Author Topic: How are traditional 401k's helpful?  (Read 5758 times)

Murse

  • Pencil Stache
  • ****
  • Posts: 540
How are traditional 401k's helpful?
« on: December 25, 2014, 11:31:22 AM »
Okay, so I was curious is having the governments money compound for you is helpful to you? So I made some assumptions. I assumed a 20% tax rate in both scenarios.
#1) 100k invested in a 401k for 20 years at 8% annual gains= 466,095.71*.8= 372,876.57 after taxes.
#2) (in my mind this would be like a roth 401k) 100k*.8=80k 80k compounded 20 years at 8% = 372,876.57.

Now I understand there are tricks in the traditional to get it out without taxes, and I understand these accounts protect it from taxation while growing. This is more of a roth vs 401k question. We can not see into the future so how do you decide between the two unless you are in one of the extremes (super high or super low income?) My thinking is if you are limited to 17k/ year, roth would be best because is a traditional (again using a 20% tax rate) it seems to me you can only fit 13,600$ of YOUR money in while in a Roth, you get the full 17,000 of your money protected from taxation while growing.

dandarc

  • Magnum Stache
  • ******
  • Posts: 3375
  • Age: 36
Re: How are traditional 401k's helpful?
« Reply #1 on: December 25, 2014, 11:46:13 AM »
The standard thought is that if you think your tax rates will be higher in retirement, Roth is better.  If you think they will be lower in retirement, Traditional is better.

Most people on this forum, I would venture, are betting on paying lower tax rates in retirement than now.  Why?  Take my wife and I - our gross right now is ~180K.  But we spend ~60K (hoping to get this down).  In retirement, it would be downright stupid of us to create an after-tax income of more than 60K per year, because we don't need that income to live.  It would take a substantial change in the tax code to make our effective tax rate on 60K the same or higher than it is on 180K (we do a lot to reduce our tax bill already, and still our AGI should be something like 90K).

Murse

  • Pencil Stache
  • ****
  • Posts: 540
Re: How are traditional 401k's helpful?
« Reply #2 on: December 25, 2014, 12:01:37 PM »
Isn't there quite a lot of risk in assuming that the loop holes aren't closed for pulling money out without taxes? I mean, if your entire retirement plan is based on not having to pay taxes, could the whole plan not be destroyed? This is all theoretical for me but I plan on getting my first "big boy" job in 6 months or so.

Travis

  • Handlebar Stache
  • *****
  • Posts: 2403
  • Location: Arizona
Re: How are traditional 401k's helpful?
« Reply #3 on: December 25, 2014, 12:05:54 PM »
 One of the variables you're missing in this equation is your current income tax rate.  A traditional 401k would lower your taxable income now by $17.5k ($18k next year) while using a Roth would have your full current income taxed.  How it looks on the back end entirely depends on what your retirement-age income ends up being.  Right now I consider using the traditional to be a good option because it keeps me in the 15% tax bracket. When I retire I don't know what taxes will be like, but I'm making a planning assumption that my income will be at or less than I'm making now which should keep me in that lower bracket later.

I'm confused by your math.  Where does the $13.6k number come from?  I think you're oversimplifying how taxes affect these scenarios.  Regardless of which type you use, you're still investing the same amount of money.  You can't just lop of a percentage and do your calculation from there.

Murse

  • Pencil Stache
  • ****
  • Posts: 540
Re: How are traditional 401k's helpful?
« Reply #4 on: December 25, 2014, 12:19:45 PM »
Isn't there quite a lot of risk in assuming that the loop holes aren't closed for pulling money out without taxes? I mean, if your entire retirement plan is based on not having to pay taxes, could the whole plan not be destroyed? This is all theoretical for me but I plan on getting my first "big boy" job in 6 months or so.

A low or zero tax rate in retirement is not a loophole. The whole point of the traditional account (at the federal level anyway; it's actually different in some states) is that it lets you defer income until retirement and then pay retirement tax rates on it. So that's not a loophole, it's the design of the system.

You might, however, be referring to the loopholes required to extract the money before the designated retirement ages without paying the 10% penalty. The most popular loophole discussed on these forums is the "Roth pipeline", and I agree with you that it is risky to base your retirement strategy around that, since the ability to withdraw Roth conversions after 5 years could be closed at any time. It's not an essential part of the system and few people depend on it, so it would be a relatively uncontroversial change.

Additionally, the "Roth pipeline" is overrated as a loophole. It only allows you to access the conversion amounts early, not the income earned on those conversions. Suppose you are converting $10,000 per year. At any given point during the pipeline, you would have $50,000 in conversions underway. If you are earning 10%, that money is generating $5,000 per year that you won't be able to access until the distant future (assuming you retire around age 30) without paying a penalty -- and that compounds.

