Author Topic: 401K Tax advantage  (Read 6992 times)

Dynasty

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401K Tax advantage
« on: January 29, 2013, 08:42:21 PM »
Hey all, been doing some thinking the past few weeks.

Here is my situation.

25% tax bracket

My employer matches 5% 401K contributions.  I contribute my 5%, and get the match.

In addition to my salary, and I get 770/month tax free veterans benefits.

I don't spend a penny of the VA bennies. Currently, 416 of the va money goes into a ROTH, and the remainder goes into a Vanguard fund.

Would it make more sense to increase my 401k contribution by however much my VA benefits are?

Based on rough math, it seems like I'm leaving about 2300 dollars in tax benefits on the table every year.

my thinking was, I increase my 401 contributions by the $770, and use the VA money towards living expenses. However, after all is said in done my check ever two weeks would be netting me an extra 80 or 90 dollars in tax benefits.

Am is missing something? Or would it make more sense to contribute a little less every month so I the combination of the tax benefits, and lesser amount of VA money is still enough to max the Roth IRA out?


twinge

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Re: 401K Tax advantage
« Reply #1 on: January 30, 2013, 05:17:20 AM »
Both the Roth and the 401k have tax benefits.  The 401k you get the benefit right away but are taxed on withdrawal, the Roth you pay taxes now and have tax-free withdrawals.

The thinking to do is think through at least these questions and make a judgment based on your situations:
1) Do you expect to be in a lower or higher tax bracket in retirement?
2) Do you expect the general tax rates to be lower or higher in retirement?
3) Do you want the freedom/flexibility of the Roth to be able to withdraw contributions and in some cases earnings without penalty before traditional retirement age if needed?

For my own situation -- in a similar/sometimes higher tax bracket-- I max out a 401k and then max out a Roth IRA--choosing that over maxing out a traditional IRA for the flexibility and to hedge my bets on future taxes.

bo_knows

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Re: 401K Tax advantage
« Reply #2 on: January 30, 2013, 05:46:50 AM »
Without knowing more, I'd say that your plan to further increase your 401k is a good one.

Like Twinge, I prefer to max out my 401k first, then pursue other investing avenues.

Questions though:  What is your medium/long term plans for retirement? Are you looking to RE? If so, whats the time horizon?

Also... that $416/mo into Roth is based on the old max contribution of $5000/yr.  They upped it to $5500 for 2013. (though, as I said before, I prefer maxing the 401k first, unless you're planning on buying a house, in which you could use some of the Roth contributions for a downpayment).

Dynasty

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Re: 401K Tax advantage
« Reply #3 on: January 30, 2013, 10:18:52 AM »
IRA contribution was upped this year?  That is good to know.

No one really has any idea what the tax rate is going to be 30 years from now.  So its probably a good idea to have a combination of taxed and tax free retirement.  I'll have to figure out what my split should be.

I would like to up my 401K. I'll probably start with adding an extra $150/paycheck.

My next question is, do I see the tax savings immediately on my paycheck, or after I file taxes for the year? 

icefr

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Re: 401K Tax advantage
« Reply #4 on: January 30, 2013, 10:49:43 AM »
My next question is, do I see the tax savings immediately on my paycheck, or after I file taxes for the year?

It directly reduces your taxable income on your paycheck, so you should pay less taxes each payroll period.

James

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Re: 401K Tax advantage
« Reply #5 on: January 30, 2013, 11:04:34 AM »
One consideration is where your tax rate will end up in the rest of your career.  If you expect to get to a higher tax rate than 25%, then I would keep maxing your Roth.

Dynasty

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Re: 401K Tax advantage
« Reply #6 on: February 01, 2013, 09:34:09 AM »
This is a tricky question regarding the tax rate when I retire.

Currently I live in a income tax free state, but we have sales tax.  Supposedly, when I retire I could move to a sales tax free state that does have an income tax.

My gut could be wrong, but its telling me to have 60/40 mix of taxable and non taxable retirement.

Another concern I have, and this may be completely psychological. Since I'm funding my ROTH with tax free income, why would I want to convert it to taxable income?

I'm going to need to run the numbers in the next few weeks, and see what my projected retirement is at my current savings rate, and hopefully be able to figure out how much of it is going to be taxable at 25% or greater.  I played around with this a couple days ago, and it showed a retirement income of 110.8%... Not sure how this can be so high because I input 3.75% annual inflation, and only 4% investment growth.

