Author Topic: 401k/Roth IRA questions  (Read 9908 times)

unitsinc

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401k/Roth IRA questions
« on: May 01, 2012, 11:22:09 AM »
Ok, so I've got a 401k with about 15k in it and a Roth IRA with about 8k in it.

The 401k has just been ran by my employer through Fidelity.

I set up my IRA just randomly and tossed about 5k into Vanguard 500 Index Fund Investor Shares and 3k into Vanguard Balanced Index Fund Investor Shares. Don't ask me why those, I just decided to pull the trigger(prematurely I suppose) and invest a chunk of cash I had lying around.

Well, to get to my point; I finally read The 4 Pillars of Investing and have more of an idea about how I'd like to set up my portfolio.
My question is, could I sell off everything I have(so I can re-allocate) without realizing any capital gains? Since the money would just stay in my 401k/Roth I wouldn't actually be earning anything, correct?

Also, my company allows an employee stock purchase plan for a max of 5k a year. We can buy the stock at a 15% discount. This is just sitting in my Fidelity account. I know I'd have to realize capital gains if I sold it, but is it wise to invest so heavily in one company even considering the very large discount. For the record, the company isn't going anywhere, it is VERY established.

Jarvis

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Re: 401k/Roth IRA questions
« Reply #1 on: May 01, 2012, 11:33:08 AM »
From my own experience, it's no trouble to reallocate the funds of your retirement accounts.  Within Vanguard, there is an option, I believe called 'exchange' that allows you to swap funds within your Roth IRA without ever receiving cash, so there would be no penalties or taxes for a withdrawal.

It should be even simpler to reallocate within the 401k.  My own 401k is run by Wells Fargo, and at any time I can redistribute the money already in my 401k, as well as change the funds purchased with my ongoing contributions.

velocistar237

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Re: 401k/Roth IRA questions
« Reply #2 on: May 01, 2012, 11:36:42 AM »
Is the purchase plan through your 401k or in a taxable account? Are there restrictions on selling it? Even if you don't want the stock and you'd have to pay short-term capital gains, if you can just buy it and sell it immediately, it's essentially free money. I've been at a company where you had to keep the stock until you left the company.

unitsinc

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Re: 401k/Roth IRA questions
« Reply #3 on: May 01, 2012, 01:01:40 PM »
Is the purchase plan through your 401k or in a taxable account? Are there restrictions on selling it? Even if you don't want the stock and you'd have to pay short-term capital gains, if you can just buy it and sell it immediately, it's essentially free money. I've been at a company where you had to keep the stock until you left the company.

It is in a separate taxable account, still through Fidelity though.

And correct me if I'm wrong, but buying it at a 15% discount and then selling at 15% tax rate(isn't that what capital gains is) would pretty much do nothing, right?

Other than the discount, it's all my money. I just choose to participate by taking out a bit from each check.

unitsinc

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Re: 401k/Roth IRA questions
« Reply #4 on: May 01, 2012, 01:02:50 PM »
From my own experience, it's no trouble to reallocate the funds of your retirement accounts.  Within Vanguard, there is an option, I believe called 'exchange' that allows you to swap funds within your Roth IRA without ever receiving cash, so there would be no penalties or taxes for a withdrawal.

It should be even simpler to reallocate within the 401k.  My own 401k is run by Wells Fargo, and at any time I can redistribute the money already in my 401k, as well as change the funds purchased with my ongoing contributions.

Awesome, that's what I wanted to know. I just didn't wanna lose a chunk of my money while doing the exchanges. Thanks!

gestalt162

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Re: 401k/Roth IRA questions
« Reply #5 on: May 01, 2012, 01:03:46 PM »
Yes. As look as the money doesn't leave your IRA/401(k), capital gains will not be taxed. If you have received any dividend payments in your IRA/401(k), you will notice that they are not taxed as well, for the same reason. Feel free to reallocate within each account at will (of course, in your IRA standard trading fees will apply, for Fidelity usually $7.95/trade, although some trade free).

Welcome to the world of tax-deferred investing.

unitsinc

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Re: 401k/Roth IRA questions
« Reply #6 on: May 01, 2012, 01:13:37 PM »
Yes. As look as the money doesn't leave your IRA/401(k), capital gains will not be taxed. If you have received any dividend payments in your IRA/401(k), you will notice that they are not taxed as well, for the same reason. Feel free to reallocate within each account at will (of course, in your IRA standard trading fees will apply, for Fidelity usually $7.95/trade, although some trade free).

Welcome to the world of tax-deferred investing.

Perfect. Thank you very much.

