Author Topic: Maximize 401k?  (Read 5243 times)

fe_us_2000

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Maximize 401k?
« on: March 05, 2014, 10:51:35 AM »
Recently my tax person recommended my wife and I to max our 401k contribution. I understand that it will lower the tax bracket. However, I am thinking if someday I am retired at age 70, isn't it that I still have to pay the tax from the 401k money that I take it out? By the way, my wife employer and my employer do not do any contribution matching at all.

If this is the case, what is the difference? Why not pay more taxes at this time and invest the cash into other properties such as house. There is a chance of the house market appreciates much more than putting the money into 401k.

Thank you for any feedbacks! Greatly appreciated.

-Frank

Frankies Girl

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Re: Maximize 401k?
« Reply #1 on: March 05, 2014, 11:09:43 AM »
There are ways to access tax deferred accounts much earlier than 70, with no penalties or taxes paid depending on methods used, such as Roth pipelines and SEPPs. There have been many threads on this forum discussing them.

Here is a few other sites that discuss:
http://www.madfientist.com/traditional-ira-vs-roth-ira/
http://www.gocurrycracker.com/never-pay-taxes-again/
http://www.investopedia.com/articles/retirement/02/112602.asp

In retirement (whether early or at the traditional age) it's expected that you'd likely be in a lower tax bracket than when you were working, so the money that you withdraw would be taxed lower than if you paid taxes on it right now. And if you keep the income in/below the 15% bracket, you can never pay taxes again (GoCurryCracker's site link above explains how this works). 

Maxing your 401K has a two-fold effect: you reduce your taxable income (dropping you to a lower tax bracket in some cases) and you are saving more money that can grow tax deferred. If you can afford it, it's a great idea.
« Last Edit: March 05, 2014, 11:58:32 AM by Frankies Girl »

nawhite

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Re: Maximize 401k?
« Reply #2 on: March 05, 2014, 11:13:44 AM »
Without a match, the decision to put money into a 401k vs another savings vehicle should hinge on your marginal tax rate now vs your expected effective tax rate when you retire.

I'll use myself as an example:

Lets assume:
Tax rates stay the same between now and when I retire.
I'm married and the 2 of us make a combined $100k/year (this puts us in the 25% tax bracket)

This means that every additional dollar I make gets taxed at 25% today. Conversely, every dollar I put towards my 401k does not get taxed at 25%. This 25% marginal rate is different than my "effective tax rate."

Even though I am in the "25% tax bracket," my total taxes (simplified) would be 1785+8197.50+3825 = $13,807.50 (I took out a standard deduction, then charged 10% on the first 17k of income, then 15% on the income up to 72500 then 25% on the income up to 87800)

So my effective tax rate is only 13.8% but my marginal tax rate is 25%.

Money I take out now and put towards my 401k would have been taxed at the full 25%. When I retire, that money will only get taxed at 13.8%, assuming I make the same amount in retirement as I do now. If I were only expecting to live off of 60k/year in retirement vs the full 100k, then the tax rate charged on that money in the 401k would be even lower than 13.8%.

So long story short, assuming you will retire with a similar or smaller income than you are making now, and you don't expect tax rates to go up SIGNIFICANTLY, you will be better off (tax-wise) with saving in a 401k than a Roth or taxable account. I can't say anything about expected returns but personally I'll take the one time 11.2% boost when I can get it.

curler

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Re: Maximize 401k?
« Reply #3 on: March 05, 2014, 11:18:26 AM »
First off, I agree with Nawhite and Frankie's that contributing to a tax-favored account (either a 401(k) or an IRA) is generally preferable to contributing to a taxable account.  Since you aren't getting a match, the general advice is that contributing to an IRA (if you don't already) is preferable to contributing to a 401(k) (But both is better!)


So my effective tax rate is only 13.8% but my marginal tax rate is 25%.

Money I take out now and put towards my 401k would have been taxed at the full 25%. When I retire, that money will only get taxed at 13.8%, assuming I make the same amount in retirement as I do now. If I were only expecting to live off of 60k/year in retirement vs the full 100k, then the tax rate charged on that money in the 401k would be even lower than 13.8%.


Nawhite,
I've never been able to understand this argument, that money withdrawn from a 401(k) is taxed at your average rate.  For every extra dollar that you contribute to the 401(k) now, and withdraw in retirement, that dollar is getting taxed at your marginal rate.  What am I missing?

nawhite

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Re: Maximize 401k?
« Reply #4 on: March 05, 2014, 11:44:33 AM »
Nawhite,
I've never been able to understand this argument, that money withdrawn from a 401(k) is taxed at your average rate.  For every extra dollar that you contribute to the 401(k) now, and withdraw in retirement, that dollar is getting taxed at your marginal rate.  What am I missing?

I'll use my example again. Before I calculated my taxes as:
1785 (10% on the first 17,850) +
8197.50 (15% on the money between 17,850 and 72500) +
3825 (25% on the money between 72,500 and 87800, which is 100k- the standard deduction of 12200)
-------
$13,807.50

If I contribute 10k to my 401k then instead of 25% on money between 72,500 and 87800 (15,300) its 25% on money between 72,500 and 77,800 (5,300). This lowers the taxes I pay by 3825 - 1325 = $2500.

So that 10k gets taxed at 25% (just proved it again by coming from a different direction)

Now, when I retire, lets say 100% of my income comes from my 401k. If I pull out 100k of my 401k in a year, then my income is 100k again and I'll get taxed $13,800 or 13.8%. I will not get taxed 25%.

So money in isn't taxed at 25% and money out gets taxed at 13.8%.

