Author Topic: My understanding correct on 401k and IRA?  (Read 5237 times)

Hoosier Daddy

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My understanding correct on 401k and IRA?
« on: March 04, 2015, 10:34:02 AM »
I am currently making probably $60k once you figure in bonuses. I am trying to stay in 15% tax (approx $37k income) bracket as long as I can. I know we can deduct mortgage interest so next year I'll buy a house with a mortgage of approx $100k with let's say 5% interest (Thanks Yellen!) so that's $5k reduction (rounding I know). Also I believe you can contribute up to $18k to 401k tax free correct? Then this is where I need clarification: is it true that in addition to this $18k I could then contribute and ADDITIONAL $5,500 to a traditional IRA bringing my total taxable income to $31,500 a year?? The problem with us early retirees then becomes getting the money out. I heard you can take money out of your retirement in equal monthly buckets until your 59.5 penalty free if it's an unchanging, periodic withdrawal... Is this true? Where do my fellow mustachians put their early retirement savings (401k, etc.) and how do you pull it back out starting in early to mid 30's? (I'm currently 25 if that matters for tax questions)

Sid Hoffman

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Re: My understanding correct on 401k and IRA?
« Reply #1 on: March 04, 2015, 10:44:18 AM »
First things first, the standard deduction for single workers is $6300 for next year, so unless you have a lot of other stuff to deduct, your $5000 in mortgage interest isn't even going to reach the standard deduction.  The bright side is that at least $6300 is more than the $5000 you thought you'd be deducting.  Health insurance is also deducted from your taxable income, along with qualifying vision and dental coverage.  Suppose you're paying $1500/year for those; that's removed off the top, separate from itemization.  If you're contributing to an HSA, that also comes off the top.

Your quick & dirty tax return would look something like this:
 $60,000 gross
-$18,000 401k
   -$1500 health coverage
      -$??? HSA
   -$6300 standard deduction
   -$4000 personal exemption
   -$5500 Traditional IRA
-------------------------------
 $24,700 AGI

Federal tax approximately $3245

Based on your AGI, you'd still qualify for a 10% savers credit, which is a $550 tax credit in this case.

So $3245 - $550 = $2695 federal tax owed.  Someone else correct me if I'm wrong and missed something.  We did a similar exercise yesterday which is where I learned about the savers credit.

jmusic

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Re: My understanding correct on 401k and IRA?
« Reply #2 on: March 04, 2015, 10:45:13 AM »
I am currently making probably $60k once you figure in bonuses. I am trying to stay in 15% tax (approx $37k income) bracket as long as I can. I know we can deduct mortgage interest so next year I'll buy a house with a mortgage of approx $100k with let's say 5% interest (Thanks Yellen!) so that's $5k reduction (rounding I know).

That's partially true.  You have to overcome the standard deduction before home interest even matters.  For 2015 that's $6300 (x2 if married), and would include both mortgage interest and property tax.  For a $100k property you'd save $0 in taxes barring other factors.

Quote
Also I believe you can contribute up to $18k to 401k tax free correct? Then this is where I need clarification: is it true that in addition to this $18k I could then contribute and ADDITIONAL $5,500 to a traditional IRA bringing my total taxable income to $31,500 a year??

That is correct. 

Edit:  Technically it's not "tax free" just "tax deferred."  Meaning you pay the tax when you get the money out later on.

Quote
The problem with us early retirees then becomes getting the money out. I heard you can take money out of your retirement in equal monthly buckets until your 59.5 penalty free if it's an unchanging, periodic withdrawal... Is this true? Where do my fellow mustachians put their early retirement savings (401k, etc.) and how do you pull it back out starting in early to mid 30's? (I'm currently 25 if that matters for tax questions)

Look up the "Roth IRA conversion pipeline."  Basically, after retirement you convert your income from your 401K to a Roth IRA slowly over time.  It takes 5 years for the first year's money to become available without a tax hit though.
« Last Edit: March 04, 2015, 10:47:04 AM by jmusic »

slugline

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Re: My understanding correct on 401k and IRA?
« Reply #3 on: March 04, 2015, 10:45:42 AM »
I think you're basically correct.

As for withdrawals -- have you read this MMM blog post yet?

http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

mandy_2002

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Re: My understanding correct on 401k and IRA?
« Reply #4 on: March 04, 2015, 10:58:39 AM »
The "equal monthly buckets" withdrawal that you wrote about is actually a yearly withdrawal under the Revenue Code 72(t) (also known as substantially equal periodic payments).  There are several hangups with the rule that the government may catch you on, and force early withdrawal penalties from the beginning of you SEPP's.  Consult someone who knows about the system before you budget them into your future retirement.  This is a handy calculator that can show you about how much to expect from the SEPP.

