Author Topic: Why do we want to Max out 401k?  (Read 21242 times)

beltim

  • Magnum Stache
  • ******
  • Posts: 2964
Re: Why do we want to Max out 401k?
« Reply #50 on: July 28, 2014, 01:51:42 PM »
Scandium, this is not limited to $10k and you shouldn't have to pay penalties. You will pay tax on anything > $10k if you don't have other deductions. But you will be paying some tax at 10% and some at 15% at worst.
eh ok. I may be more confused now than before. Need to do some more reading on this. Good thing I'm 20 years away from implementing this.. 

- There's a limit on tax-free roth conversion, correct? That what I meant by limit. This is the standard deductions/credits. So about $20k for couple? The $10k number mad fientist uses is for an individual?
- Above this limit conversions are taxed at regular income tax rates? So <15% up to $70k for a couple.

So from this it looks like with some foresight there is no reason to do a direct 401k distribution, even with just the 10% penalty, since it's always better to convert to roth first, even if you have to pay 10% or 15% tax? Only disadvantage is the 5 year wait.

If you commit to regular distributions, you can withdraw nearly 4% (it depends on current interest rates, but a 45 year old person could withdraw 3.85% annually) from a 401k without bothering with the Roth pipeline and corresponding 5 year wait.  http://www.bankrate.com/calculators/retirement/72-t-distribution-calculator.aspx
« Last Edit: July 28, 2014, 01:53:21 PM by beltim »

gobius

  • Stubble
  • **
  • Posts: 167
Re: Why do we want to Max out 401k?
« Reply #51 on: July 28, 2014, 01:53:06 PM »
I don't know if anyone has mentioned that your money will grow faster in the 401(k) as well.  If you are in the 15% tax bracket and put $17,500 into a 401(k), you are saving about $2,500 (15% of $17,500) in taxes.  In other words, $2,500 MORE is working for you as an investment.  Granted, if you are FIRE'ing only a year or so later it won't have as much time to compound, but if it's growing at 8%, that difference becomes about $2,700 after a year, $2,900 after 2 years, and $5,400 after 10 years.

This isn't really true.  If your tax rate in retirement is the same as your tax rate now, then it doesn't matter when the taxes are withdrawn you wind up with the same amount after tax.  If the tax rates aren't the same, then the savings come from the difference in tax rates.

Yes, you are correct, but I don't think that applies here necessarily.  I was mostly talking about working within the current tax system in the U.S.  You will be able to build a much bigger stash if you do it pre-tax, and since we have deductions, exemptions, a progressive tax rate, and ways around the 10% penalty, there will likely be a benefit.  Sure, if your current marginal tax rate equals the overall tax rate (plus penalty if applicable) at withdrawal, it's a wash. 

If you can build to $300K and have to pay 25% taxes on all of it, vs $225K and pay no taxes, it's a wash.  However, $300K has a 4% SWR of $1K/mo ($12K/yr) and $225K has $750/mo ($9K/yr).  You will pay $200/yr more in taxes unless there are other sources of income (but even in the 25% bracket you would pay $750/yr more).  Either way, the amount of taxes will likely not add up to the $75K extra in there due to deferring taxes, unless some major changes to the tax code come about.

Gin1984

  • Magnum Stache
  • ******
  • Posts: 4834
Re: Why do we want to Max out 401k?
« Reply #52 on: July 28, 2014, 02:20:49 PM »
I don't know if anyone has mentioned that your money will grow faster in the 401(k) as well.  If you are in the 15% tax bracket and put $17,500 into a 401(k), you are saving about $2,500 (15% of $17,500) in taxes.  In other words, $2,500 MORE is working for you as an investment.  Granted, if you are FIRE'ing only a year or so later it won't have as much time to compound, but if it's growing at 8%, that difference becomes about $2,700 after a year, $2,900 after 2 years, and $5,400 after 10 years.

