Why you should maximize 401k contributions

[Joel]

If you are married filing jointly, your standard deduction is $12,400 in year 2014, plus two exemptions at $3,950 each. That means your first $20,300 in income is tax-free. The next $18,150 is at a 10% rate. The next $55,650 is at a 15% rate.

$20,300 (tax free income) / 0.04 withdrawal rate = $507,500 nest egg required.

That means the first $507,500 you can set aside in tax-deferred accounts (401k, traditional IRA, etc.) will be tax free.

$18,150 (10% income) / 0.04 withdrawal rate = $453,750 additional nest egg (10% marginal).

The means the next $453,750 you can set aside in tax-deferred accounts will be taxed at 10%. That means you can set aside 960k in tax deferred accounts that are taxed at 0% or 10%. That is probably close to enough for most people.

$55,650 (15% income) / 0.04 withdrawal rate = $1,391,250 additional nest egg (15% marginal).

That means the next $1.4million you can set aside in tax-deferred accounts will be taxed at 15%. That allows for $2.3 million to be set aside in tax deferred accounts that are taxed at 0%, 10%, or 15%. That is more than enough money to retire on, and that is at a marginal tax rate that is lower than most people are paying during their working years.

That is why I contribute enough to my 401k and IRA in order to keep my marginal tax rate below 25% whenever possible.

[Mover]

Thanks. 

[FastStache]

Other benefits are not paying payroll taxes or income taxes upfront!

[ender]

Other benefits are not paying payroll taxes or income taxes upfront!

You pay payroll taxes on 401k deductions.

You do not on HSA deductions, when made through an employer (unfortunately if you self-fund an HSA and do not have employer insurance you will have to).

[DrTesla]

There are some investors and savers that think otherwise. Sometimes it's better to have money now, and invest it now in whatever you desire, then to have it be restricted.

[dragoncar]

Cool analysis.  Only glitch is that tax rates may not stay the same

[kpd905]

Cool analysis.  Only glitch is that tax rates may not stay the same

I think his post makes it clear that they would have to go up an extreme amount for most people around here to not benefit from the 401k tax break.  Save 25% on the contribution, and a married couple withdrawing $50k a year right now pays 7.2% federal tax on that amount. 

[Undecided]

There are some investors and savers that think otherwise. Sometimes it's better to have money now, and invest it now in whatever you desire, then to have it be restricted.

Yes, there sure are, and many of them have a strong interest in Tesla, at least on this board.

[Joel]

Other benefits are not paying payroll taxes or income taxes upfront!

As mentioned you pay payroll taxes regardless.

And if your marginal tax rate is 25% than it absolutely makes sense. If you are in the 15% bracket, it's going to depend on your future income prospects and needs.

[nawhite]

I agree that 401k's and traditional IRA's are awesome. One problem that I see though is that you need to have all of it withdrawn between 59.5 and 70.5. Doesn't that limit the actual amount that you can minimize taxes?

So for the example of "$20,300 (tax free income) / 0.04 withdrawal rate = $507,500 nest egg required."

Don't you need to withdraw all of that $507k over 11 years? This means that you have to withdraw at least $46k/year assuming it was earning 0% over those 11 years. $46k gets taxed where $20,300 does not.

Can someone explain the "everything must be out by 70.5" rules a little better?

[rayt168]

Besides the employer matching contribution, is there any financial advantages to maximizing the 401K over contributing to a traditional IRA?  I realize that the maximum allowed under each option is different.  Thanks in advance.

[nawhite]

You don't need to have everything withdrawn by 70.5. You must start withdrawing by age 70.5, or else you will be required to withdraw a minimum amount every year.

Thanks for clarifying. Makes more sense that way.

Besides the employer matching contribution, is there any financial advantages to maximizing the 401K over contributing to a traditional IRA?  I realize that the maximum allowed under each option is different.  Thanks in advance.

The only difference that I can find other than the income and contribution limits and the company match is that, in some states, 401k's are protected assets while IRA's may not be. So if someone sues you (or you get divorced), depending on the state, an IRA may be included in your assets while a 401k may not be. Check with a local attorney.

[Allen]

So, my income is around 83k with my wife bringing in between 10-30k depending (she owns a small business)

So, with the exemptions and std deduction we are just barely cracking the 25% tax bracket.  Would it make more sense for me to contribute towards the match (and whatever keeps us below 25%) and put the rest in Roth?

I still like saving 15% now on my taxes, but it really doesn't add up to much vs. taking the tax hit and investing the difference (or paying off a 5.12% student loan).

Which is smarter?

[KBecks]

This is good to know. I was struggling to understand why people want to max the 401k, especially when the choices are limited, the performance might suck wind, and the admin fees are often 1%+.

Income tax savings, well, really, deferred taxes.

I will ask our accountant about what bracket we end up in.   Thanks for the info.

[teen persuasion]

Besides the employer matching contribution, is there any financial advantages to maximizing the 401K over contributing to a traditional IRA?  I realize that the maximum allowed under each option is different.  Thanks in advance.

If you are eligible for the EITC, maxing your 401k can really increase your refund, while contributing to a tIRA often makes no change in EITC.  The phaseout rate seems to be 21%, and our state matches EITC at 30%, for a combined 27.3% return on 401k contributions, plus 10% fed and 4% state tax savings for a total of 41.3% return on 401k contributions for us.  Payroll contributions to our HSA avoid another 7.65% FICA, so they can be 48.95% return, until we begin hitting zero federal tax range.