The pipeline mentioned above is also a good option, especially if you can cover your expenses without earnings for a few years to convert them within the standard deductions (so tax free).

theknitcycle

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Re: My understanding correct on 401k and IRA?
« Reply #5 on: March 04, 2015, 11:03:32 AM »
is it true that in addition to this $18k I could then contribute and ADDITIONAL $5,500 to a traditional IRA

This should be true for you this year, given your stated income and the other adjustments/deductions you have.  One thing to be aware of for the future as your income goes up, though, is that there is an income phase-out range above which you lose the ability to deduct Traditional IRA contributions if you are covered by an employer-sponsored retirement plan.  For 2015, the range (assuming single filing status) is $61k-$71k.  Not a worry for right now unless your bonus turns out to be a lot more than you expect, but don't let it catch you buy surprise in some future year!

Hoosier Daddy

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Re: My understanding correct on 401k and IRA?
« Reply #6 on: March 04, 2015, 11:06:04 AM »
is it true that in addition to this $18k I could then contribute and ADDITIONAL $5,500 to a traditional IRA

This should be true for you this year, given your stated income and the other adjustments/deductions you have.  One thing to be aware of for the future as your income goes up, though, is that there is an income phase-out range above which you lose the ability to deduct Traditional IRA contributions if you are covered by an employer-sponsored retirement plan.  For 2015, the range (assuming single filing status) is $61k-$71k.  Not a worry for right now unless your bonus turns out to be a lot more than you expect, but don't let it catch you buy surprise in some future year!i

Oh wow I didn't know that. Is that range you mentioned your net taxable income after all deductions and tax deferred contributions? Or is that saying if I make $61k gross?

Hoosier Daddy

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Re: My understanding correct on 401k and IRA?
« Reply #7 on: March 04, 2015, 11:07:05 AM »
I had never heard of that Roth ira pipeline before that is absolutely amazing! Thanks all! Any worries they will eliminate this loop hole half way into your early retirement??

Davids

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Re: My understanding correct on 401k and IRA?
« Reply #8 on: March 04, 2015, 11:22:34 AM »
First things first, the standard deduction for single workers is $6300 for next year, so unless you have a lot of other stuff to deduct, your $5000 in mortgage interest isn't even going to reach the standard deduction.  The bright side is that at least $6300 is more than the $5000 you thought you'd be deducting.  Health insurance is also deducted from your taxable income, along with qualifying vision and dental coverage.  Suppose you're paying $1500/year for those; that's removed off the top, separate from itemization.  If you're contributing to an HSA, that also comes off the top.

Your quick & dirty tax return would look something like this:
 $60,000 gross
-$18,000 401k
   -$1500 health coverage
      -$??? HSA
   -$6300 standard deduction
   -$4000 personal exemption
   -$5500 Traditional IRA
-------------------------------
 $24,700 AGI

Federal tax approximately $3245

Based on your AGI, you'd still qualify for a 10% savers credit, which is a $550 tax credit in this case.

So $3245 - $550 = $2695 federal tax owed.  Someone else correct me if I'm wrong and missed something.  We did a similar exercise yesterday which is where I learned about the savers credit.

OP should be able to itemize, property, state and local taxes are also deductible so he sHould be above the standard deduction.

ReadySetMillionaire

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Re: My understanding correct on 401k and IRA?
« Reply #9 on: March 04, 2015, 11:30:07 AM »
I am currently making probably $60k once you figure in bonuses. I am trying to stay in 15% tax (approx $37k income) bracket as long as I can. I know we can deduct mortgage interest so next year I'll buy a house with a mortgage of approx $100k with let's say 5% interest (Thanks Yellen!) so that's $5k reduction (rounding I know). Also I believe you can contribute up to $18k to 401k tax free correct? Then this is where I need clarification: is it true that in addition to this $18k I could then contribute and ADDITIONAL $5,500 to a traditional IRA bringing my total taxable income to $31,500 a year?? The problem with us early retirees then becomes getting the money out. I heard you can take money out of your retirement in equal monthly buckets until your 59.5 penalty free if it's an unchanging, periodic withdrawal... Is this true? Where do my fellow mustachians put their early retirement savings (401k, etc.) and how do you pull it back out starting in early to mid 30's? (I'm currently 25 if that matters for tax questions)

OP: This might not be the answer you're looking for, and I hope I'm not insulting your intelligence here, but this sentence caught me off guard:

Quote
I am trying to stay in 15% tax (approx $37k income) bracket as long as I can.

Just to make sure, you know tax brackets are marginal, right? In other words, if you cross the 15% threshold, your entire income isn't taxed at a higher rate--just the amount that exceeds the tax threshold.