Also, one other question, I know that the first 17k I put into a 401k effectively reduces my tax burden.

Now what I am unsure about is if I choose to put in MORE than 17k, it will no longer lower my taxes, but that money will still benefit from all of the other benefits(no capital gains/trading fee/so on) I just asked about, correct?

Jarvis

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Re: 401k/Roth IRA questions
« Reply #7 on: May 01, 2012, 01:35:12 PM »
Also, one other question, I know that the first 17k I put into a 401k effectively reduces my tax burden.

Now what I am unsure about is if I choose to put in MORE than 17k, it will no longer lower my taxes, but that money will still benefit from all of the other benefits(no capital gains/trading fee/so on) I just asked about, correct?

You would not be able to contribute more than 17k into a 401k.  A 401k is, by definition, a tax-deferred account.  You would need to allocate other investments to a taxable account somewhere else.  As for avoiding capital gains, trading fees, etc., I would suggest buying index funds with low expense ratios and holding them for the long term.

TLV

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Re: 401k/Roth IRA questions
« Reply #8 on: May 01, 2012, 03:08:07 PM »
And correct me if I'm wrong, but buying it at a 15% discount and then selling at 15% tax rate(isn't that what capital gains is) would pretty much do nothing, right?

No, that's not right.

Short version: ESPP discount is free money, like a 401k match. If you aren't limited in when you can sell it (like velocistar said, if you have to leave the company first) then put the max in that you can, then sell immediately so you don't have to worry about the complicated stuff.

Long version:

Step 1. You get paid: 401k is deducted pre-tax; then you pay taxes; then your ESPP is deducted from your net pay. (So you pay taxes on the ESPP contribution up front, at your normal tax rate).

Step 2. ESPP is used to buy stock at 15% discount, for example if you have $850 in ESPP and the stock is $100/share market price, you get 10 shares for your $850.

Step 3. When you sell the ESPP, depending on when you sell it and what the price is when you sell it, one of several situations occurs:
* If you sell in less than 1 year since the ESPP was used to buy the stock, then you pay taxes at your normal rate on the amount you gained from the discount at the time of the stock purchase, and then have a short-term capital gain/loss depending on where the stock price has moved since the purchase was made. This is considered a "disqualifying disposition," and your employer will probably include the amount you gained from the discount on your W-2.

Example: You sell the stock as soon as possible after the purchase, to lock in your "free money." Using the previous numbers, you'd get ~$1000 in proceeds from the sale. $850 of that is what you put in - you're already taxed on that as part of your wages, so it's not taxed again. $150 of that is gain from the discount - it should be added to your wages when you file taxes for the year that you made the sale, and it's taxed just like the $850. So, if your marginal tax rate on this money is 25%, then you would get $637.5 after taxes if you DON'T use the ESPP. If you do use the ESPP, then you get $750 after taxes - $637.5 from your contribution, plus $112.5 in free money from the discount.

Example: 6 months after the ESPP purchase, the stock price doubles and you sell. Using the previous numbers, you'd get $2000 in proceeds from the sale. $850 of that is what you put in - you're already taxed on that as part of your wages, so it's not taxed again. $150 of that is gain from the discount - it will be added to your wages in the year that you make the sale (which might be the year after you paid taxes on the original $850), so you'll pay regular taxes on that $150. The other $1000 is short term capital gain, which is also currently taxed at your normal rate.

Example: 6 months after the ESPP purchase, the stock price halves, and you sell. You'd get only $500 from the sale. You were already taxed on the $850 you put in. You'll still be taxed on the $150 gain from the discount. Then you have a $500 short term capital loss, which is kind of like a tax deduction, and will usually cancel out the extra taxes you paid on the income (since you were taxed on $1000 but only got $500 out of it).

*If you sell more than 1 year after the ESPP purchase, but less than 2 years after the "grant date" (for my employer, the ESPP buys stock every 3 months; the grant date is 3 months before the purchase date), then it's still a "disqualifying disposition." The only difference is that any capital gains are long-term, which means that the 15% tax rate (which is probably lower than your marginal tax rate on wages) applies.

Example: A year and a day after the ESPP purchase, the stock price has doubled and you sell. Proceeds are $2000. You already paid taxes on $850, so that has no additional tax. You pay your marginal tax rate on $150 gain from the discount. You pay 15% taxes on the $1000 long term capital gain. (This is a better deal than if you had sold at 1 day less than a year, because then you would have paid your 25% marginal rate on the capital gain).

*If you sell more than 2 years after the grant date, then funny things happen. It's a "qualifying disposition."