This isn't really true.  If your tax rate in retirement is the same as your tax rate now, then it doesn't matter when the taxes are withdrawn you wind up with the same amount after tax.  If the tax rates aren't the same, then the savings come from the difference in tax rates.
Except it won't, because you are deducting at the highest rate but your effective tax rate in retirement will include your deductions and lower brackets.

beltim

  • Magnum Stache
  • ******
  • Posts: 2964
Re: Why do we want to Max out 401k?
« Reply #53 on: July 28, 2014, 02:23:18 PM »
I don't know if anyone has mentioned that your money will grow faster in the 401(k) as well.  If you are in the 15% tax bracket and put $17,500 into a 401(k), you are saving about $2,500 (15% of $17,500) in taxes.  In other words, $2,500 MORE is working for you as an investment.  Granted, if you are FIRE'ing only a year or so later it won't have as much time to compound, but if it's growing at 8%, that difference becomes about $2,700 after a year, $2,900 after 2 years, and $5,400 after 10 years.

This isn't really true.  If your tax rate in retirement is the same as your tax rate now, then it doesn't matter when the taxes are withdrawn you wind up with the same amount after tax.  If the tax rates aren't the same, then the savings come from the difference in tax rates.
Except it won't, because you are deducting at the highest rate but your effective tax rate in retirement will include your deductions and lower brackets.

What won't?  Any difference comes from the difference in taxation, not because of compounding of the tax savings.  It's just the multiplicative property.

lpep

  • Bristles
  • ***
  • Posts: 285
  • Location: Hanoi, VN
    • My MMM journal
Re: Why do we want to Max out 401k?
« Reply #54 on: July 29, 2014, 04:33:02 AM »
One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

This is also how backdoor Roth works. You take enough money out of your traditional IRA to match your standard tax deductions. Since money withdrawn from your t-IRA counts as income, your tax deductions apply. If you deduct all of it - you don't pay taxes on it at all, and you're free to put it into a Roth and never pay taxes on it again.

I struggled to understand that too :)

boarder42

  • Walrus Stache
  • *******
  • Posts: 7845
Re: Why do we want to Max out 401k?
« Reply #55 on: July 29, 2014, 05:20:13 AM »
yes but to deduct all of it you have to live at a very low spending level 20k... give or take depending on how you have been harvesting your losses.  my wife and i plan to live on 50-60k  so we will be paying taxes

ender

  • Walrus Stache
  • *******
  • Posts: 5419
Re: Why do we want to Max out 401k?
« Reply #56 on: July 29, 2014, 06:07:04 AM »
I am maxing out my 401k now because I am in a 30% or higher marginal tax rate, single, and hope to be married and have kids at some point in my life.

Since my marginal tax rate will drop significantly if/when I have kid(s) it seems to make sense to me to contribute to my pretax 401k now and post-tax, taxable investments later when I have a much lower tax liability. And presumably a higher income to go with it.

There will likely become a point when my marginal rate is zero or even negative. At this point pretax retirement options become much less advantageous. But I'm not there.

Scandium

  • Handlebar Stache
  • *****
  • Posts: 2317
  • Location: EastCoast
Re: Why do we want to Max out 401k?
« Reply #57 on: July 29, 2014, 07:39:49 AM »
yes but to deduct all of it you have to live at a very low spending level 20k... give or take depending on how you have been harvesting your losses.  my wife and i plan to live on 50-60k  so we will be paying taxes

We're about the same. I think we'd need around 50K, maybe 40k if we get a cheaper house (or pay off mortgage). Taxes would still be 10-15% which is much less than the 25% we pay on some of our income now. So there's not really any reason not to max our 401k if we can. Which we don't yet but are working towards it.

As I think I understood from the discussion above, to completely avoid taxes you'd have to get $20k from your 401k/backdoor roth, and then the rest from taxable investments. Since you have zero capital gains tax in the 10/15% brackets. But then you're investing with after tax money now, so effectively 25% less. I'm sure someone has run the numbers, but I would think in pretty much every case it's better to pay 10-15% after FIRE (on your 401k money), than dumping tons into taxable investments now.

Any excess goes into taxable now, but I plan to adjust my 401k contribution up as much as possible.

teen persuasion

  • Handlebar Stache
  • *****
  • Posts: 1087
Re: Why do we want to Max out 401k?
« Reply #58 on: July 29, 2014, 08:36:42 AM »
One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

This is also how backdoor Roth works. You take enough money out of your traditional IRA to match your standard tax deductions. Since money withdrawn from your t-IRA counts as income, your tax deductions apply. If you deduct all of it - you don't pay taxes on it at all, and you're free to put it into a Roth and never pay taxes on it again.

I struggled to understand that too :)

It is no wonder that people are confused about how it works, all of our invented terms are getting crossed.