So let's say you gross $70,000 one year, and (hypothetically) $40-60,000 incomes are taxed at 15%, while $60-100,000 incomes are taxed at 18%.

If you made $70,000, your first $60,000 would be taxed at the 15% rate, while the remainder would be taxed at 18%.


If you already knew this, I apologize. But it just seemed to me like you were trying to avoid a higher tax bracket for fear of paying all of your income at a higher tax rate, and that's not how it works.

In short: always, always, always try to make more income and don't worry about the tax liability. Hopefully somebody learned something new today haha.
« Last Edit: March 04, 2015, 11:32:02 AM by ReadySetMillionaire »

jmusic

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Re: My understanding correct on 401k and IRA?
« Reply #10 on: March 04, 2015, 11:37:51 AM »
Oh wow I didn't know that. Is that range you mentioned your net taxable income after all deductions and tax deferred contributions? Or is that saying if I make $61k gross?

The tIRA deductibility phase-out starts at $61K Adjusted Gross Income (meaning after 401K is subtracted).  So if you're maxing out 401K then your starting salary would be $79K befor this becomes an issue.

rocketman48097

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Re: My understanding correct on 401k and IRA?
« Reply #11 on: March 04, 2015, 01:32:50 PM »
I am 38, here is what I (and you should do) do:

1.  Put enough money into 401k and or traditional IRA to avoid the 25% bracket.

2.  Put additional funds into post tax investments, which you will cash out at 0% during early retirement (cap gains and dividends are taxed at 0% in the 15% bracket, so it's key to stay in this bracket).

3.  Once you have five years of early retirement living expenses secure (I am working on this late, always assumed 55 for me until I did the math and realized we were millionaires with net home equity already)  then continue to max out ALL pre tax accounts, full max, 18k for 401k first, $5500 per year for traditional IRA second.  You need to be 100% stocks until retirement, no exceptions.  Once the numbers work, tell your boss to go F off and quit. 

MrMoogle

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Re: My understanding correct on 401k and IRA?
« Reply #12 on: March 04, 2015, 02:41:23 PM »
is it true that in addition to this $18k I could then contribute and ADDITIONAL $5,500 to a traditional IRA
For 2015, the range (assuming single filing status) is $61k-$71k.  Not a worry for right now unless your bonus turns out to be a lot more than you expect, but don't let it catch you buy surprise in some future year!i

Oh wow I didn't know that. Is that range you mentioned your net taxable income after all deductions and tax deferred contributions? Or is that saying if I make $61k gross?

$61k is MAGI, which is Gross - 401k - HSA.  Other things can affect it too, but they're rarer.  If you break this limit, you can put it into a Roth IRA.  Well really you'll split between the two until $71k.  There's an even higher limit that phases Roth out.  Then there's an option of the backdoor Roth IRA. AGI takes tIRA into account, that can be a useful number too.

In Sid's post, it's not $24.7k AGI, it's $24.7k taxable income.  Although I must have missed the $1500 in health coverage...

And that mortgage isn't going to save you anything in taxes, unless you have other deductibles.  I had a $140k house at 3.5% and I never got over the standard deduction.

Edited, I had AGI and MAGI backwards >.<
« Last Edit: March 04, 2015, 04:37:23 PM by MrMoogle »

dandarc

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Re: My understanding correct on 401k and IRA?
« Reply #13 on: March 04, 2015, 02:50:36 PM »
First things first, the standard deduction for single workers is $6300 for next year, so unless you have a lot of other stuff to deduct, your $5000 in mortgage interest isn't even going to reach the standard deduction.  The bright side is that at least $6300 is more than the $5000 you thought you'd be deducting.  Health insurance is also deducted from your taxable income, along with qualifying vision and dental coverage.  Suppose you're paying $1500/year for those; that's removed off the top, separate from itemization.  If you're contributing to an HSA, that also comes off the top.

Your quick & dirty tax return would look something like this:
 $60,000 gross
-$18,000 401k
   -$1500 health coverage
      -$??? HSA
   -$6300 standard deduction
   -$4000 personal exemption
   -$5500 Traditional IRA
-------------------------------
 $24,700 AGI

Federal tax approximately $3245

Based on your AGI, you'd still qualify for a 10% savers credit, which is a $550 tax credit in this case.

So $3245 - $550 = $2695 federal tax owed.  Someone else correct me if I'm wrong and missed something.  We did a similar exercise yesterday which is where I learned about the savers credit.
AGI is before deductions / exemptions (but after tIRA), so 60K - 18K - 1.5K - 5.5K = 35K.  So no saver's tax credit, even with a maxed out HSA if OP is single.

