Author Topic: Considering scaling down on 401k contributions  (Read 8254 times)

frugaltechie

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Considering scaling down on 401k contributions
« on: October 06, 2016, 08:38:28 AM »
Big fan of the community. I feel many people are lucky enough to have someone convince them of retirement savings early in the career world. That person for me was my dad. And since, I am now 30 years old with 100k in a roth account but feel it's time to scale down or stop contributions. I have one rental property now, soon to be two. And right now it just seems that I could make better use of the money (to pay down mortgages or save a DP for another investment property) rather than stow more away into an account I can't access for another 35 years. Have others hit this dilemma themselves? I always think of that classic compounding interest example and think that I'd rather invest in retirement strongly the first few years into the working world and then stop contributions as they become less and less (or closer and closer to retirement) beneficiary.

seattlecyclone

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Re: Considering scaling down on 401k contributions
« Reply #1 on: October 06, 2016, 08:53:02 AM »
The idea that you can't access your retirement accounts until you're old is a myth. Read this thread for instructions on how to get at this money at any age without paying a penalty.

It's possible that you can do better by investing in rental properties, but diversification is nice too. Sounds like you've already been able to invest a little bit in each of real estate and tax-advantaged savings; more of the same is probably a good idea.

MustacheAndaHalf

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Re: Considering scaling down on 401k contributions
« Reply #2 on: October 06, 2016, 09:07:14 AM »
The main point of diversification isn't maximal profit, it's to make sure the portfolio survives and keeps growing.  I assume your 401(k) isn't 100% invested in Vanguard REIT, but that seems to be what you're trying to do with your overall holdings.  In a dire situation, the bottom could drop out of the rental or real estate markets.  In that situation you might have to start selling property at large losses to cover mortgage payments.  I know when times are great that seems impossible, but it has happened.

Not to get too bleak, but you get to keep retirement accounts when declaring bankruptcy (check this yourself - I'm not an expert or lawyer on this).  So in a real estate collapse, your 401(k) could be the only thing left standing.

zephyr911

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Re: Considering scaling down on 401k contributions
« Reply #3 on: October 06, 2016, 09:10:49 AM »
It's a tough call, and a personal one - not just numbers. Despite high (20%+) returns in residential rentals over the last few years, and the fact that I will be relying on that portion of my portfolio much more for income in early FIRE, I have stayed at max TSP contributions (fed version of 401k) as well as IRAs. This is for various reasons:
- I'm still overcoming a badly undisciplined past and I like to stick as much $$ as possible where I can't get to it without pain
- As a real estate investor, being cash-constrained will push me to hone my cost control, creative financing and investor recruitment skills*
   *I think long-term despite being near FIRE, because I plan to keep doing it afterward as a PT/play job
- I don't just want to hit crossover point and quit, I want to get seriously rich and use it for pet causes in my old age, so padding the stash in tax-deferred/exempt accounts now is worth it, even if I don't need those returns or have an immediate use for them.

YMMV...

frugaltechie

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Re: Considering scaling down on 401k contributions
« Reply #4 on: October 06, 2016, 09:29:35 AM »
The difference in perspective is helpful, I am guilty of operating with the assumption that rental investments will always trump a boring old 401k. But you guys are correct, a bit of diversification is well worth the effort.

Perhaps a bit of an underlying qualm I have is would you consider scaling back on 401k contributions as you approach retirement-age or near? I figure the majority of the gains are to be had over compounding years of returns and less so as you approach the age when you'd be taking distributions.

Oh, and the method for withdrawing from an IRA, that is most helpful. Dangerous I would even say -- it's nice to lock away money. We're all financially responsible people hear but still human.

RedmondStash

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Re: Considering scaling down on 401k contributions
« Reply #5 on: October 06, 2016, 09:34:02 AM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.

I wish I'd figured this out years ago. I mostly only contributed the minimum to get employer matching. But you can trim your taxable income down by 1/3 to 1/2 or more, depending on how much you earn and how old you are. That ain't peanuts.

It still may make more sense for you personally to pull back on your 401k. Only you can know that. Just make sure to take all the ramifications into account.

I know I'll be maxing out my 401k each year, and also contributing the additional allowed $6,500 (I'm over 50) to my Roth IRA. Untaxed growth, whether on pre-tax or post-tax dollars, is a wonderful thing.

Goldielocks

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Re: Considering scaling down on 401k contributions
« Reply #6 on: October 06, 2016, 09:45:53 AM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

MasterStache

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Re: Considering scaling down on 401k contributions
« Reply #7 on: October 06, 2016, 12:27:01 PM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

That is not entirely accurate. I'll use my own case as an example. After I bumped up my own 401K to max, I saw a $100 reduction in federal taxes being withdrawn from my paycheck.  I can look at this one of two ways.
1. I am getting an extra $100/check.
/OR/
2. I need $100 less to max out my 401k contributions.

If I decide to forgo the 401K and invest in the Roth, I won't enjoy the same tax break (lower tax bracket) until I tap into those Roth withdrawals a couple decades down the road. All things being somewhat equal (same tax brackets as you stated), I would rather have the extra $100 to invest now then when I am 60 years old.   

boarder42

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Re: Considering scaling down on 401k contributions
« Reply #8 on: October 06, 2016, 12:35:34 PM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

doesnt have to be a lower tax bracket.  it can be the same bracket just have a spending level lower than their current AGI.

CheapskateWife

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Re: Considering scaling down on 401k contributions
« Reply #9 on: October 06, 2016, 01:04:57 PM »
To the OP, we are about 18 months away from full FIRE, DH is already a SAHD and is waiting for me to come home.  He has a pension that covers more than half our expenses which means we need the other half readily available.

Taking a page for Nords book, we are planning to keep 2-3 years of the delta in savings, then withdraw our Roth Contributions for years 3-5, all the while working the 5 year cycle on Roth Conversions from our 401K's to our tIRAs.  I feel like that cash cushion helps us avoid selling when the market is weak.

However, I haven't stopped putting my earnings in tax advantaged accounts, just spending even less to maximize the 2 years of cash buffer.

chasesfish

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Re: Considering scaling down on 401k contributions
« Reply #10 on: October 07, 2016, 06:07:51 AM »
If you're more comfortable with another rental property, then go that route.  People have reached financial independence with either route.  Rental real estate can have solid returns and they have their own tax benefits, but come with work that not everyone is up for.

Congrats on getting 100k in a Roth IRA by 30, its a nice accomplishment

CareCPA

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Re: Considering scaling down on 401k contributions
« Reply #11 on: October 07, 2016, 06:53:32 AM »
Or do both. Continue your Roth contributions and use them to purchase rentals within your Roth IRA...

boarder42

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Re: Considering scaling down on 401k contributions
« Reply #12 on: October 07, 2016, 01:55:43 PM »
To the OP, we are about 18 months away from full FIRE, DH is already a SAHD and is waiting for me to come home.  He has a pension that covers more than half our expenses which means we need the other half readily available.

Taking a page for Nords book, we are planning to keep 2-3 years of the delta in savings, then withdraw our Roth Contributions for years 3-5, all the while working the 5 year cycle on Roth Conversions from our 401K's to our tIRAs.  I feel like that cash cushion helps us avoid selling when the market is weak.

However, I haven't stopped putting my earnings in tax advantaged accounts, just spending even less to maximize the 2 years of cash buffer.

most often avoiding"selling when the market is weak" by keeping money in savings accounts will actually cost you over the long run.  have you run cFiresim with your anticipated asset allocation vs not having money in basically cash as thtas what most savings accounts return.

Nords

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Re: Considering scaling down on 401k contributions
« Reply #13 on: October 08, 2016, 09:06:48 PM »
To the OP, we are about 18 months away from full FIRE, DH is already a SAHD and is waiting for me to come home.  He has a pension that covers more than half our expenses which means we need the other half readily available.