The backdoor Roth is a method for high income taxpayers, who would be above the income cutoffs for making Roth contributions, to still get to make that contribution.  They make a nondeductible traditional IRA contribution, then turn around and immediately convert it to a Roth.  Since it was nondeductible in the first place, there was no tax deduction, so it was already post tax money.

The Roth pipeline is a method for converting traditional IRA money to Roth accounts, a portion at a time, to take advantage of zero or low tax brackets.  Another advantage of the pipeline is that conversions are treated as contributions after "seasoning" for five years, and can then be withdrawn at any time without penalty.  It is a pipeline because you convert a portion every year, and wait for that portion to season five years, rinse and repeat.  In five years time, you continue to convert a new portion, but now you can withdraw the conversion from year one.  And continue...

davef

  • Stubble
  • **
  • Posts: 222
  • Age: 38
  • Location: Wilsonville, OR
Re: Why do we want to Max out 401k?
« Reply #59 on: July 29, 2014, 11:45:28 AM »


One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

This is also how backdoor Roth works. You take enough money out of your traditional IRA to match your standard tax deductions. Since money withdrawn from your t-IRA counts as income, your tax deductions apply. If you deduct all of it - you don't pay taxes on it at all, and you're free to put it into a Roth and never pay taxes on it again.

I struggled to understand that too :)

It is no wonder that people are confused about how it works, all of our invented terms are getting crossed.

The backdoor Roth is a method for high income taxpayers, who would be above the income cutoffs for making Roth contributions, to still get to make that contribution.  They make a nondeductible traditional IRA contribution, then turn around and immediately convert it to a Roth.  Since it was nondeductible in the first place, there was no tax deduction, so it was already post tax money.

The Roth pipeline is a method for converting traditional IRA money to Roth accounts, a portion at a time, to take advantage of zero or low tax brackets.  Another advantage of the pipeline is that conversions are treated as contributions after "seasoning" for five years, and can then be withdrawn at any time without penalty.  It is a pipeline because you convert a portion every year, and wait for that portion to season five years, rinse and repeat.  In five years time, you continue to convert a new portion, but now you can withdraw the conversion from year one.  And continue...



Good to know.
When do you typically start the conversion? when you retire or otherwise loose your primary income? IF you did it while still employed you would loose the tax advantage correct?

matchewed

  • Magnum Stache
  • ******
  • Posts: 4376
  • Location: CT
Re: Why do we want to Max out 401k?
« Reply #60 on: July 29, 2014, 12:05:18 PM »


One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

This is also how backdoor Roth works. You take enough money out of your traditional IRA to match your standard tax deductions. Since money withdrawn from your t-IRA counts as income, your tax deductions apply. If you deduct all of it - you don't pay taxes on it at all, and you're free to put it into a Roth and never pay taxes on it again.

I struggled to understand that too :)

It is no wonder that people are confused about how it works, all of our invented terms are getting crossed.

The backdoor Roth is a method for high income taxpayers, who would be above the income cutoffs for making Roth contributions, to still get to make that contribution.  They make a nondeductible traditional IRA contribution, then turn around and immediately convert it to a Roth.  Since it was nondeductible in the first place, there was no tax deduction, so it was already post tax money.

The Roth pipeline is a method for converting traditional IRA money to Roth accounts, a portion at a time, to take advantage of zero or low tax brackets.  Another advantage of the pipeline is that conversions are treated as contributions after "seasoning" for five years, and can then be withdrawn at any time without penalty.  It is a pipeline because you convert a portion every year, and wait for that portion to season five years, rinse and repeat.  In five years time, you continue to convert a new portion, but now you can withdraw the conversion from year one.  And continue...

Good to know.
When do you typically start the conversion? when you retire or otherwise loose your primary income? IF you did it while still employed you would loose the tax advantage correct?

All depends on your taxes. The traditional to Roth conversion gets put into your 1040 as taxable income. Ideally you'd like low to no tax environment, generally that would mean not working or any other method of lowering your income taxes. If you do it while employed you'd subject the conversion to additional income taxes. But I could see a business owner perhaps playing some interesting games by giving themselves zero income through their business while pulling off conversions like this so I guess you could still be technically employed while pulling off the pipeline actions.

The best thing to do is to understand it and just apply it to your circumstances. There won't be a "typical" start. Just whatever makes sense for you and your plan.