 

momo

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Re: 401K Tax advantage
« Reply #7 on: February 01, 2013, 01:57:59 PM »
Just thinking outloud for a minute so please bear with me. Isn't it true our national debt has exceeded 16 trillion dollars and grows hourly? Aren't our entitlement programs vastly underfunded and our leaders cannot seem to solve the overspending? The tax code continues to grow and there is no sign it will be simplified, right? So perhaps I am oversimplifying things but where will our government get the money they need?

I feel the main source will be our taxes which they must raise over time to fund programs and reduce our ballooning national debt. So I feel when people say they do not know where taxes will be in the future, I wonder isn't it obvious that taxes will be higher? Does anyone really believe we will eliminate our national debt? I do not, so I believe the post-tax benefits of a Roth IRA, Roth401k or other tax advantaged vehicles are worth considering even if I may end up earning less and have the large deductions (mortgage, children) eliminated by the time I retire. 

Perhaps a more balanced approach for the 401 can be explored using both the tax deferred and tax advantaged opinions? What have others done and if you are willing to share, why did you choose that approach?

Thanks for sharing. Cheers!
« Last Edit: February 04, 2013, 10:55:50 AM by Stashtastic Momo »

chucklesmcgee

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Re: 401K Tax advantage
« Reply #8 on: February 02, 2013, 09:59:30 AM »
I feel when people say they do not know where taxes will be in the future, I wonder isn't it obvious that taxes will be higher? Does anyone really believe we will eliminate our national debt? I do not, so I believe the post-tax benefits of a Roth IRA, Roth401k or other tax advantaged vehicles are worth considering even if I may end up earning less and have the large deductions (mortgage, children) eliminated.

I'm right with you on this. People are poo-pooing the importance of that national debt but the fact is that we're on a mathematically unsustainable path with no signs of stopping. Income taxes are pretty much at historic lows and I have to imagine that taxes are going to look more like Carter-early Reagan rates (~70%) than Clinton-Bush ones. I'm shoving every penny I can into tax-exempt earnings- Roth 401k, Roth IRA (backdoor conversion), HSA, 529. I'm looking into doing a backdoor employer contribution (traditional) 401k-> traditional IRA-> Roth IRA so that I can get another $30k or so of employer contributions as tax-exempt earnings.

Quick240

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Re: 401K Tax advantage
« Reply #9 on: February 05, 2013, 11:56:35 AM »
I'm looking into doing a backdoor employer contribution (traditional) 401k-> traditional IRA-> Roth IRA so that I can get another $30k or so of employer contributions as tax-exempt earnings.

Can you elaborate on this?

sherr

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Re: 401K Tax advantage
« Reply #10 on: February 05, 2013, 12:06:12 PM »
One consideration is where your tax rate will end up in the rest of your career.  If you expect to get to a higher tax rate than 25%, then I would keep maxing your Roth.

I disagree, I think this is completely irrelevant. The only two things that matter are tax rates at contribution time and tax rates at withdrawal time. If you withdraw from a Traditional 401k / IRA while your tax bracket is 28%, then yes you should have put it in a Roth account instead. But why on earth would you do that? If you are still working and making enough money to be in a 28% tax bracket then you shouldn't need to withdraw any money from your 401k, on the contrary you should be even more motivated to contribute every last penny to Traditional accounts.

sherr

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Re: 401K Tax advantage
« Reply #11 on: February 05, 2013, 12:23:16 PM »
I feel when people say they do not know where taxes will be in the future, I wonder isn't it obvious that taxes will be higher? Does anyone really believe we will eliminate our national debt? I do not, so I believe the post-tax benefits of a Roth IRA, Roth401k or other tax advantaged vehicles are worth considering even if I may end up earning less and have the large deductions (mortgage, children) eliminated.

I'm right with you on this. People are poo-pooing the importance of that national debt but the fact is that we're on a mathematically unsustainable path with no signs of stopping. Income taxes are pretty much at historic lows and I have to imagine that taxes are going to look more like Carter-early Reagan rates (~70%) than Clinton-Bush ones. I'm shoving every penny I can into tax-exempt earnings- Roth 401k, Roth IRA (backdoor conversion), HSA, 529. I'm looking into doing a backdoor employer contribution (traditional) 401k-> traditional IRA-> Roth IRA so that I can get another $30k or so of employer contributions as tax-exempt earnings.

Taxes *will* obviously be higher, but it is not at all obvious that taxes on *low income* families will be much higher. Just looking through some inflation adjusted historical tax rates, if you only withdraw $30k (or the inflation-adjusted equivalent) in retirement then it is incredibly unlikely that you will pay more than an average of 15% tax on it in any given period of history. And a 15% average tax rate in retirement is the break-even point where Roth and Traditional accounts are equivalent, assuming a 10% early withdrawal penalty and a 25% current tax bracket and no additional tricks to reduce / eliminate retirement tax / early withdrawal penalty.