Instead of the "Roth pipeline", you have the option of moving to Canada to avoid the early withdraw penalties (seriously; it's not a joke and American early retirees should seriously consider it). Or in the worst case, if you pay the 10% penalty, that's equivalent to having to work roughly a year longer than necessary. Some people might hate work so much that an extra year is disturbing, but most on these boards, so far as I can read, are building in buffers larger than a year, so that probably doesn't scare them too much.

I'm confused by your math.  Where does the $13.6k number come from?  I think you're oversimplifying how taxes affect these scenarios.  Regardless of which type you use, you're still investing the same amount of money.  You can't just lop of a percentage and do your calculation from there.

The OP's math is correct and my post may illustrate that in a way that is easier to follow. If you assume the tax will be the same on both ends (which is the OP's assumption), a designated Roth account allows you to shelter more assets than a traditional 401(k) account. It is not true that the same amount of money is being sheltered.
Thank you for deciphering my post for the others, are retirement taxes different then income taxes? How so?

kpd905

  • Handlebar Stache
  • *****
  • Posts: 1712
Re: How are traditional 401k's helpful?
« Reply #5 on: December 25, 2014, 12:55:21 PM »
Withdrawals from traditional 401ks and IRAs will count as income, but you will not pay FICA and medicare on that amount like you do with normal wages. 

The benefit to a traditional 401k is that you can save taxes at your marginal rate (right now every dollar I put into my 401k saves me 30%+ taxes), and then withdraw and fill up the tax brackets from the bottom up.  The first $10k is tax free, then $10k at 10%, then a bunch at 15%.


Additionally, the "Roth pipeline" is overrated as a loophole. It only allows you to access the conversion amounts early, not the income earned on those conversions.

I think the Roth pipeline is a better option than 72t, since you can control your taxes.  As for not accessing the gains, most people plan to need some money after age 59.5, so this can be part of it.  It definitely seems like an easier option than moving to a whole different country.
« Last Edit: December 25, 2014, 01:04:16 PM by kpd905 »

glorkvorn

  • 5 O'Clock Shadow
  • *
  • Posts: 8
Re: How are traditional 401k's helpful?
« Reply #6 on: December 25, 2014, 01:10:10 PM »
Okay, so I was curious is having the governments money compound for you is helpful to you? So I made some assumptions. I assumed a 20% tax rate in both scenarios.
#1) 100k invested in a 401k for 20 years at 8% annual gains= 466,095.71*.8= 372,876.57 after taxes.
#2) (in my mind this would be like a roth 401k) 100k*.8=80k 80k compounded 20 years at 8% = 372,876.57.

Now I understand there are tricks in the traditional to get it out without taxes, and I understand these accounts protect it from taxation while growing. This is more of a roth vs 401k question. We can not see into the future so how do you decide between the two unless you are in one of the extremes (super high or super low income?) My thinking is if you are limited to 17k/ year, roth would be best because is a traditional (again using a 20% tax rate) it seems to me you can only fit 13,600$ of YOUR money in while in a Roth, you get the full 17,000 of your money protected from taxation while growing.
You're confusing the marginal tax rate with the effective tax rate.  Even if you're in the 20% tax bracket, most of your money isn't being taxed at that rate.  The money that you put into the Roth probably is, because that's coming off the top of your income.  But if you're relying on the retirement account money for all your income, then that will "fill up" the lower tax brackets (including the 0% tax bracket) before you get to the 20% bracket, so you're overall average rate might be something like 10% or even lower.

If you're going to completely stop working in retirement than the traditional is the way to go.  The Roth only makes sense if you think you're going to keep on working and accumulate a huge amount.

kpd905

  • Handlebar Stache
  • *****
  • Posts: 1712
Re: How are traditional 401k's helpful?
« Reply #7 on: December 25, 2014, 03:49:14 PM »
I think the Roth pipeline is a better option than 72t, since you can control your taxes.  As for not accessing the gains, most people plan to need some money after age 59.5, so this can be part of it.  It definitely seems like an easier option than moving to a whole different country.

The amount of money required for ages 30 to 59.5 is approximately the same as, or not much less than, the amount required for ages 30 through to your death, so not much extra money is required for the latter part. As a result, the Roth pipeline forces you to basically "forget about" the income earned on your conversions for 29.5 years, because you must have saved enough to get by without it. This means you need to significantly oversave if you use the Roth pipeline method, compared to the moving to Canada method.

Yes, but the Roth pipeline method doesn't involve moving to another country.  Most people will not want to do that.  I would just pay the 10% penalty before moving to another country.  It is nice to know that option is there though.

