When to bite the bullet and accept a higher tax bracket

[Angers]

Hey guys, so my current strategy is to keep our tax bracket below 25% and to do that we're putting as much as we need to into 401k to bring us to the $75k mark and then investing our excess after bills into a taxed account.  My thoughts on doing this in this way is that if we do indeed retire early, we'll have penalty free access to some money.

Is this even correct? If not, stop me there.

However, I could be in line for a promotion, meaning to keep us out of that higher bracket would take even more into the tax deferred accounts. The question becomes, at what point do we say fine, let's go to the higher bracket and focus heavily on the investor account?

[Heroes821]

Try to remember that Tax Brackets are actually Buckets that you fill first.  I like SeattleCPA's post here about it:  http://evergreensmallbusiness.com/income-tax-buckets-not-income-tax-brackets/

[benjaminbutton]

this reminds me of a coworker that didn't want OT pay because it would put him into a higher tax bracket.

[Fire2025]

Hey guys, so my current strategy is to keep our tax bracket below 25% and to do that we're putting as much as we need to into 401k to bring us to the $75k mark and then investing our excess after bills into a taxed account.  My thoughts on doing this in this way is that if we do indeed retire early, we'll have penalty free access to some money.

Is this even correct? If not, stop me there.

However, I could be in line for a promotion, meaning to keep us out of that higher bracket would take even more into the tax deferred accounts. The question becomes, at what point do we say fine, let's go to the higher bracket and focus heavily on the investor account?

May I ask why you're not taking all the tax advantages you can by maxing your tax deferred investments? Are the options bad or the fees super high?

I tend to agree with this post from MadFientist on speeding up FIRE with tax deferred accounts:
http://www.madfientist.com/retire-even-earlier/

[Cpa Cat]

Your tax bracket is the tax on your last dollar earned - not your first dollar.

As someone else mentioned, you get to fill up each bracket as you go up.

There are reasons to keep AGI low - especially if you're running into phase-outs for the child tax credit. Plus, as you earn more, you get a bigger bang for your buck by putting money in tax deductible savings tools.

Being in the 35% tax bracket does not mean you're paying 35% in taxes on all of your dollars. But it can mean that you're getting a 33-35% return (or more, with state taxes) on your deductible retirement contributions/HSA by the mere act of depositing them into your retirement accounts. That's hard to pass up. It's hard to give up that kind of investment return.

You should have accessible emergency savings. Beyond that, if you're worried about tax bracket, then you never give up on tax-advantaged savings until you've filled up that space, because the deduction is too sweet. And if you qualify for a ROTH, it's a no brainer to put money there before taxable investments.

[Angers]

So I guess I was thinking to avoid some early withdrawal penalties, but I guess my thinking is wrong here? The return on investing it (25%) plus the amount that extra 25% earns over time more than offsets the later penalties?

Forgive me, for a smart guy I can be pretty dumb. I've been reading a lot but I guess not everything has clicked yet, only that I want to do this right

[msilenus]

You probably shouldn't worry too much about early withdrawal penalties.  See the Mad Fientist link above.  You should be able to tap the 401(k) in retirement using either a Roth conversion ladder, or 72(t) distributions.  If you're getting close-ish to FIRE, and understand those strategies, and think they aren't going to be enough --then shift to taxable.  (Or maybe Roth.)

It's possible your earning power will improve naturally beyond your ability to offset with pretax vehicles.  At that point, you'd be forced to "bite the bullet" in a way that is guaranteed not to be an error.  Maybe that sets you up comfortably.  Ie: as you get close to FIRE, you see no need to adjust because you have enough in taxable to bridge the way to penalty-free withdrawal age.  (It might not take much.)

You'll tend to make better decisions about this stuff later, when you understand it better.  So I wouldn't leave any tax breaks on the table now, when it's newer to you.

[Jaayse]

Definitely take advantage of the tax deferral, if you don't retire early you will appreciate the tax reduction and if you do you can Roth ladder your accounts like msilenus said.  You have time before next years taxes to really think it through.  Good luck!

[aetheldrea]

Here's a simple rule of thumb I saw on the Bogleheads forum:

1) If your 'stache is < 1 million
  --max out traditional pre-tax 401(k)
  --then max out Roth IRAs for you and spouse
  --then contribute to non-tax-advantages accounts

2) Once 'stache is > 1million
  --do Roth 401(k) first

For this thumb-rule, 'stache is investment accounts only, don't include the value of your home or '56 Stratocaster that will be buried with you.

If you are contributing to 401(k) pre-tax and taking all the deductions you qualify for, your tax is going to be what it is. If you are still in a high marginal bracket, congratulations on having a nice income. As mentioned in the posts above, you should be able to access your money penalty-free once you retire. Don't pay extra tax now that you don't have to.

[MDM]

Here's a simple rule of thumb....

It would be good to understand the assumptions behind that, lest someone not fitting those assumptions make an incorrect choice.

E.g., I might guess (maybe correctly, maybe incorrectly) that some of the assumptions were
- no pension
- single
- close to retirement
- ...?

Even the rules of thumb in Traditional versus Roth - Bogleheads have disclaimers and a suggestion to "check your own situation."

[MDM]

Hey guys, so my current strategy is to keep our tax bracket below 25% and to do that we're putting as much as we need to into 401k to bring us to the $75k mark and then investing our excess after bills into a taxed account.  My thoughts on doing this in this way is that if we do indeed retire early, we'll have penalty free access to some money.

Is this even correct? If not, stop me there.

However, I could be in line for a promotion, meaning to keep us out of that higher bracket would take even more into the tax deferred accounts. The question becomes, at what point do we say fine, let's go to the higher bracket and focus heavily on the investor account?

See Investment Order and How to withdraw funds from your IRA and 401k without penalty before age 59.5 for some general suggestions that appear applicable to your situation.

[msilenus]

Here's a simple rule of thumb I saw on the Bogleheads forum:

1) If your 'stache is < 1 million
  --max out traditional pre-tax 401(k)
  --then max out Roth IRAs for you and spouse
  --then contribute to non-tax-advantages accounts

2) Once 'stache is > 1million
  --do Roth 401(k) first

That obviously breaks down at high incomes and low spending rates, esp. for FIRE-enthusiasts.  Consider: if you're netting 250k/yr and spending 50, then only about a 20%-50% of your savings is going to be sheltered at all.  (Depends on 401(k) match, spouse's situation, et c)   

You'll pass a million bucks in 'stache, have at least 500k in taxable to access early, and be looking forward to a huge drop in tax rate after retirement.  You won't want to switch over to prioritizing Roth.  Strategy (1) will continue to be correct until you FIRE.

ETA: I gather that it's not uncommon for things said at Bogleheads to be like this.

[Fire2025]

I know not everyone has access, but don't forget those HSA's.  That is a great tax sheltered account!!!

[ShoulderThingThatGoesUp]

Bottom line is, tax brackets don't make you lose money from a raise.

Also you should be maxing out your 401k almost no matter what.

[catccc]

Bottom line is, tax brackets don't make you lose money from a raise.

Yup, this.  It drives me a little crazy when people don't understand that our federal tax system is progressive.

I'm with others, max out your 401K.  If you don't have a mix of before and after tax retirement specific investments, get that going.  For example, max out your 401K, and contribute to a Roth IRA.  In retirement it will be beneficial to get to choose if your income is taxable or not...  draw from your 401K to the amount of your personal exemptions and standard deduction, then draw from your Roth once you've hit that cap.