Example: 3 years after the ESPP purchase, the stock has doubled and you sell. Proceeds are $2000. You already paid taxes on $850, so that has no additional tax. At the grant date, (in my case 3 months before the purchase), the stock price was only $90 instead of $100 - instead of paying regular taxes on the actual discount of $150 (15% of the $1000 that the stock was worth when you bought it), you pay regular taxes on the theoretical discount - 15% of the $900 that the stock was worth at the grant date, or $135. Then, you pay long term capital gains on the $1000 of capital gain, plus the $15 extra that you didn't pay regular taxes on because it was a qualifying disposition. Since long term capital gain tax is usually lower than your regular tax, this is an improvement (although a very minor one).

Example: 3 years after the ESPP purchase, the stock has halved and you sell. Proceeds are $500. You already paid taxes on $850. If it were a disqualifying distribution, then you would still pay regular taxes on the $150 discount, but because it's a loss and it's a qualifying distribution, you don't pay those taxes. You also have a long term capital loss of $350 (the rest of the difference between the $1000 it was initially worth , which is similar to a tax deduction.

Confused yet? That's why I recommended just selling ASAP.

TLV

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Re: 401k/Roth IRA questions
« Reply #9 on: May 01, 2012, 03:13:33 PM »
Also, one other question, I know that the first 17k I put into a 401k effectively reduces my tax burden.

Now what I am unsure about is if I choose to put in MORE than 17k, it will no longer lower my taxes, but that money will still benefit from all of the other benefits(no capital gains/trading fee/so on) I just asked about, correct?

You would not be able to contribute more than 17k into a 401k.  A 401k is, by definition, a tax-deferred account.  You would need to allocate other investments to a taxable account somewhere else.  As for avoiding capital gains, trading fees, etc., I would suggest buying index funds with low expense ratios and holding them for the long term.

Some 401k plans do allow you to make additional, after-tax contributions. Those contributions don't get the special tax considerations as far as I know - they just let you use the mutual funds that the 401k has access to. For example, my 401k gives me access to VIIIX, which is the vanguard 500 index but only has .02% expenses instead of the .05% that admiral shares have. I don't know if the after tax contributions have the same withdrawal restrictions as the pretax contributions.

unitsinc

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Re: 401k/Roth IRA questions
« Reply #10 on: May 01, 2012, 03:36:04 PM »
Wow, that was a hell of a response. I had to read it a time or two to get all of the examples but I think I get it now.

Thanks for taking the time to give such a detailed response.

Jarvis

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Re: 401k/Roth IRA questions
« Reply #11 on: May 01, 2012, 03:54:21 PM »
Also, one other question, I know that the first 17k I put into a 401k effectively reduces my tax burden.

Now what I am unsure about is if I choose to put in MORE than 17k, it will no longer lower my taxes, but that money will still benefit from all of the other benefits(no capital gains/trading fee/so on) I just asked about, correct?

You would not be able to contribute more than 17k into a 401k.  A 401k is, by definition, a tax-deferred account.  You would need to allocate other investments to a taxable account somewhere else.  As for avoiding capital gains, trading fees, etc., I would suggest buying index funds with low expense ratios and holding them for the long term.

Some 401k plans do allow you to make additional, after-tax contributions. Those contributions don't get the special tax considerations as far as I know - they just let you use the mutual funds that the 401k has access to. For example, my 401k gives me access to VIIIX, which is the vanguard 500 index but only has .02% expenses instead of the .05% that admiral shares have. I don't know if the after tax contributions have the same withdrawal restrictions as the pretax contributions.

Interesting, I've never heard of this.  Is it still called a 401k at that point?  Or is it a taxable investment account managed by the same brokerage running your 401k?

Jarvis

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Re: 401k/Roth IRA questions
« Reply #12 on: May 01, 2012, 04:01:24 PM »
I just found an interesting article when looking for more information about after-tax 401k contributions:

http://www.2millionblog.com/2006/05/are_after_tax_401k_contributio.html

The author's conclusion was that it'd be better to use a regular investment account and eventually pay capital gains taxes rather than use the after tax 401k and eventually pay income taxes on the distributions, even after the savings based on lower expense ratios.  Depending on an individual's tax bracket at retirement, that may be different.

TLV

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Re: 401k/Roth IRA questions
« Reply #13 on: May 01, 2012, 04:27:01 PM »
One more thing I forgot to mention about ESPP:

You need to be careful when filing your taxes to make sure the cost basis is correct, especially with disqualifying distributions. Some brokerages (my employer does it through Fidelity) don't report ESPP cost basis correctly - they use the price you paid instead of the market value at time of purchase (in my previous examples, they report $850 as the cost basis instead of $1000). This results in double-taxation of the discount (the $150) unless you report the correct cost basis. You should also double-check the amount reported by your employer as wages to make sure it includes the discount for any ESPP shares you sold during the year.

