Author Topic: Increase 401k contributions or pay off debt?  (Read 4327 times)

jadbgee

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Increase 401k contributions or pay off debt?
« on: September 30, 2014, 08:53:53 AM »
I'm trying to wrap my head around a tax scenario.

Let's say I have 100k per year of taxable income and my federal tax rate is 25%.  My Iowa state tax rate is 9%, for a total of 34%.

If my retirement expenses are $30,000 per year, would I be paying income taxes at that $30,000 level?  $30k, minus the standard deduction of around $12k, which would mean $18k taxable income?  So that means a 10% federal rate and a 6% state tax rate at that point? 

Adding in the 10% early withdrawal penalty, this would add up to 26% taxes at retirement?  Does that 34% - 26% equal an automatic 8% return, just by using the money in the pre-tax account?

If that's the case, would it not make more sense to max out 401k contributions before paying any debts that are less than 8% interest?

Thanks for any and all replies.

Gin1984

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Re: Increase 401k contributions or pay off debt?
« Reply #1 on: September 30, 2014, 09:01:18 AM »
Why are you even including a 10% penalty?

jadbgee

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Re: Increase 401k contributions or pay off debt?
« Reply #2 on: September 30, 2014, 09:16:30 AM »
Why are you even including a 10% penalty?

I hear there are ways to avoid the early withdrawal penalty, but I haven't done enough research to be certain how to implement them.  Just throwing it in there to steer a little more toward the conservative side of the scenario.

frugaliknowit

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Re: Increase 401k contributions or pay off debt?
« Reply #3 on: September 30, 2014, 09:47:23 AM »
Are we talking about before age 59.5?  Once you're 59.5, there's no 10% penalty...

dandarc

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Re: Increase 401k contributions or pay off debt?
« Reply #4 on: September 30, 2014, 09:58:29 AM »
Not sure the math works exactly that way, but the concept here is exactly why the traditional 401K / IRA is such a great deal.  Assuming you keep your spending level constant between the accumulation and retirement phases, and you retire to no paid work, and there isn't a HUGE shift in the tax law, your effective tax rate will be much lower in retirement than your marginal tax rate today.

Actually, the effective tax rate in retirement will be quite a lot lower than you're projecting - 16% on 18K for federal / state combined, so 2880 / 30K total income = 9.6% effective rate.  Compared to 34% marginal rate you're paying today - this is a fantastic deal.  And this assumes you're not very creative with your tax planning post-retirement (we will assume you at least find ways to avoid the 10% penalty - that is fairly easy to accomplish) - if you've got some Roth IRA and taxable account as well, at 30K of spending you could very well pay no income tax in retirement at all.

Cheddar Stacker

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Re: Increase 401k contributions or pay off debt?
« Reply #5 on: September 30, 2014, 09:59:20 AM »
Here's where your research should start:
http://www.madfientist.com/retire-even-earlier/

You don't need to pay any penalties. And, with spending only $30K (assuming you're married) you won't really need to pay much tax at all either.

We would need more details to properly analyze. However, the answer would likely be "Max out all possible 401k space, and likely anything else you have available to you for tax deferral".

Questions:

Are you married? Your post has a few numbers that indicate you are.
What are your actual interest rates on the debt?
Do you have an employer match? If so, are you getting 100% of that?
Do you have decent investment options in your 401k?
How long do you plan to work?

dandarc

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Re: Increase 401k contributions or pay off debt?
« Reply #6 on: September 30, 2014, 10:00:00 AM »
Oh - and we forgot the exemptions - that's another 8K roughly for a married couple, so you're actually only paying 16% on 10K of taxable income in retirement - 1600 / 30000 = 5.3%.

dandarc

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Re: Increase 401k contributions or pay off debt?
« Reply #7 on: September 30, 2014, 10:02:18 AM »
Cheddar - funny that we seem to reply to the same posts at basically the same time so often.

jadbgee

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Re: Increase 401k contributions or pay off debt?
« Reply #8 on: September 30, 2014, 10:46:56 AM »
Thanks, guys.  I know the numbers are a little off; I just wanted to make sure I had the general concept right in my head.

I need to go make a journal page.