Taking a page for Nords book, we are planning to keep 2-3 years of the delta in savings, then withdraw our Roth Contributions for years 3-5, all the while working the 5 year cycle on Roth Conversions from our 401K's to our tIRAs.  I feel like that cash cushion helps us avoid selling when the market is weak.

However, I haven't stopped putting my earnings in tax advantaged accounts, just spending even less to maximize the 2 years of cash buffer.

most often avoiding"selling when the market is weak" by keeping money in savings accounts will actually cost you over the long run.  have you run cFiresim with your anticipated asset allocation vs not having money in basically cash as thtas what most savings accounts return.
The "2-3 years of savings in cash" is to insure against the sequence-of-returns risk during the first decade of retirement.  After the first decade, especially if the portfolio has grown, then there's probably no more need for the cash.

For those with a military pension, the inflation-adjusted annuity will recover from a lot of stock-market recessions.  Military retirees could probably have a 100% success rate with a 100% equity portfolio.  But when the recession hits, most of us will sleep better at night with some cash on hand.

Now that I'm 14 years into (military retirement) financial independence, my spouse and I have been drawing down our cash.  Our last CD just matured, and over the next year we'll spend most of that on gifting and a rental-property rehab.  After that stash is gone we'll have to raise extra cash (when necessary) by selling equity shares.

Frugalman19

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Re: Considering scaling down on 401k contributions
« Reply #14 on: October 12, 2016, 07:39:19 AM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

What he said is 100% true...

401k does reduce your taxable income in the year you contribute and it grows tax free. It is absolutely not the same if you contribute to a non-retirement account, the exact opposite actually.

OP if you said you had 500k in your 401k that would be one thing, but just based on the rule of 72, your investment will only double every 10 years or so. In 30 years you'll want more than that as a nest egg. Rentals have a big problem, you cant eat the shingles, you have to sell the rental sometimes to get money out if things go poorly. Diversify!
« Last Edit: October 12, 2016, 07:43:31 AM by Awgolfer »

boarder42

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Re: Considering scaling down on 401k contributions
« Reply #15 on: October 12, 2016, 07:46:26 AM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

What he said is 100% true...

401k does reduce your taxable income in the year you contribute and it grows tax free. It is absolutely not the same if you contribute to a non-retirement account, the exact opposite actually.

OP if you said you had 500k in your 401k that would be one thing, but just based on the rule of 72, your investment will only double every 10 years or so. In 30 years you'll want more than that as a nest egg. Rentals have a big problem, you cant eat the shingles, you have to sell the rental sometimes to get money out if things go poorly. Diversify!

http://www.madfientist.com/how-to-access-retirement-funds-early/#ck_modal2

see madfientist's post on why even taking the 10% penalty is likely better than investing in taxable. 

also if i'm in the 15% bracket and i'm putting money into my 401k all that money is coming from the 15% part of that.  now when i'm retired and i'm pulling money out is is being taxed on a graduated scale some of that money being taxed at 0% some at 10% and then the last bit at 15% if my spending is that high.  so your point that if you're in the same bracket now and in retirement and putting that money in a taxable account being equal to a Traditional tax deferred account is 100% false

onlykelsey

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Re: Considering scaling down on 401k contributions
« Reply #16 on: October 12, 2016, 07:46:37 AM »
- I'm still overcoming a badly undisciplined past and I like to stick as much $$ as possible where I can't get to it without pain

I feel like so many people on this forum ignore this point.  Looking back, buying my condo in 2013 was a bad decision, despite having 15% down and having payments well within my income.  But...I also would not have spent that money on investments if I hadn't had to pay my mortgage.  Maybe some of it, but lots of it would have leaked away.  It's good to recognize your own shortcomings.

Now I'm much more confident and sock nearly 10K monthly in to investments, but I wasn't there in my mid 20s.

Frugalman19

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Re: Considering scaling down on 401k contributions
« Reply #17 on: October 12, 2016, 08:07:28 AM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

What he said is 100% true...

401k does reduce your taxable income in the year you contribute and it grows tax free. It is absolutely not the same if you contribute to a non-retirement account, the exact opposite actually.

OP if you said you had 500k in your 401k that would be one thing, but just based on the rule of 72, your investment will only double every 10 years or so. In 30 years you'll want more than that as a nest egg. Rentals have a big problem, you cant eat the shingles, you have to sell the rental sometimes to get money out if things go poorly. Diversify!

http://www.madfientist.com/how-to-access-retirement-funds-early/#ck_modal2

see madfientist's post on why even taking the 10% penalty is likely better than investing in taxable. 

also if i'm in the 15% bracket and i'm putting money into my 401k all that money is coming from the 15% part of that.  now when i'm retired and i'm pulling money out is is being taxed on a graduated scale some of that money being taxed at 0% some at 10% and then the last bit at 15% if my spending is that high.  so your point that if you're in the same bracket now and in retirement and putting that money in a taxable account being equal to a Traditional tax deferred account is 100% false

Exactly

Vagabond76

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Re: Considering scaling down on 401k contributions
« Reply #18 on: October 12, 2016, 10:03:23 AM »
Both rentals and 401ks have tax-deferred elements to them.

The distinct advantage of rentals if someone else goes to work everyday and earns money to pay you.  If the person that is working retires or otherwise stops making you money, you replace him or her with someone that will.  With a 401k, you go to work every day, probably get a little match on your contributions, and then hope it goes up in value.  When you stop working, there is no more money going into the account.

Goldielocks

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Re: Considering scaling down on 401k contributions
« Reply #19 on: October 12, 2016, 10:29:27 AM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

What he said is 100% true...

401k does reduce your taxable income in the year you contribute and it grows tax free. It is absolutely not the same if you contribute to a non-retirement account, the exact opposite actually.

OP if you said you had 500k in your 401k that would be one thing, but just based on the rule of 72, your investment will only double every 10 years or so. In 30 years you'll want more than that as a nest egg. Rentals have a big problem, you cant eat the shingles, you have to sell the rental sometimes to get money out if things go poorly. Diversify!

Just do the math for yourself.
MTR is marginal tax rate, e.g., 20% in this example.

401k OPTION

   $100k (PRETAX) put into a 401k, grows by 50% (x1.5) over a set time,
   and you withdraw ($100k x 1.5)x (1-MTR) = $150k x    80% = $120k after tax, in your pocket, to spend in future...



Non Tax Deferred option:
$100k PRETAX becomes $80k POST TAX before you even invest it (pay your 20% tax up front)
    Put in only $80k , and the remaining investment grows by the same 50% over the same time..
   $100k x (1-MTR) x 1.5  = $80k x 1.5 = $120k after tax, in your pocket, to spend in future

You have the SAME money.  There is no incremental boost to tax free growth on the interest, because taxes are a percentage, not a set dollar amount.

So why do people use 401k?  Because most of us will have a LOWER (e.g., 15%) top tax bracket in our later years, especially those who FIRE and use rollover exit strategies, it is fantastic... and there are good MATCHING plans, and it makes it so easy to save through payroll deduction, it works very well. 

   ***Putting $100k pretax through payroll deposit into a  401k  is just like putting $80k Post tax dollars in, and then being good and putting in ALL of your tax deduction right away, to bring it back up to $100k.

 The danger, of course, for those using post tax dollars in an IRA, are those of us that do not put all of our tax refund into the 401k to fully top it up. ***


To the OP -- there is definitely a point where you will end up having TOO MUCH money in your 401k and could be forced to withdraw it at more than a 15% top tax bracket point.   It does not happen as much for FIRE, but for steady savers who max out all retirement plans through age 60+, get full SS, etc.......   it is a very real possibility.   

You do not want to force an excess in your taxable 401k, when you could instead invest the excess in non-registered or ROTH accounts. 