I've never had a qualifying distribution, so I don't know if they get the cost basis right for those or not.

unitsinc

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Re: 401k/Roth IRA questions
« Reply #14 on: May 02, 2012, 10:40:19 AM »

*If you sell more than 2 years after the grant date, then funny things happen. It's a "qualifying disposition."

Example: 3 years after the ESPP purchase, the stock has doubled and you sell. Proceeds are $2000. You already paid taxes on $850, so that has no additional tax. At the grant date, (in my case 3 months before the purchase), the stock price was only $90 instead of $100 - instead of paying regular taxes on the actual discount of $150 (15% of the $1000 that the stock was worth when you bought it), you pay regular taxes on the theoretical discount - 15% of the $900 that the stock was worth at the grant date, or $135. Then, you pay long term capital gains on the $1000 of capital gain, plus the $15 extra that you didn't pay regular taxes on because it was a qualifying disposition. Since long term capital gain tax is usually lower than your regular tax, this is an improvement (although a very minor one).

Example: 3 years after the ESPP purchase, the stock has halved and you sell. Proceeds are $500. You already paid taxes on $850. If it were a disqualifying distribution, then you would still pay regular taxes on the $150 discount, but because it's a loss and it's a qualifying distribution, you don't pay those taxes. You also have a long term capital loss of $350 (the rest of the difference between the $1000 it was initially worth , which is similar to a tax deduction.

Confused yet? That's why I recommended just selling ASAP.


OK, one question in regards to this, if I invest in the ESPP every year, does this constantly reset my timeframe for qualifying dispositions?

TLV

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Re: 401k/Roth IRA questions
« Reply #15 on: May 02, 2012, 01:02:39 PM »
OK, one question in regards to this, if I invest in the ESPP every year, does this constantly reset my timeframe for qualifying dispositions?

The ESPP will run in periods. Mine is every 3 months. I contribute from paycheck from January - March, then on April 1st the purchase is made at discount. The shares bought on April 1st 2012 can be sold as a qualifying distribution starting January 1 2014. The next ESPP period ends on June, so the shares that are bought on July 1st 2012 can be sold as qualifying distribution starting April 1 2014, but the date for the ones bought April 1st does not change.

unitsinc

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Re: 401k/Roth IRA questions
« Reply #16 on: May 02, 2012, 02:01:25 PM »
OK, one question in regards to this, if I invest in the ESPP every year, does this constantly reset my timeframe for qualifying dispositions?

The ESPP will run in periods. Mine is every 3 months. I contribute from paycheck from January - March, then on April 1st the purchase is made at discount. The shares bought on April 1st 2012 can be sold as a qualifying distribution starting January 1 2014. The next ESPP period ends on June, so the shares that are bought on July 1st 2012 can be sold as qualifying distribution starting April 1 2014, but the date for the ones bought April 1st does not change.

Gotcha, thanks for clearing that up.

elysianfields

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Re: 401k/Roth IRA questions
« Reply #17 on: May 03, 2012, 12:21:57 AM »
I just found an interesting article when looking for more information about after-tax 401k contributions:

http://www.2millionblog.com/2006/05/are_after_tax_401k_contributio.html

The author's conclusion was that it'd be better to use a regular investment account and eventually pay capital gains taxes rather than use the after tax 401k and eventually pay income taxes on the distributions, even after the savings based on lower expense ratios.  Depending on an individual's tax bracket at retirement, that may be different.

That article doesn't seem correct.  The author claims that if you make after-tax contributions to a 401(k), that you then pay taxes again at ordinary rates when you withdraw them.  That doesn't seem right.  If the contributions were already taxed, then you shouldn't pay taxes again when you withdraw them.  I know that Roth 401(k)s work like that, and the author's discussing non-Roth after-tax 401(k)s.  Do your research and remember, just because somebody says something on the Internet, it's not necessarily true.

TLV

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Re: 401k/Roth IRA questions
« Reply #18 on: May 03, 2012, 02:00:28 PM »
Quote
The author claims that if you make after-tax contributions to a 401(k), that you then pay taxes again at ordinary rates when you withdraw them.  That doesn't seem right.  If the contributions were already taxed, then you shouldn't pay taxes again when you withdraw them.
You wouldn't pay taxes again on your contribution amount, but when you withdraw the gains they are taxed at ordinary income rates instead of as capital gains. It's similar to non-deductible contributions to a traditional IRA.