Yes, married.  Debts ranging from 2% up to 10%, some of which aren't particularly mustachian.

There is an employer match of 50% of the first 6%, which is my current contribution rate.

The 401k is currently returning about 6%.  I'm not sure what options I have for changing the allocation of the investments.

I'm trying to figure out a ten year plan.

Cheddar Stacker

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Re: Increase 401k contributions or pay off debt?
« Reply #9 on: September 30, 2014, 10:50:34 AM »
10% is steep. I would attack that. But your tax rate is high and tax deferral is a huge win so consider increasing 401k contributions as well. You can do both with a little work on trimming expenses.

You should definitely look into your 401k investment options and post them on the forum for all to see. If you're not savvy with investments don't be shy, there are many people here who are legitimate experts. I'm not one of them, I've asked for help as well.

Seņora Savings

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Re: Increase 401k contributions or pay off debt?
« Reply #10 on: September 30, 2014, 11:01:35 AM »
That's an 8% total return, not an 8% annual return, like your debts will have.  I'm going to use 18% because anyone pulling this shit can research how to avoid penalties.  The equation would be

(1+ Interest)^years < 1.18

For when it's a good deal.  Solved for interest:

Interest < 1.18^(1/years) -1

If you are 10 years from retirement, that's

Interest < 1.18^(0.1) -1 = 0.017 = 1.7% interest.

Solved for years; it is a good idea if

years < ln(1.18)/ln(1+interest)

There's also the question of how the market will perform.  When dealing with debt you should probably use a bad case scenario, like market returns of 3%.  That means you can add 3% to the debt that you should pay off, in the ten year scenario, it would make sense to keep debts over 4.7%.

jadbgee

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Re: Increase 401k contributions or pay off debt?
« Reply #11 on: September 30, 2014, 12:31:49 PM »
So when you guys are thinking of your taxes, are you just adding that 18% into your living expenses, and then doing the 4% rule or whatever to work backward from that to determine the amount you'll need?

Cheddar Stacker

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Re: Increase 401k contributions or pay off debt?
« Reply #12 on: September 30, 2014, 12:59:21 PM »
So when you guys are thinking of your taxes, are you just adding that 18% into your living expenses, and then doing the 4% rule or whatever to work backward from that to determine the amount you'll need?

If you really only need $30K, you will not be paying taxes. Even if 100% of it is pulled from retirement accounts and therefore taxable, you will have $20K to deduct just with 2 exemptions and the standard deduction. That brings you down to $10K with no other deductions. The tax on that would only be about $1,500, so in that instance you would need to draw down $31,500 ish.

But here's the thing, you don't need to take out $30K from retirement accounts. You will have some cash, some taxable investments, some social security income, etc. If you are living off $30K your healthcare will be subsidized and you might even get some other tax credits to reduce your income. All of these things can reduce your tax burden well below that $1,500.

Maybe I should've linked you over to this post instead. Give it a read: http://www.gocurrycracker.com/the-go-curry-cracker-2013-taxes/


dandarc

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Re: Increase 401k contributions or pay off debt?
« Reply #13 on: September 30, 2014, 01:04:03 PM »
I'm personally planning on managing our income taxes to the point the amount will be negligible in early retirement.  So I'm just using 25X expenses - not worrying about taxes.

The plan is also for at least one of us to continue to work the day job for at least a year post hitting the number - this will give us more safety margin by giving the 'stache a year or more to compound.

Keep in mind, the 4% rule has a lot of safety margin built in - it is designed for your portfolio to last 30 years even if you retired at the worst time ever, historically, and you set your retirement budget and increased it every single year by the CPI.  We can give our individual portfolios a better chance of lasting forever in many ways - side income, adjust spending when the market is down, structure our lives so our personal inflation is less than nation-wide inflation.  So be smart about managing your taxes (by having low spending, you're already doing 80% of the work here), and have faith in yourself to execute the plan!

Gone Fishing

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Re: Increase 401k contributions or pay off debt?
« Reply #14 on: September 30, 2014, 01:13:37 PM »
Most investors would happily accept a guaranteed 8% return (paying off debt).  An interest rate of 5% is about my threshold for hanging on to debt vs investing.