Author Topic: Balancing taxable and tax-free contributions  (Read 1347 times)

FireLane

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Balancing taxable and tax-free contributions
« on: September 23, 2015, 07:52:17 PM »
Here's an investment-strategy question that Go Curry Cracker's "Never Pay Taxes Again" post got me thinking about. I haven't seen this discussed much on MMM or the other finance and FIRE blogs I read. Maybe I've missed it and someone can give me some links. Otherwise, thoughts welcome.

My main investment vehicles are an employer 401(K) and a personal Vanguard account invested in index funds. What I'm struggling with is whether it's better to contribute the maximum legally allowable amount to my 401(K), which I could do, or whether I should just contribute up to the limit of my employer match and put the rest into my personal Vanguard account.

I get that because I can contribute to my 401(K) out of pre-tax money, it reduces my taxable income, which is what I want since I'm working and paying a higher tax rate than I will be in retirement. That makes sense.

However, my understanding is that when I start withdrawing from my 401(K), either at 59 1/2 or earlier using the Roth ladder method, that gets taxed as regular income. When I withdraw money from my taxable Vanguard account, it counts as capital gains, which is taxed at a lower rate.

I'm married, so assuming the laws don't change by the time I FIRE, I could withdraw up to $74,900 each year from my Vanguard account without paying any taxes at all. That ought to be more than enough to live on. Even the smallest withdrawals from a 401(K) get taxed at 10%. Plus, if you use the Roth ladder, you have to anticipate your spending five years in advance, so you have a lot less flexibility.

Doesn't this argue for putting as much money as possible into a taxable account? How do you all split your contributions between taxable and tax-free accounts?

MDM

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Re: Balancing taxable and tax-free contributions
« Reply #1 on: September 23, 2015, 08:06:01 PM »
Check http://forum.mrmoneymustache.com/investor-alley/to-401k-or-not-to-401k-that-is-the-question-43459/ to see if that answers your question.  If so, great.  If not, rephrase and we'll try again.

terran

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Re: Balancing taxable and tax-free contributions
« Reply #2 on: September 23, 2015, 08:37:46 PM »
You shouldn't be comparing the 10% (or 15%) tax to a 0% capital gains rate, you should be comparing it to your current tax rate. You will (just about) always pay tax at some point, so if you can defer and pay less later, it's better than paying now and then not paying capital gains later.

seattlecyclone

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Re: Balancing taxable and tax-free contributions
« Reply #3 on: September 24, 2015, 07:55:15 AM »
Yes, terran has it exactly right. Would you rather pay your current tax rate now, dividend taxes every year that your income is over $74.9k, and zero capital gains later, or would you rather pay zero now, zero until you retire, and 10-15% later?