depends on your situation.  Not a bad problem to have, if you do....

If I had enough in my stache to draw up to the top of the 10% bracket indefinitely...i'd be FIRE right now. And if I cross that threshold at some point, I will probably just FIRE rather than continue to work.  I suppose if the market gets 25% returns every year for the next decade I might already be FI and not know it yet, but I doubt that is going to happen.  My plan is to reach FIRE, and then withdraw enough to stay in the 0% bracket indefinitely.  Maybe towards the end of my life if everything goes well I will be in a situation where my stache has outpaced my spending and i'm forced to withdraw ever increasing amounts that will bump me into a higher tax bracket.  But in that situation it would be a nice problem to have.

Drifterrider

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All,

I was hoping you could help me understand if I am missing something: is there any reason you would want to max your 401k contributions instead of find out what is the lowest tax bracket you can get into and then contribute just enough to stay in that progressive tax bracket? I make 53k a year and can stay in 15% tax bracket but don't need to put in 18k to do it with exemptions and standard deduction thus is there any reason I should max the 401k instead of just pay the 15% tax and get my money out?

For me the greatest reason is that it acts as a forced savings.  Out of sight, out of mind. 

randommadness

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For me the greatest reason is that it acts as a forced savings.  Out of sight, out of mind.

This. I'm terrible at saving but in my mind I think... damn I'm getting to invest an extra 25% of my money + I don't see it.... yay.

Pooperman

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Many of the "15%" dollars I am deferring right now will be taken out at 0% or 10%.
In the best possible way, I hope you are wrong. :)

But that would be good!  Let me explain....  Depending on how much you have already deferred and the rate of return you get on those deferrals and how long the returns compound (and of course future tax brackets and rates), it's possible you have already covered the 0% or even 10% brackets with the future value of those past deferrals.  If so, the dollars being deferred now might be withdrawn at a 15% tax rate.  Or not - depends on your situation.  Not a bad problem to have, if you do....

If I had enough in my stache to draw up to the top of the 10% bracket indefinitely...i'd be FIRE right now. And if I cross that threshold at some point, I will probably just FIRE rather than continue to work. I suppose if the market gets 25% returns every year for the next decade I might already be FI and not know it yet, but I doubt that is going to happen. My plan is to reach FIRE, and then withdraw enough to stay in the 0% bracket indefinitely.  Maybe towards the end of my life if everything goes well I will be in a situation where my stache has outpaced my spending and i'm forced to withdraw ever increasing amounts that will bump me into a higher tax bracket. But in that situation it would be a nice problem to have.

For a couple it's somewheres around $40k/yr (top of the 10% bracket). That's more than me and my fiancee spend in a year... And we live in a very high cost of living area. We could move somewhere much cheaper and spend on the order of $25k pretty easily, so I'd agree with your assessment!