And I would guess that the vast majority of people are not retiring at 30, so they will not be tying up those earnings for 30 years.  More likely 10-15 in most cases.
« Last Edit: December 25, 2014, 04:03:38 PM by kpd905 »

chasesfish

  • Magnum Stache
  • ******
  • Posts: 3003
  • Age: 37
  • Location: Texas
    • Years in the making, I created a journal!
Re: How are traditional 401k's helpful?
« Reply #8 on: December 25, 2014, 04:49:08 PM »
The 401k is very helpful to me.  I get to put $28,000 away courtesy of a generous employer match and reduce my taxable income now.  I make 3-4x in income now compared to what I spend or will need in retirement.   If you don't get an employer match and have a low rate currently, the Roth may be better.  That's assuming politicians don't change the rules years from now because only "rich" people have access to such an account.

glorkvorn

  • 5 O'Clock Shadow
  • *
  • Posts: 8
Re: How are traditional 401k's helpful?
« Reply #9 on: December 25, 2014, 04:56:53 PM »
You're confusing the marginal tax rate with the effective tax rate.  Even if you're in the 20% tax bracket, most of your money isn't being taxed at that rate.

The OP's argument doesn't rely on any confusion between marginal and average rates.

Also, it's very easy to pay over 20% average rate in the USA (especially if you include state taxes). My average rate is significantly higher than that.
Yes it does.  His calculation assumes the same tax rate on both.  That could be the case in traditional retirement planning where you have a pension supplying most of your income and the retirement account is just a cherry on top, all taxed at the marginal rate.  But if *all* your taxable income is from the retirement account, it will not be all at the marginal rate.

And, while it's great that you earn a high income Cathy I was just going with the numbers FutureNurse posted (20% marginal).  I never said that it was impossible to pay over 20% average.

Murse

  • Pencil Stache
  • ****
  • Posts: 540
Re: How are traditional 401k's helpful?
« Reply #10 on: December 26, 2014, 10:56:56 AM »
So this raises a question in my mind, at what tax bracket would you use a Roth vs traditional? And why?
« Last Edit: December 26, 2014, 10:58:38 AM by FutureNurse »

Murse

  • Pencil Stache
  • ****
  • Posts: 540
Re: How are traditional 401k's helpful?
« Reply #11 on: December 26, 2014, 11:34:25 AM »
So this raises a question in my mind, at what tax bracket would you use a Roth vs 401k?

If you assume the tax regime will be the same now as in the future, it seems like you already know how to do the math on this. Most people will tell you it depends on whether your marginal rate will be higher in retirement than now, but as you know, that is not strictly true because of how the designated Roth account holds more assets. Basically the designated Roth account is better unless you expect your marginal tax rate in retirement to be significantly lower than it is now. I don't feel like computing the exact numerical thresholds but you already know how to do that anyway.

Keep in mind, however, that the future is filled with uncertainties.
Cathy, in your mind does any of this change if we are talking about Roth 457's vs traditional 457's?

dandarc

  • Magnum Stache
  • ******
  • Posts: 3375
  • Age: 36
Re: How are traditional 401k's helpful?
« Reply #12 on: December 26, 2014, 03:11:01 PM »
I dont think there is such a thing as a Roth 457

(Edit - actually there is)
« Last Edit: December 26, 2014, 03:12:39 PM by dandarc »

dandarc

  • Magnum Stache
  • ******
  • Posts: 3375
  • Age: 36
Re: How are traditional 401k's helpful?
« Reply #13 on: December 26, 2014, 03:18:37 PM »
Any way - one important distinction is that on deposit  you save at your marginal tax rate.  On withdrawal you pay your effective tax rate, if you don't have other income.

kpd905

  • Handlebar Stache
  • *****
  • Posts: 1712
Re: How are traditional 401k's helpful?
« Reply #14 on: December 26, 2014, 03:18:48 PM »
So this raises a question in my mind, at what tax bracket would you use a Roth vs traditional? And why?

I would do traditional until I didn't have any income left in the 25% bracket, and then I might possibly switch to Roth.

randommadness

  • Stubble
  • **
  • Posts: 131
  • Location: Denver
Re: How are traditional 401k's helpful?
« Reply #15 on: December 26, 2014, 03:22:12 PM »
Did I miss this anywhere - that doing the 18k into a Traditional also frees up something like 4.5k after tax dollars that can be put into a Roth IRA, and yet still "costs" the same 18k with the reduction in taxes? That would change the dynamic of the equal taxation bit.

dandarc

  • Magnum Stache
  • ******
  • Posts: 3375
  • Age: 36
Re: How are traditional 401k's helpful?
« Reply #16 on: December 26, 2014, 03:31:45 PM »
So this raises a question in my mind, at what tax bracket would you use a Roth vs traditional? And why?

I would do traditional until I didn't have any income left in the 25% bracket, and then I might possibly switch to Roth.
This is where a lot of people draw the line - if you are really committed to keeping expenses down I think a case can be made for even lower brackets in the traditional.