TL/DR:   Don't use your 401k to generate a million dollar retirement using your $75k income.  Use a portion of non-registered instead.
« Last Edit: October 12, 2016, 10:37:23 AM by goldielocks »

Vagabond76

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Re: Considering scaling down on 401k contributions
« Reply #20 on: October 12, 2016, 11:03:29 AM »
there is definitely a point where you will end up having TOO MUCH money in your 401k and could be forced to withdraw it at more than a 15% top tax bracket point.   It does not happen as much for FIRE, but for steady savers who max out all retirement plans through age 60+, get full SS, etc.......   it is a very real possibility.

Very true.  Starting next year, my parents must withdraw over $30,000 from their tIRA accounts.  They then have to report this as ordinary income on their 2017 tax return.  The percentage of their accounts that they must withdraw increases every year.

If they fail to make a required minimum distribution--may happen when they get even older and lose it mentally--they will forfeit 50% of the required minimum distribution.  One small fuck up by a senior citizen results in a 50% tax rate.

seattlecyclone

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Re: Considering scaling down on 401k contributions
« Reply #21 on: October 12, 2016, 11:17:10 AM »
Just do the math for yourself.
MTR is marginal tax rate, e.g., 20% in this example.

401k OPTION

   $100k (PRETAX) put into a 401k, grows by 50% (x1.5) over a set time,
   and you withdraw ($100k x 1.5)x (1-MTR) = $150k x    80% = $120k after tax, in your pocket, to spend in future...



Non Tax Deferred option:
$100k PRETAX becomes $80k POST TAX before you even invest it (pay your 20% tax up front)
    Put in only $80k , and the remaining investment grows by the same 50% over the same time..
   $100k x (1-MTR) x 1.5  = $80k x 1.5 = $120k after tax, in your pocket, to spend in future

You have the SAME money.  There is no incremental boost to tax free growth on the interest, because taxes are a percentage, not a set dollar amount.

This math works pretty well when comparing traditional and Roth retirement accounts, but falls short when comparing traditional retirement accounts with taxable accounts. You're failing to account for dividend taxes each year in the taxable account as well as capital gains taxes at the time of a sale. Even if you're planning to spend your whole life in a tax bracket where the feds don't tax these, most states still do.

Goldielocks

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Re: Considering scaling down on 401k contributions
« Reply #22 on: October 12, 2016, 12:43:30 PM »
Just do the math for yourself.
MTR is marginal tax rate, e.g., 20% in this example.

401k OPTION

   $100k (PRETAX) put into a 401k, grows by 50% (x1.5) over a set time,
   and you withdraw ($100k x 1.5)x (1-MTR) = $150k x    80% = $120k after tax, in your pocket, to spend in future...



Non Tax Deferred option:
$100k PRETAX becomes $80k POST TAX before you even invest it (pay your 20% tax up front)
    Put in only $80k , and the remaining investment grows by the same 50% over the same time..
   $100k x (1-MTR) x 1.5  = $80k x 1.5 = $120k after tax, in your pocket, to spend in future

You have the SAME money.  There is no incremental boost to tax free growth on the interest, because taxes are a percentage, not a set dollar amount.

This math works pretty well when comparing traditional and Roth retirement accounts, but falls short when comparing traditional retirement accounts with taxable accounts. You're failing to account for dividend taxes each year in the taxable account as well as capital gains taxes at the time of a sale. Even if you're planning to spend your whole life in a tax bracket where the feds don't tax these, most states still do.

Well true,  but you don't have to invest in dividends and interest / income bearing funds in your post-tax account.   I would keep those in the registered account if I even wanted them.  Most people have at least a modest pre-tax account, after all.  The analysis is just the math with out the investment detail.

Second

Human behaviour is that the dividend taxes are paid out of pocket in the year that they occur, so they actually just seem to "disappear" over a lifetime.   Disappearing money is not very math-friendly, however, so I did not include this.   BUT, in this case, the non-retirement account is pushed to become even larger than the 401k, because a small additional amount is "contributed" to it each year from out of pocket payment of tax.



seattlecyclone

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Re: Considering scaling down on 401k contributions
« Reply #23 on: October 12, 2016, 01:11:14 PM »
Well true,  but you don't have to invest in dividends and interest / income bearing funds in your post-tax account.

Which non-dividend, non-interest funds would you suggest? All the stock index funds I know of pay dividends, because most stocks pay dividends. Bond funds generally pay interest as well. Even Vanguard's "tax-managed fund" where they try to track the market as well as possible while paying fewer dividends still has a 1.8% SEC yield, just 0.15% lower than VTSAX. I guess you could pick a few non-dividend stocks for yourself, but then we're comparing different investments between the two account types.

Quote
Human behaviour is that the dividend taxes are paid out of pocket in the year that they occur, so they actually just seem to "disappear" over a lifetime.   Disappearing money is not very math-friendly, however, so I did not include this.   BUT, in this case, the non-retirement account is pushed to become even larger than the 401k, because a small additional amount is "contributed" to it each year from out of pocket payment of tax.

You can't just hand-wave away the cost of dividend taxes. Maybe you don't notice each year because it's a minor part of your tax bill, but this is real money that you could have invested if you didn't have to give it to the government. It adds up over time. This is especially true of Mustachians who try to minimize unnecessary spending. Extra money in our pocket really is extra money in our investments.

boarder42

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Re: Considering scaling down on 401k contributions
« Reply #24 on: October 12, 2016, 01:23:57 PM »
Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

What he said is 100% true...

401k does reduce your taxable income in the year you contribute and it grows tax free. It is absolutely not the same if you contribute to a non-retirement account, the exact opposite actually.

OP if you said you had 500k in your 401k that would be one thing, but just based on the rule of 72, your investment will only double every 10 years or so. In 30 years you'll want more than that as a nest egg. Rentals have a big problem, you cant eat the shingles, you have to sell the rental sometimes to get money out if things go poorly. Diversify!

Just do the math for yourself.
MTR is marginal tax rate, e.g., 20% in this example.

401k OPTION

   $100k (PRETAX) put into a 401k, grows by 50% (x1.5) over a set time,
   and you withdraw ($100k x 1.5)x (1-MTR) = $150k x    80% = $120k after tax, in your pocket, to spend in future...



Non Tax Deferred option:
$100k PRETAX becomes $80k POST TAX before you even invest it (pay your 20% tax up front)
    Put in only $80k , and the remaining investment grows by the same 50% over the same time..
   $100k x (1-MTR) x 1.5  = $80k x 1.5 = $120k after tax, in your pocket, to spend in future

You have the SAME money.  There is no incremental boost to tax free growth on the interest, because taxes are a percentage, not a set dollar amount.

So why do people use 401k?  Because most of us will have a LOWER (e.g., 15%) top tax bracket in our later years, especially those who FIRE and use rollover exit strategies, it is fantastic... and there are good MATCHING plans, and it makes it so easy to save through payroll deduction, it works very well. 

   ***Putting $100k pretax through payroll deposit into a  401k  is just like putting $80k Post tax dollars in, and then being good and putting in ALL of your tax deduction right away, to bring it back up to $100k.

 The danger, of course, for those using post tax dollars in an IRA, are those of us that do not put all of our tax refund into the 401k to fully top it up. ***


To the OP -- there is definitely a point where you will end up having TOO MUCH money in your 401k and could be forced to withdraw it at more than a 15% top tax bracket point.   It does not happen as much for FIRE, but for steady savers who max out all retirement plans through age 60+, get full SS, etc.......   it is a very real possibility.   

You do not want to force an excess in your taxable 401k, when you could instead invest the excess in non-registered or ROTH accounts. 