Note, since I'm planning on retiring on more like $40k/year instead of 100k, I'd be looking at closer to an 8% rate instead of a 13.8% rate. Makes the 401k/traditional IRA pretty awesome.

BigRed

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Re: Maximize 401k?
« Reply #5 on: March 05, 2014, 12:02:27 PM »
nawhite is only right if the only income in retirement is from the 401k.  In that case, then ALL of the money going into the 401k would have been taxed at the current marginal rate (maybe... depends on your income level actually and how much you contribute, but generally this is true, especially if you are in teh 25% marginal bracket).  When it comes out, only SOME of the money is taxed at the highest marginal rate, some is taxed at lower rates and some not at all.

However, if you have other streams, then you need to calculate the tax rates AFTER including those streams.  Unless those streams are very large, then it is likely that at least SOME of the 401k money will be taxed at lower than your highest marginal rate in retirement.  Given SS, pension and earnings from taxable accounts exist, then the effective rate on your 401k withdrawals is probably higher than your overall effective rate in retirement.

But the simple thing to note is: Your non-401k retirement income is very likey to be less than your working salary.  So, the 401k withdrawal effective tax rates should be lower than the current effective tax rates.

Not sure if this is clear, but hopefully it adds to the discussion.

curler

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Re: Maximize 401k?
« Reply #6 on: March 05, 2014, 12:23:13 PM »
Thanks.  I guess it applies to your 401(k) as a whole, just not to the marginal dollar if I were considering increasing the contribution.  That is, once I have enough in my 401(k) that I will be withdrawing at the 25% marginal rate in retirement, this benefit doesn't factor into whether or not I should contribute more to me 401(k).

fe_us_2000

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Re: Maximize 401k?
« Reply #7 on: March 05, 2014, 09:42:46 PM »
Thank you all for the great info! It is very beneficial info for me and my wife.

I think we decided to max our 401k contribution. If I do this, can I contribute to regular IRA or roth IRA account that I still have from my previous employer? I have not contributed them for a while.

-Frank

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gobius

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Re: Maximize 401k?
« Reply #9 on: March 10, 2014, 03:34:08 PM »


Now, when I retire, lets say 100% of my income comes from my 401k. If I pull out 100k of my 401k in a year, then my income is 100k again and I'll get taxed $13,800 or 13.8%. I will not get taxed 25%.

So money in isn't taxed at 25% and money out gets taxed at 13.8%.

Note, since I'm planning on retiring on more like $40k/year instead of 100k, I'd be looking at closer to an 8% rate instead of a 13.8% rate. Makes the 401k/traditional IRA pretty awesome.

A couple questions:
1.  Isn't this assuming your 401k income is taxed at the same rate as wage income, rather than investment income?
2.  Is this assuming no 10% penalty?

Cheddar Stacker

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Re: Maximize 401k?
« Reply #10 on: March 10, 2014, 04:00:36 PM »


Now, when I retire, lets say 100% of my income comes from my 401k. If I pull out 100k of my 401k in a year, then my income is 100k again and I'll get taxed $13,800 or 13.8%. I will not get taxed 25%.

So money in isn't taxed at 25% and money out gets taxed at 13.8%.

Note, since I'm planning on retiring on more like $40k/year instead of 100k, I'd be looking at closer to an 8% rate instead of a 13.8% rate. Makes the 401k/traditional IRA pretty awesome.

A couple questions:
1.  Isn't this assuming your 401k income is taxed at the same rate as wage income, rather than investment income?
2.  Is this assuming no 10% penalty?

1. Yes. When you withdraw money from your 401K/IRA it is considered ordinary income and taxed much like wages. It is not taxed as investment income.
2. Yes. There are many ways around the penalties. See the links Frankies Girl provided. They are GOLD.

ender

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Re: Maximize 401k?
« Reply #11 on: March 10, 2014, 05:43:37 PM »
The biggest factor between pretax/Roth 401k is unique for people planning to retire early.

If you build up taxable assets such that you are living on taxable investments or otherwise do not have actual income between say, 45 and 60, you can slowly convert your pretax IRA money into Roth money while your income is $0/year. This will allow you to convert it at a ridiculously low average tax rate and let you take SS/pensions as your only taxable income when you reach that point.

It's considerably more important for MMM types where it's a lot more likely you will have years you have effectively no income. Otherwise, most people can only really benefit from recharacterization if they have an extended period of joblessness or have a kid/get married and reduce their tax enough.

2014 is probably going to be one of my last years contributing to a Roth IRA vs traditional (I'm 25 and not married) as the $5500 in post-tax vs pretax money cost me almost $2000 at my 33% marginal rate. Given I would save or invest that money otherwise it actually matters to me.  If I was going to buy $2000 worth of toys, I might as well do Roth.

gobius

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Re: Maximize 401k?
« Reply #12 on: March 11, 2014, 06:54:00 AM »


Now, when I retire, lets say 100% of my income comes from my 401k. If I pull out 100k of my 401k in a year, then my income is 100k again and I'll get taxed $13,800 or 13.8%. I will not get taxed 25%.

So money in isn't taxed at 25% and money out gets taxed at 13.8%.

Note, since I'm planning on retiring on more like $40k/year instead of 100k, I'd be looking at closer to an 8% rate instead of a 13.8% rate. Makes the 401k/traditional IRA pretty awesome.

A couple questions:
1.  Isn't this assuming your 401k income is taxed at the same rate as wage income, rather than investment income?
2.  Is this assuming no 10% penalty?

1. Yes. When you withdraw money from your 401K/IRA it is considered ordinary income and taxed much like wages. It is not taxed as investment income.
2. Yes. There are many ways around the penalties. See the links Frankies Girl provided. They are GOLD.

Needless to say I have more reading to do.  Thanks Cheddar!