ReadySetMillionaire

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Re: My understanding correct on 401k and IRA?
« Reply #14 on: March 04, 2015, 03:31:04 PM »
Since nobody is responding to my marginal tax bracket comment, I feel like I'm missing something pretty basic. Can somebody enlighten me? Are you guys just trying to avoid any income being taxed in a higher tax bracket, or is there something basic I'm missing here?

dandarc

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Re: My understanding correct on 401k and IRA?
« Reply #15 on: March 04, 2015, 03:49:28 PM »
Since nobody is responding to my marginal tax bracket comment, I feel like I'm missing something pretty basic. Can somebody enlighten me? Are you guys just trying to avoid any income being taxed in a higher tax bracket, or is there something basic I'm missing here?
Is that for the OP?  If I'm answering myself, then yes - avoiding having income in the higher tax brackets is our goal with our tax planning.

In general, when we're talking IRA / 401K contributions, those are last dollars, so the marginal tax bracket is what matters.  A lot of people draw the Roth / Traditional line between the 15% and 25% brackets, because the higher your marginal tax rate, the more you save on taxes today by going traditional, and 25% is a lot (even more if you're in a state with income tax).

One of the reasons that Traditional retirement accounts are so powerful is what you point out about the effective tax rate.  If your early retirement involves no other income, your withdrawals are taxed across all brackets - including the lower ones.  So even if you drew out of the traditional accounts the same amount as you were earning during the accumulation phase, you'll likely pay less taxes due to the progressive nature of the tax code.

This article explains this better:
http://www.madfientist.com/retire-even-earlier/

MrMoogle

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Re: My understanding correct on 401k and IRA?
« Reply #16 on: March 04, 2015, 04:36:06 PM »
AGI is before deductions / exemptions (but after tIRA), so 60K - 18K - 1.5K - 5.5K = 35K.  So no saver's tax credit, even with a maxed out HSA if OP is single.

Oops, you're right, I'll edit my response, I had AGI and MAGI reversed:
http://www.investopedia.com/financial-edge/0312/how-to-calculate-agi-for-tax-purposes.aspx

Hoosier Daddy

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Re: My understanding correct on 401k and IRA?
« Reply #17 on: March 04, 2015, 05:21:22 PM »
Since nobody is responding to my marginal tax bracket comment, I feel like I'm missing something pretty basic. Can somebody enlighten me? Are you guys just trying to avoid any income being taxed in a higher tax bracket, or is there something basic I'm missing here?
Is that for the OP?  If I'm answering myself, then yes - avoiding having income in the higher tax brackets is our goal with our tax planning.

In general, when we're talking IRA / 401K contributions, those are last dollars, so the marginal tax bracket is what matters.  A lot of people draw the Roth / Traditional line between the 15% and 25% brackets, because the higher your marginal tax rate, the more you save on taxes today by going traditional, and 25% is a lot (even more if you're in a state with income tax).

One of the reasons that Traditional retirement accounts are so powerful is what you point out about the effective tax rate.  If your early retirement involves no other income, your withdrawals are taxed across all brackets - including the lower ones.  So even if you drew out of the traditional accounts the same amount as you were earning during the accumulation phase, you'll likely pay less taxes due to the progressive nature of the tax code.

This article explains this better:
http://www.madfientist.com/retire-even-earlier/

Correct. I don't think I'll be able to keep marginal tax rate at 15% until next year as I need to save for a down payment on a house this year to avoid wasting more money on rent. (Just became debt free)

Thanks to everyone for taking the time to walk me through this! This is really helpful!

MrMoogle

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Re: My understanding correct on 401k and IRA?
« Reply #18 on: March 04, 2015, 05:48:00 PM »
Correct. I don't think I'll be able to keep marginal tax rate at 15% until next year as I need to save for a down payment on a house this year to avoid wasting more money on rent. (Just became debt free)
There's a lot of pros and cons for buying a house.  Renting isn't necessarily wasting money. 

Here's a ongoing discussion about it:
http://forum.mrmoneymustache.com/ask-a-mustachian/why-rent/

Hoosier Daddy

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Re: My understanding correct on 401k and IRA?
« Reply #19 on: March 05, 2015, 10:14:54 AM »
Correct. I don't think I'll be able to keep marginal tax rate at 15% until next year as I need to save for a down payment on a house this year to avoid wasting more money on rent. (Just became debt free)
There's a lot of pros and cons for buying a house.  Renting isn't necessarily wasting money. 

Here's a ongoing discussion about it:
http://forum.mrmoneymustache.com/ask-a-mustachian/why-rent/

Thanks for sharing! Very interesting... I too live in an area I would not want to live long term, thus it may be smarter to rent for now... Thanks again!