TL/DR:   Don't use your 401k to generate a million dollar retirement using your $75k income.  Use a portion of non-registered instead.

youre still massively ignoring the point i made. 

if i make 76k per year and am in the 15% tax bracket(married couple) and i put 18k into my 401k i just saved 15% taxes on the full 18k. 

if i'm then spending 76k a year from all tax deferred accounts in  retirement they dont tax ALL of that money at 15% on the way out.  they tax some at 0 and some at 10 then some at 15% .  so everything that i spend up to the top of the 10% bracket comes out ahead of putting it in a taxable account.

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Re: Considering scaling down on 401k contributions
« Reply #25 on: October 12, 2016, 01:28:19 PM »
Well true,  but you don't have to invest in dividends and interest / income bearing funds in your post-tax account.

Which non-dividend, non-interest funds would you suggest? All the stock index funds I know of pay dividends, because most stocks pay dividends. Bond funds generally pay interest as well. Even Vanguard's "tax-managed fund" where they try to track the market as well as possible while paying fewer dividends still has a 1.8% SEC yield, just 0.15% lower than VTSAX. I guess you could pick a few non-dividend stocks for yourself, but then we're comparing different investments between the two account types.

Quote
Human behaviour is that the dividend taxes are paid out of pocket in the year that they occur, so they actually just seem to "disappear" over a lifetime.   Disappearing money is not very math-friendly, however, so I did not include this.   BUT, in this case, the non-retirement account is pushed to become even larger than the 401k, because a small additional amount is "contributed" to it each year from out of pocket payment of tax.

You can't just hand-wave away the cost of dividend taxes. Maybe you don't notice each year because it's a minor part of your tax bill, but this is real money that you could have invested if you didn't have to give it to the government. It adds up over time. This is especially true of Mustachians who try to minimize unnecessary spending. Extra money in our pocket really is extra money in our investments.

I didn't hand wave them away -- I just did not include them in my math, as I assumed a stock equity (Capital gains) portfolio, originally.

My point is that they are usually dealt with each year, and forgotten by the investor, and as such, are actually a BOOST to the final retirement portfolio value, as they thus induce greater contributions.  ALSO,  taxes on dividends ARE eventually paid out of a 401k.. back to the original arguement.. Interest free growth is why ROTH is so much better than 401k.

Here is a new point -- if you really insist on having dividends and income in your non-retirement account, then I would actually BORROW MONEY from a HELOC to contribute to the investment account, for those funds, and pay down my mortgage faster instead, as for me the math works out.  (Mortgage rate versus tax discounted HELOC loan).

Here is another point -- you can harvest tax losses in your non-registered investment account as well.  Can't do that in your registered accounts, so they are great for more volatile investments, as well as getting at your money.

There are so many permutations to the details you could delve into.   BUT, at its basic level, just do basic math to see if it is true....  Recall upthread that someone was trying to claim that 401k was substantially better, even if there was no tax % difference upon withdrawals...simply because of deferred taxes on investment and income... which is not so. 

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Re: Considering scaling down on 401k contributions
« Reply #26 on: October 12, 2016, 07:18:59 PM »
A few points regarding traditional vs. Roth
1) One really does need to compare "marginal vs. marginal" rates, not "marginal now vs. average later".
2) Tax drag on a taxable account is a real thing, and can make Roth more effective than traditional, even for equal marginal savings and withdrawal rates.
3) For most people without a defined benefit pension, traditional is likely the better choice.  The earlier one retires, the more likely that becomes.

See https://www.bogleheads.org/wiki/Traditional_versus_Roth for more details, but here are a couple of pertinent excerpts:

Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

Quote
If you will have mostly taxable income in retirement (because of a pension or a large traditional IRA or 401(k)), then it is likely that you will retire in a tax bracket equal to or only slightly lower than your current tax bracket, and you should prefer a Roth. If you will have mostly non-taxable income in retirement (because you have a large Roth account) or income taxed at a lower rate (because you have a large taxable account), you might retire at a much lower marginal tax rate; it isn't worth tax-deferring a bit more in a Roth if you have to pay 33% now to avoid paying 25% later.

ooeei

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Re: Considering scaling down on 401k contributions
« Reply #27 on: October 13, 2016, 06:59:21 AM »
Well true,  but you don't have to invest in dividends and interest / income bearing funds in your post-tax account.

Which non-dividend, non-interest funds would you suggest? All the stock index funds I know of pay dividends, because most stocks pay dividends. Bond funds generally pay interest as well. Even Vanguard's "tax-managed fund" where they try to track the market as well as possible while paying fewer dividends still has a 1.8% SEC yield, just 0.15% lower than VTSAX. I guess you could pick a few non-dividend stocks for yourself, but then we're comparing different investments between the two account types.

Quote
Human behaviour is that the dividend taxes are paid out of pocket in the year that they occur, so they actually just seem to "disappear" over a lifetime.   Disappearing money is not very math-friendly, however, so I did not include this.   BUT, in this case, the non-retirement account is pushed to become even larger than the 401k, because a small additional amount is "contributed" to it each year from out of pocket payment of tax.

You can't just hand-wave away the cost of dividend taxes. Maybe you don't notice each year because it's a minor part of your tax bill, but this is real money that you could have invested if you didn't have to give it to the government. It adds up over time. This is especially true of Mustachians who try to minimize unnecessary spending. Extra money in our pocket really is extra money in our investments.

I didn't hand wave them away -- I just did not include them in my math, as I assumed a stock equity (Capital gains) portfolio, originally.

My point is that they are usually dealt with each year, and forgotten by the investor, and as such, are actually a BOOST to the final retirement portfolio value, as they thus induce greater contributions.  ALSO,  taxes on dividends ARE eventually paid out of a 401k.. back to the original arguement.. Interest free growth is why ROTH is so much better than 401k.

Here is a new point -- if you really insist on having dividends and income in your non-retirement account, then I would actually BORROW MONEY from a HELOC to contribute to the investment account, for those funds, and pay down my mortgage faster instead, as for me the math works out.  (Mortgage rate versus tax discounted HELOC loan).

Here is another point -- you can harvest tax losses in your non-registered investment account as well.  Can't do that in your registered accounts, so they are great for more volatile investments, as well as getting at your money.

There are so many permutations to the details you could delve into.   BUT, at its basic level, just do basic math to see if it is true....  Recall upthread that someone was trying to claim that 401k was substantially better, even if there was no tax % difference upon withdrawals...simply because of deferred taxes on investment and income... which is not so.

Based on this logic, we should be encouraging everyone to buy houses too, because for many people the house payment is a forced savings plan that they'd otherwise blow on stupid stuff.  Here's my math to prove it.

With house:  $400k house as asset after 30 years.  You pay the mortgage monthly, and would be paying some for rent anyway, so you don't really notice it.
Without house:  $0 after 30 years.  You spent the money on stuff and rent.

Sure, maybe it emotionally works for some people, but that does not make it the best mathematical choice, which is what the people in the top posts are saying.  You are simplifying the math against the benefits of tax advantaged accounts, assuming the person is not disciplined enough to invest the extra from not paying taxes.  That's fine, it's just not optimal assuming a disciplined person.  I think it's this part of the post I bolded that bothered people, because it is demonstrably false:

Don't forget that your 401k has a double payout: 1) growth of pre-tax investments, and 2) reducing your annual salary, thus reducing your taxes and potentially dropping you into a lower tax bracket.



This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- in fact a non retirement account can be great if you pay taxes on it out of pocket as you go or borrow to invest while paying down mortgage.

401 k is great because of employer matching and payroll deduction ( forced savings) where people do not get a big tax rebate and the full pretax amount stays in the account.

401 k is awesome as most will have a smaller tax bracket in retirement.

It is a hassle to get at 401 k money early, but can be done.

I love Roth IRAs.. Hard to find Anything wrong with maxing those out.

Additionally, even with capital gains investments, you pay tax on the capital gains if it's not in a 401k/IRA.  If your income is low enough that you don't pay capital gains, then you're right, they are equal.  I think most index funds have SOME turnover every year though, and even if you buy individual stocks you'll likely rebalance occasionally and have to take some gains during your working years.