The "risk" of heavily increased taxes on low-spenders like ourselves is IMHO heavily over-hyped, and hedging against that small risk is not worth the potentially large decrease in portfolio value. Neither of us can see the future, the tax rates for low-income families could just as easily go to zero as they could double. Choosing the lesser choice given information currently available in order to hedge against the possibility that things could be much worse in the future is a very risky bet.

sherr

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Re: 401K Tax advantage
« Reply #12 on: February 05, 2013, 12:58:05 PM »
I'm looking into doing a backdoor employer contribution (traditional) 401k-> traditional IRA-> Roth IRA so that I can get another $30k or so of employer contributions as tax-exempt earnings.

Can you elaborate on this?

Unless Chuckles knows of a magical conversion loophole that I do not, then he's probably referring to a 5-year revolving Roth IRA account to avoid early withdrawal fees. I'm no expert in this myself since it's something I won't have to deal with for a while, but I believe it goes something like this.

The Setup:
1) You contributed all your money to Traditional 401k / IRA accounts to reduce your total tax burden to the lowest possible levels.
2) If you withdraw money from your Traditional 401k / IRA before you are old (69 1/2 I think) you have to pay a 10% early-withdrawal penalty, which you want to avoid if you can
3) In Roth accounts you can withdraw principal payments after 5 years without an early-withdrawal penalty, after all you've already paid taxes on that money. Any capital gains you withdraw though you will owe the early-withdrawal penalty on.
4) You can convert money from a Traditional account to a Roth account without paying the 10% early-withdrawal penalty. After all, you aren't withdrawing it, you're converting it to a different type of retirement account.
5) Any money you convert from a Traditional to Roth will be counted as income and taxed at your current tax rate. There's no free lunch here.
6) Money you convert from Traditional to Roth counts as a "principle" in your Roth account.

So the plan goes something like:
1) Convert as much money as you can from Traditional to Roth before you get into the higher tax brackets. Do this every year.
2) After 5 years the money you converted is eligible for withdrawal. No further taxes or penalties are required.

So really you just have to have enough money in Roth / other accounts to sustain you for those first 5 years. Every year after that you will have money available in the Roth that was originally in the Traditional account.

The benefit is that you can almost entirely avoid the 10% early-withdrawal penalties while enjoying the larger benefits of Traditional accounts (at least for us High-income-while-working and Low-income-in-retirement folks).

The 401k -> Traditional IRA bit comes from pre-2008 rules where you could only convert from Traditional IRA to Roth IRA. So when you retired or changed jobs you'd convert the 401k into a Traditional IRA first. Now the rules let you convert from 401k directly to Roth IRA, so that step isn't really necessary.

Again, I'm not 100% sure on this strategy, so if I got something wrong please correct me.

chucklesmcgee

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Re: 401K Tax advantage
« Reply #13 on: February 05, 2013, 07:29:07 PM »
I run my own company and 401k plan, so I'm the employer and the employee. Plan is to do an immediate employer contribution (I run my own corporation) and then do an in-service 401k rollover of employer contributions to a traditional IRA, then convert this to a Roth IRA. I'm really still very fuzzy on this and the law has just changed regarding in-service 401k rollovers for people under 59 1/2, so I'm still investigating.

Real point is that I'm gung ho about Roth contributions.

**update**

After looking into it, it appears quite possible that I CAN directly perform an in-plan 401k conversion of the employer traditional 401k contributions to Roth 401k assets. Obviously I'll have to pay tax on that as income. This comes thanks to recent passing of the Fiscal Cliff law and "SEC. 902. AMOUNTS IN APPLICABLE RETIREMENT PLANS MAY BE TRANSFERRED TO DESIGNATED ROTH ACCOUNTS WITHOUT DISTRIBUTION." But this is a topic for another thread.
« Last Edit: February 06, 2013, 10:36:10 AM by chucklesmcgee »

eyePod

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Re: 401K Tax advantage
« Reply #14 on: February 06, 2013, 09:57:36 AM »

2) If you withdraw money from your Traditional 401k / IRA before you are old (69 1/2 I think) you have to pay a 10% early-withdrawal penalty, which you want to avoid if you can

It's 59 1/2, not 69 and 1/2.  I didn't get to read anything else you posted, but that just jumped out at me!