Investing outside of a 401k/IRA to take advantage of tax loss harvesting is like buying a house for the mortgage tax deduction, you're spending money to save a little less money.  In this case, you're putting it in an account where you have to pay taxes, so you can save on taxes...  You're getting some tax flexibility through tax loss harvesting, but you get even better tax treatment in a 401k/IRA.  If you assume you're going to be losing enough money to make tax loss harvesting worth it, I'm not sure why you're investing in the first place, as you'd be better just not losing it.

The person upthread WAS correct on it being better due to being deferred, if we assume the person is deciding whether or not to open a 401k/IRA (which the OP is).  The money goes in at their marginal rate, and comes out at their average rate.

A few points regarding traditional vs. Roth
1) One really does need to compare "marginal vs. marginal" rates, not "marginal now vs. average later".
2) Tax drag on a taxable account is a real thing, and can make Roth more effective than traditional, even for equal marginal savings and withdrawal rates.
3) For most people without a defined benefit pension, traditional is likely the better choice.  The earlier one retires, the more likely that becomes.

See https://www.bogleheads.org/wiki/Traditional_versus_Roth for more details, but here are a couple of pertinent excerpts:

Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

Quote
If you will have mostly taxable income in retirement (because of a pension or a large traditional IRA or 401(k)), then it is likely that you will retire in a tax bracket equal to or only slightly lower than your current tax bracket, and you should prefer a Roth. If you will have mostly non-taxable income in retirement (because you have a large Roth account) or income taxed at a lower rate (because you have a large taxable account), you might retire at a much lower marginal tax rate; it isn't worth tax-deferring a bit more in a Roth if you have to pay 33% now to avoid paying 25% later.

This is correct that you should compare marginal rates, but that's only AFTER you already have enough in your 401k to withdraw up to your marginal rate.  At that point, any additional you contribute will be taxed marginally, so it's worth considering changing at that point.  Then again, you get the option to convert to a roth during low income years (perhaps a sabbatical or layoff), so the traditional still isn't exactly a bad option.  Since OP currently has $0 in a 401k, the "marginal in, average out" advice applies. 

For a single person working in the 25% bracket, they need to have enough to withdraw $37,650/year in their account for the quoted statements to be true.  Based on the 4% rule that's $941,250 they need in their 401k before the two are equivalent.  For a married couple, it's $1.88 million.  I'm kind of surprised Bogleheads phrases it that way, because that's a high enough balance that their advice doesn't apply to most people.

Edit:  The numbers are actually higher, because you get a standard deduction and personal exemption, therefore reducing your taxable income.
« Last Edit: October 13, 2016, 08:34:51 AM by ooeei »

boarder42

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Re: Considering scaling down on 401k contributions
« Reply #28 on: October 13, 2016, 07:38:51 AM »
A few points regarding traditional vs. Roth
1) One really does need to compare "marginal vs. marginal" rates, not "marginal now vs. average later".
2) Tax drag on a taxable account is a real thing, and can make Roth more effective than traditional, even for equal marginal savings and withdrawal rates.
3) For most people without a defined benefit pension, traditional is likely the better choice.  The earlier one retires, the more likely that becomes.

See https://www.bogleheads.org/wiki/Traditional_versus_Roth for more details, but here are a couple of pertinent excerpts:

Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

Quote
If you will have mostly taxable income in retirement (because of a pension or a large traditional IRA or 401(k)), then it is likely that you will retire in a tax bracket equal to or only slightly lower than your current tax bracket, and you should prefer a Roth. If you will have mostly non-taxable income in retirement (because you have a large Roth account) or income taxed at a lower rate (because you have a large taxable account), you might retire at a much lower marginal tax rate; it isn't worth tax-deferring a bit more in a Roth if you have to pay 33% now to avoid paying 25% later.

MDM explain number 1 to me b/c it doesnt make sense in my head. if i'm making 76k(married joint) and put that all in a 401k it is not taxed. all 18k of it at the 15% bracket ... when i'm retired and draw down on that each year assuming all my money was saved in a 401k and i'm spending 76k per year some of my money is coming out at a lower tax rate than 15%.  and since i'm taking a little out every year its beating the 15% tax rate on my taxable account that was coming out free and clear.

ooeei

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Re: Considering scaling down on 401k contributions
« Reply #29 on: October 13, 2016, 07:46:31 AM »
MDM explain number 1 to me b/c it doesnt make sense in my head. if i'm making 76k(married joint) and put that all in a 401k it is not taxed. all 18k of it at the 15% bracket ... when i'm retired and draw down on that each year assuming all my money was saved in a 401k and i'm spending 76k per year some of my money is coming out at a lower tax rate than 15%.  and since i'm taking a little out every year its beating the 15% tax rate on my taxable account that was coming out free and clear.

I'm not MDM, but I wondered the same thing.  Here's the entire quote:

Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

For example, assume a couple already has enough in traditional accounts to withdraw $42,000/yr (giving a taxable income of $21,300), currently earn $90,000/yr (taxable income of $69,300) and expect to earn that amount for the foreseeable future. They are looking at an $18K 401k contribution and expect it to grow at 5% for 15 years, at which time they will withdraw 4%/yr from what that $18K has grown to, or ~$1,500/yr.

For this couple, the contribution tax rate is 15% (marginal tax rate stays at 15% as the taxable income drops from $69,300 to $51,300), and the withdrawal tax rate is also 15% (marginal tax rate stays at 15% as the taxable income increases from $21,300 to $22,800 and tax goes from $2,268 to $2,493). It would be incorrect to compare a 15% contribution rate to the average withdrawal tax rate of $2,493/$43,500 = 5.7%.

Basically it only applies if you already have enough in your 401k that you can withdraw up to your marginal rate every year. 

For the advice to make sense, someone in the 25% bracket needs to have nearly a million dollars projected in their 401k when they retire if they're single, and nearly 2 million if they're married.  Any contributions ABOVE that level will be marginal-marginal.

For someone with income in the 15% bracket the numbers are much lower ($230k single $460k married), but the idea is the same.

EDIT:  Actually the numbers are higher, as standard deduction and personal exemption need to be factored in. 
« Last Edit: October 13, 2016, 08:33:56 AM by ooeei »

boarder42

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Re: Considering scaling down on 401k contributions
« Reply #30 on: October 13, 2016, 08:41:31 AM »
MDM explain number 1 to me b/c it doesnt make sense in my head. if i'm making 76k(married joint) and put that all in a 401k it is not taxed. all 18k of it at the 15% bracket ... when i'm retired and draw down on that each year assuming all my money was saved in a 401k and i'm spending 76k per year some of my money is coming out at a lower tax rate than 15%.  and since i'm taking a little out every year its beating the 15% tax rate on my taxable account that was coming out free and clear.

I'm not MDM, but I wondered the same thing.  Here's the entire quote:

Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

For example, assume a couple already has enough in traditional accounts to withdraw $42,000/yr (giving a taxable income of $21,300), currently earn $90,000/yr (taxable income of $69,300) and expect to earn that amount for the foreseeable future. They are looking at an $18K 401k contribution and expect it to grow at 5% for 15 years, at which time they will withdraw 4%/yr from what that $18K has grown to, or ~$1,500/yr.

For this couple, the contribution tax rate is 15% (marginal tax rate stays at 15% as the taxable income drops from $69,300 to $51,300), and the withdrawal tax rate is also 15% (marginal tax rate stays at 15% as the taxable income increases from $21,300 to $22,800 and tax goes from $2,268 to $2,493). It would be incorrect to compare a 15% contribution rate to the average withdrawal tax rate of $2,493/$43,500 = 5.7%.

Basically it only applies if you already have enough in your 401k that you can withdraw up to your marginal rate every year. 

For the advice to make sense, someone in the 25% bracket needs to have nearly a million dollars projected in their 401k when they retire if they're single, and nearly 2 million if they're married.  Any contributions ABOVE that level will be marginal-marginal.

For someone with income in the 15% bracket the numbers are much lower ($230k single $460k married), but the idea is the same.

EDIT:  Actually the numbers are higher, as standard deduction and personal exemption need to be factored in.

ahh thanks that helps.  makes much more sense.  higher end contributions become marginal to marginal. doesnt really apply around here as much as boggle heads. 2MM in tax deferred investments is a metric shit ton.  i plan to retire around 2MM total even with my S corp ESOP only 70% or so is tax deferred.

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Re: Considering scaling down on 401k contributions
« Reply #31 on: October 13, 2016, 08:56:48 AM »
MDM explain number 1 to me b/c it doesnt make sense in my head. if i'm making 76k(married joint) and put that all in a 401k it is not taxed. all 18k of it at the 15% bracket ... when i'm retired and draw down on that each year assuming all my money was saved in a 401k and i'm spending 76k per year some of my money is coming out at a lower tax rate than 15%.  and since i'm taking a little out every year its beating the 15% tax rate on my taxable account that was coming out free and clear.

I'm not MDM, but I wondered the same thing.  Here's the entire quote:

Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

For example, assume a couple already has enough in traditional accounts to withdraw $42,000/yr (giving a taxable income of $21,300), currently earn $90,000/yr (taxable income of $69,300) and expect to earn that amount for the foreseeable future. They are looking at an $18K 401k contribution and expect it to grow at 5% for 15 years, at which time they will withdraw 4%/yr from what that $18K has grown to, or ~$1,500/yr.

For this couple, the contribution tax rate is 15% (marginal tax rate stays at 15% as the taxable income drops from $69,300 to $51,300), and the withdrawal tax rate is also 15% (marginal tax rate stays at 15% as the taxable income increases from $21,300 to $22,800 and tax goes from $2,268 to $2,493). It would be incorrect to compare a 15% contribution rate to the average withdrawal tax rate of $2,493/$43,500 = 5.7%.

Basically it only applies if you already have enough in your 401k that you can withdraw up to your marginal rate every year. 

For the advice to make sense, someone in the 25% bracket needs to have nearly a million dollars projected in their 401k when they retire if they're single, and nearly 2 million if they're married.  Any contributions ABOVE that level will be marginal-marginal.

For someone with income in the 15% bracket the numbers are much lower ($230k single $460k married), but the idea is the same.

EDIT:  Actually the numbers are higher, as standard deduction and personal exemption need to be factored in.

ahh thanks that helps.  makes much more sense.  higher end contributions become marginal to marginal. doesnt really apply around here as much as boggle heads. 2MM in tax deferred investments is a metric shit ton.  i plan to retire around 2MM total even with my S corp ESOP only 70% or so is tax deferred.

You don't need to have $2 million in retirement accounts before you need to consider what your marginal tax rate will be at retirement. Suppose you have $200k in a traditional 401(k), you plan for the money you have already invested to grow to $400k by the time you retire, and you will then be taking out 4% each year. That means you've already invested enough for your AGI at retirement to be $16,000. If you're single and taking the standard deduction, you're already in the 10% bracket at retirement. If you invest more in your 401(k), you should expect that money to be taxed at 10% when you take it out, not at some average tax rate that takes your previous contributions into account.

boarder42

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Re: Considering scaling down on 401k contributions
« Reply #32 on: October 13, 2016, 09:04:00 AM »
MDM explain number 1 to me b/c it doesnt make sense in my head. if i'm making 76k(married joint) and put that all in a 401k it is not taxed. all 18k of it at the 15% bracket ... when i'm retired and draw down on that each year assuming all my money was saved in a 401k and i'm spending 76k per year some of my money is coming out at a lower tax rate than 15%.  and since i'm taking a little out every year its beating the 15% tax rate on my taxable account that was coming out free and clear.

I'm not MDM, but I wondered the same thing.  Here's the entire quote:

Quote
A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

For example, assume a couple already has enough in traditional accounts to withdraw $42,000/yr (giving a taxable income of $21,300), currently earn $90,000/yr (taxable income of $69,300) and expect to earn that amount for the foreseeable future. They are looking at an $18K 401k contribution and expect it to grow at 5% for 15 years, at which time they will withdraw 4%/yr from what that $18K has grown to, or ~$1,500/yr.

For this couple, the contribution tax rate is 15% (marginal tax rate stays at 15% as the taxable income drops from $69,300 to $51,300), and the withdrawal tax rate is also 15% (marginal tax rate stays at 15% as the taxable income increases from $21,300 to $22,800 and tax goes from $2,268 to $2,493). It would be incorrect to compare a 15% contribution rate to the average withdrawal tax rate of $2,493/$43,500 = 5.7%.

Basically it only applies if you already have enough in your 401k that you can withdraw up to your marginal rate every year. 

For the advice to make sense, someone in the 25% bracket needs to have nearly a million dollars projected in their 401k when they retire if they're single, and nearly 2 million if they're married.  Any contributions ABOVE that level will be marginal-marginal.

For someone with income in the 15% bracket the numbers are much lower ($230k single $460k married), but the idea is the same.

EDIT:  Actually the numbers are higher, as standard deduction and personal exemption need to be factored in.

ahh thanks that helps.  makes much more sense.  higher end contributions become marginal to marginal. doesnt really apply around here as much as boggle heads. 2MM in tax deferred investments is a metric shit ton.  i plan to retire around 2MM total even with my S corp ESOP only 70% or so is tax deferred.

You don't need to have $2 million in retirement accounts before you need to consider what your marginal tax rate will be at retirement. Suppose you have $200k in a traditional 401(k), you plan for the money you have already invested to grow to $400k by the time you retire, and you will then be taking out 4% each year. That means you've already invested enough for your AGI at retirement to be $16,000. If you're single and taking the standard deduction, you're already in the 10% bracket at retirement. If you invest more in your 401(k), you should expect that money to be taxed at 10% when you take it out, not at some average tax rate that takes your previous contributions into account.

got it not a big deal

MDM

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Re: Considering scaling down on 401k contributions
« Reply #33 on: October 13, 2016, 11:31:35 AM »
This is correct that you should compare marginal rates, but that's only AFTER you already have enough in your 401k to withdraw up to your marginal rate.
You will always have a marginal withdrawal rate, correct?  It may be lower, the same, or higher than your current marginal savings rate, but there will always be a marginal withdrawal rate and your estimate of that value is what should guide your traditional vs. Roth decision today.

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Since OP currently has $0 in a 401k, the "marginal in, average out" advice applies.
No.  What does apply is that with $0 in pre-tax investments now, the expected marginal withdrawal rate on this year's 401k contribution is very low.  Next year the OP should look at the marginal rate on withdrawals from the second year of contributions, with the withdrawals based on the first year's contributions forming the floor above which the marginal rate is calculated.

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For a single person working in the 25% bracket, they need to have enough to withdraw $37,650/year in their account for the quoted statements to be true.
What part of the quoted statements appears false to you if, for example, that single person has only enough to withdraw $10K/yr?

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I'm kind of surprised Bogleheads phrases it that way, because that's a high enough balance that their advice doesn't apply to most people.
Edit:  The numbers are actually higher, because you get a standard deduction and personal exemption, therefore reducing your taxable income.
Appears the advice is generic enough to apply to anyone.  For someone not receiving a pension, it does take a large account balance before Roth is better than traditional.  Also, the standard deduction and personal exemptions are specifically mentioned in the example.

ooeei

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Re: Considering scaling down on 401k contributions
« Reply #34 on: October 13, 2016, 11:53:48 AM »
This is correct that you should compare marginal rates, but that's only AFTER you already have enough in your 401k to withdraw up to your marginal rate.
You will always have a marginal withdrawal rate, correct?  It may be lower, the same, or higher than your current marginal savings rate, but there will always be a marginal withdrawal rate and your estimate of that value is what should guide your traditional vs. Roth decision today.

That's true.

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Since OP currently has $0 in a 401k, the "marginal in, average out" advice applies.
No.  What does apply is that with $0 in pre-tax investments now, the expected marginal withdrawal rate on this year's 401k contribution is very low.  Next year the OP should look at the marginal rate on withdrawals from the second year of contributions, with the withdrawals based on the first year's contributions forming the floor above which the marginal rate is calculated.

Also true.

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For a single person working in the 25% bracket, they need to have enough to withdraw $37,650/year in their account for the quoted statements to be true.
What part of the quoted statements appears false to you if, for example, that single person has only enough to withdraw $10K/yr?

You're correct, I guess I was arguing with a position you weren't holding. My bad!  Marginal-marginal is the right way to look at it, you just have to change your strategy each year based on what you currently have accrued and your estimated withdrawal amount. 

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I'm kind of surprised Bogleheads phrases it that way, because that's a high enough balance that their advice doesn't apply to most people.
Edit:  The numbers are actually higher, because you get a standard deduction and personal exemption, therefore reducing your taxable income.
Appears the advice is generic enough to apply to anyone.  For someone not receiving a pension, it does take a large account balance before Roth is better than traditional.  Also, the standard deduction and personal exemptions are specifically mentioned in the example.

Good points. 

I guess maybe I was thinking along the lines of people who say things like "my tax rate is 15% now, and I expect it'll be 25% in retirement, so I save all of my money in Roth accounts so I get the taxes over with now."  Basically, when someone assumes their final tax rate before actually having the money saved.  Assuming that person is working a regular career and not doing real estate or something where they get paid during retirement, they'll still be better off contributing to a traditional until they have enough saved to push them into the 15% bracket in retirement.  That goes against conventional wisdom, but actually does line up with the bogleheads article. 

A typical question here or on reddit or wherever is phrased like "I make $50,000 a year, should I contribute to Roth or Traditional IRA?" and the average response is "If you think your tax rate will be higher in retirement, do the Roth, if you think it'll be lower, do Traditional, and if you think it'll be the same, it doesn't matter."  The question asker thinks "Well I'd like to have as much in retirement as I do now, so let's say my income/taxes are the same.  Guess it doesn't matter either way.  I'll contribute to the Roth because it's more flexible."  The advice was technically right, but wasn't explained quite well enough because the person asking most likely doesn't know how to properly estimate their tax rate in retirement.

tldr:  You're totally right, as is the article. 
« Last Edit: October 13, 2016, 11:58:39 AM by ooeei »

Jack

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Re: Considering scaling down on 401k contributions
« Reply #35 on: October 13, 2016, 12:09:15 PM »
The distinct advantage of rentals if someone else goes to work everyday and earns money to pay you.  If the person that is working retires or otherwise stops making you money, you replace him or her with someone that will.  With a 401k, you go to work every day, probably get a little match on your contributions, and then hope it goes up in value.  When you stop working, there is no more money going into the account.

No, that's hardly even a difference (let alone an advantage). Owning shares of businesses (i.e., stocks or stock funds) entails "someone else go[ing] to work everyday and earn[ing] money to pay you" just as much as owning rentals does. The only difference is superficial: with stock investing, the income is called a "dividend" instead of "rent."

Similarly, for real estate investors, "when you stop working, there is no more money going into the [down-payment fund]." You're still ceasing additional investment, same as when you stop contributing to a 401k.

MDM

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Re: Considering scaling down on 401k contributions
« Reply #36 on: October 13, 2016, 12:26:24 PM »
I guess maybe I was thinking along the lines of people who say things like "my tax rate is 15% now, and I expect it'll be 25% in retirement, so I save all of my money in Roth accounts so I get the taxes over with now."  Basically, when someone assumes their final tax rate before actually having the money saved.  Assuming that person is working a regular career and not doing real estate or something where they get paid during retirement, they'll still be better off contributing to a traditional until they have enough saved to push them into the 15% bracket in retirement.  That goes against conventional wisdom, but actually does line up with the bogleheads article. 

A typical question here or on reddit or wherever is phrased like "I make $50,000 a year, should I contribute to Roth or Traditional IRA?" and the average response is "If you think your tax rate will be higher in retirement, do the Roth, if you think it'll be lower, do Traditional, and if you think it'll be the same, it doesn't matter."  The question asker thinks "Well I'd like to have as much in retirement as I do now, so let's say my income/taxes are the same.  Guess it doesn't matter either way.  I'll contribute to the Roth because it's more flexible."  The advice was technically right, but wasn't explained quite well enough because the person asking most likely doesn't know how to properly estimate their tax rate in retirement.
Agreed on all points. 

Goldielocks

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Re: Considering scaling down on 401k contributions
« Reply #37 on: October 13, 2016, 02:16:13 PM »
ooeei -- thanks for the long, considered answer.   I appreciate the thought you put into it, but I think at the core, there are some misconceptions...

Sorry all, but I am removing the quotes / linking / assigning who said what, to try to get to the core and shorten this up a bit... the authors below are likely wrongly referenced!

Based on this logic, we should be encouraging everyone to buy houses too, because for many people the house payment is a forced savings plan that they'd otherwise blow on stupid stuff.  Here's my math to prove it.

With house:  $400k house as asset after 30 years.  You pay the mortgage monthly, and would be paying some for rent anyway, so you don't really notice it.
Without house:  $0 after 30 years.  You spent the money on stuff and rent.

Yes, I think that this is what really happens to many people, especially for the first 10-15 years of home ownership.  It is hard to quantify, person specific (MMMs excluded?); which is why we don't quantify it, but it really does exist.

  You are simplifying the math against the benefits of tax advantaged accounts, assuming the person is not disciplined enough to invest the extra from not paying taxes. 


 
Actually, the math I have shown is that the full pretax amount ($100k) is invested into the 401k, direct from paycheck which does not generate an additional tax refund, and assumes that the investor has adjusted pay to have no refund at year end, even after the 401k contributions.


   
 I think it's this part of the post I bolded that bothered people, because it is demonstrably false:
[/size]
Quote from Goldielocks:
This is not true.  If you are in the same tax bracket, it is the same money out as if you invested it in a non Retirement account- (shows basic math - see upthread for details)


  ooeei -- Please demonstrate to me that it is false.   
There is another excellent discussion chain on this, but the essence is that you compare the taxes as marginal to marginal (as you will likely have other income like SS) that is taxed first.


My other points on tax loss harvesting, paying the dividend taxes as you go, borrowing to invest, etc. are just nice points if you have already decided to carry a non-taxable account.  They are there to show the complexity and highlight more advantages to having both a 401k and a non-taxable account.

I did not build these advantages into my basic math comparing 401k taxes to non-registered taxes, because they are very person-specific, and should only influence decisions when you have a large enough amount to make it worthwhile.   

My take on 401k's advantages:

1)  Employer matching
2) Reduced taxes if your top marginal tax bracket in future is lower than today.   The 401k can be quite large before you need to be concerned about this!
3)  Easy to set up and pay the full amount of Pre tax dollars, direct from paycheck, without risk of spending your refund.

distant 4th)   Defer paying taxes -- you may die before you pay your taxes, and only your estate needs to.
distant 5th)  Easier to file taxes if all your investments are wrapped inside a 401k instead of taxable / trackable each year.  Don't have to pay taxes as you go, etc.

For tax advantaged income investments, like capital gains and dividends, 401k's are less advantageous, (if you have no drop in marginal tax rate), as you actually eventually pay tax on capital gains and dividends as if they are earned income when you withdraw them-- a 401k removes their underlying tax advantages.

NOTE  This is only a factor when choosing what to put in non-taxable vs taxable accounts vs Roth... does not apply if you only need a matching 401k and Roth account -- don't worry about the differences, which are minor at lower levels.

I hope this helps... 


TLDR

Without a match, 401k's are not stunningly fabulous devices, rather they are just pretty decent pension / saving vehicles for deferring taxes to retirement years, and for moving income from high tax to low tax years.

Roths, HSAs, etc, all have even nicer features than 401k's, but lower limits (typically).

ooeei

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Re: Considering scaling down on 401k contributions
« Reply #38 on: October 13, 2016, 03:23:50 PM »
Edited some parts out for... well.. I was going to say brevity...

Actually, the math I have shown is that the full pretax amount ($100k) is invested into the 401k, direct from paycheck which does not generate an additional tax refund, and assumes that the investor has adjusted pay to have no refund at year end, even after the 401k contributions.

Yes, but your math basically says they are identical, yet you neglect to add in the additional cost of paying taxes out of pocket, saying they're small and over time so they don't matter.  They aren't identical, because in one you pay more than the other.

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  ooeei -- Please demonstrate to me that it is false.   
There is another excellent discussion chain on this, but the essence is that you compare the taxes as marginal to marginal (as you will likely have other income like SS) that is taxed first.

This is similar to the response I gave to MDM above.  You're correct, if the investor is ACTUALLY going to be in the same tax bracket, and has income set up that way.  This is also assuming we're comparing a traditional and Roth option.  A taxable fund will pay additional taxes on capital gains/dividends compared to a 401k/roth in most cases.

The part that is often missed, is that the tax bracket the person is in is dependent on whether they use a 401k or not, so it's sort of a cyclical question that you may have to iterate a few times. 

For example:  You find that if you contribute the max to a 401k, your tax bracket in retirement will be higher than working because of all the money in your 401k.  Because of that, you decide to contribute to a roth instead.  What you then need to do is re-calculate your tax bracket under that assumption and you may find that the traditional makes sense again because now your tax bracket will be lower in retirement due to your money coming from a roth instead of 401k.  Most people only do the calculation once and that's it.  Likely you should contribute a traditional up to a (large) point, then switch to roth.  If you have an idea of what your income will be you can do the roth first, the order doesn't matter.

Most people asking this question don't have a 401k set up with $ in it yet, or very little.  That means their expected tax bracket in retirement is VERY LOW, but most of them just think "Well I want my income to be about what it is today, so my tax bracket in retirement will probably be what it is now or maybe higher."  We're relying on a fairly complex calculation from someone who doesn't have the proper knowledge to estimate their tax bracket in retirement, and it's often wrong.  In my response I was assuming they were wrong about it since it's so common, but that doesn't mean your advice was wrong. 

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My other points on tax loss harvesting, paying the dividend taxes as you go, borrowing to invest, etc. are just nice points if you have already decided to carry a non-taxable account.  They are there to show the complexity and highlight more advantages to having both a 401k and a non-taxable account.

I did not build these advantages into my basic math comparing 401k taxes to non-registered taxes, because they are very person-specific, and should only influence decisions when you have a large enough amount to make it worthwhile.   

Fair enough, that makes sense.
 
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My take on 401k's advantages:

1)  Employer matching
2) Reduced taxes if your top marginal tax bracket in future is lower than today.   The 401k can be quite large before you need to be concerned about this!
3)  Easy to set up and pay the full amount of Pre tax dollars, direct from paycheck, without risk of spending your refund.

distant 4th)   Defer paying taxes -- you may die before you pay your taxes, and only your estate needs to.
distant 5th)  Easier to file taxes if all your investments are wrapped inside a 401k instead of taxable / trackable each year.  Don't have to pay taxes as you go, etc.

The part I bolded is a key point in this, and is often very under-emphasized.  Agree on all points.

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For tax advantaged income investments, like capital gains and dividends, 401k's are less advantageous, (if you have no drop in marginal tax rate), as you actually eventually pay tax on capital gains and dividends as if they are earned income when you withdraw them-- a 401k removes their underlying tax advantages.

Yes you pay income taxes on them, sort of.  Mathematically paying 20% taxes (for example) at the start of an investment vs the end of it is the same.  For an example of $1,000 over 30 years at 10% interest with 20% taxes:

Taxes at contribution:  $1,000 * .8 * 1.1^30 = $13959
Taxes at withdrawal:  $1,000 * 1.1^30 * .8 = $13959

They are the same.  So a Roth and Traditional are the same in that way.  Let's look at the same situation in a taxable:
Taxes at contribution :  $1,000 * .8 *1.1^30 = $13959, but now you have to pay 15% taxes on the gains.  So ($13959-$1000) * .15 = $1943 in additional taxes, giving you a grand total of $13959 - $1943 = $12015

If your income is low enough to not pay capital gains, then you're right that it's all the same.  But that assumes you can avoid taking any capital gains until your income is that low, which if you use index funds may not be possible.


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TLDR

Without a match, 401k's are not stunningly fabulous devices, rather they are just pretty decent pension / saving vehicles for deferring taxes to retirement years, and for moving income from high tax to low tax years.

Roths, HSAs, etc, all have even nicer features than 401k's, but lower limits (typically).

I guess stunning is subjective, but they are pretty great in my book.  Roths and HSAs can have nicer features in some situations (an HSA especially, except for the all too common fees, and potential for rules to change), but for most people the traditional 401k is the best bet if they structure it properly.  If I had to pick whether to have only a Roth IRA or Traditional 401k available with the same limits, I'd pick the Traditional hands down.  Well, maybe not, since then IDK how a Roth pipeline would work.  Anyway, you get my point.

Thanks for the polite discussion, that's part of why I like this site. 
« Last Edit: October 13, 2016, 03:26:39 PM by ooeei »

Goldielocks

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Re: Considering scaling down on 401k contributions
« Reply #39 on: October 13, 2016, 03:27:08 PM »
Edited some parts out for... well.. I was going to say brevity...

Actually, the math I have shown is that the full pretax amount ($100k) is invested into the 401k, direct from paycheck which does not generate an additional tax refund, and assumes that the investor has adjusted pay to have no refund at year end, even after the 401k contributions.

Yes, but your math basically says they are identical, yet you neglect to add in the additional cost of paying taxes out of pocket, saying they're small and over time so they don't matter.  They aren't identical, because in one you pay more than the other.

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No.   Actually I assumed a non-dividend paying equity portfoliio under both scenarios. 

So there is no tax to pay on income each year.  (to keep it simple).  If we tried to compare across dividend payers, fixed income, cap gains, etc., we could be here for a very long time.   my comments on paying tax each year was just a "bonus" comment about non-taxable.

Goldielocks

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Re: Considering scaling down on 401k contributions
« Reply #40 on: October 13, 2016, 03:32:45 PM »
...
Yes you pay income taxes on them, sort of.  Mathematically paying 20% taxes (for example) at the start of an investment vs the end of it is the same.  For an example of $1,000 over 30 years at 10% interest with 20% taxes:

Taxes at contribution:  $1,000 * .8 * 1.1^30 = $13959
Taxes at withdrawal:  $1,000 * 1.1^30 * .8 = $13959

They are the same.  So a Roth and Traditional are the same in that way.  Let's look at the same situation in a taxable:
Taxes at contribution :  $1,000 * .8 *1.1^30 = $13959, but now you have to pay 15% taxes on the gains.  So ($13959-$1000) * .15 = $1943 in additional taxes, giving you a grand total of $13959 - $1943 = $12015

If your income is low enough to not pay capital gains, then you're right that it's all the same.  But that assumes you can avoid taking any capital gains until your income is that low, which if you use index funds may not be possible.


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I see what you are getting at.