401k Loophole

Factual Questions
1

Lets say that someone is planning to quit their job to go back to school, have a baby, or whatever at the end of the year. Lets also say that they are single, make 60k, have 15k in their 401k, and have another 5-10k in liquid non tax deferred savings. Would it make sense for this person to live off their liquid savings and increase their 401k contributions to the maximum tax deferred amount? This would accomplish two things:

(1) 2009 income would be lower, and thus overall tax rate would be lower.

(2) Since they would be earning no income in 2010 their effective tax rate would be very low. This means that the 401k money would be taxed the 10% penalty+whatever the low tax bracket rate is.

To put numbers to it:

Assume normal 6% retirement savings:

Gross income for Oct-Dec: 15k
401k contribution: .9k
Taxable income: 14.1k
Effective tax rate: 35%
Tax: 4.935k
Net Income: 9.165

Assuming max 35% retirement savings:

Gross income for Oct-Dec: 15k
401k contribution: 5.25k
Taxable income: 9.75k
Effective tax rate: 25%
Tax: 2.4375k

IRS 401k Penalty: 10%
2010 Tax rate: 10%
Tax: 1.05k
Total tax: 3.4875k

Included in this, but unaccounted for would be the application of the lower effective tax rate to all of 2009 earnings.

Am I looking at this right or am I missing something?

2

I haven’t taken the time to do a good numerical analysis but something doesn’t smell right.

First, the marginal tax bracket for someone earning 60K a year is 25%, not 35%, so you are way overstating the taxes in the first scenario. And that’s the marginal bracket, which is tax on money over the first $32,550 (although that rate would apply to the money earned in the last quarter).

Second, I don’t know where you got the 35% max savings rate. The maximum 401(k) rate is generally a percentage of annual income with a dollar amount cap. If you save $5,250 in the last quarter, and have saved $2,700 in the prior three quarters for a total of $7,950 for the year, or 13.25%. That may exceed your cap, but for now let’s assume it doesn’t.

Your effective (marginal) tax rate in the second scenario is OK.

Your last statement is incorrect, but I don’t have time to rework all the arithmetic. You need to study up on how marginal tax rates work. The lower marginal tax rate does not impact *all *of the 2009 earnings (as mentioned above), and it looks to me like your marginal tax rate doesn’t change anyway between the two scenarios.

You have also failed to take into account any company contribution, which you would forfeit if you spend your 401(k) money before it is vested. So there is an opportunity cost you are not considering.

Let me do a quick and dirty qualitative analysis for you. If you start spending your savings and pump more money into your 401(k), at first you are making a good long-term decision if you don’t need the liquid savings. The money will grow tax-free instead of with taxable interest, and probably at a higher rate of return. You will also get a larger company contribution, which will pay off after it vests.

But when you start spending it like a savings account, you are losing all that tax advantage by paying taxes on the money as regular income paying a *huge *penalty that wipes out any tax advantage you gained by sheltering the gains, and then some.

Planning to use your 201(k) to support a sabbatical when it is not an emergency is not good financial planning.

Another option is to borrow the money out of your 401(k) and pay it back when you start working again. You have to pay interest but the beauty of this is that you are paying it to yourself and it goes back into the 401(k).

3

I wouldn’t call this a loophole. It certainly might reduce tax overall.

However, I see some flaws in your math. For the first example, you assume 35% tax rate and the for the second, you assume 25%. A change in only $5k taxable income will not change the tax bracket. Using 25% for that first calculation, tax on $14.1k in earnings is only $3,500. That means your total tax is different for the two scenarios only by a few dollars.

I’m not clear on how $10,500 from a 401k is enough to live on and go to school in 2010, but I’ll trust that you’ve got reasons to assume that. If you have to take out more… well, you’ll pay more tax.

Anyway, here’s the best scenario: contribute everything you can to the 401k, quit the job, roll the 401k into a traditional IRA, then take $10,000 for education. Because it was an IRA distribution for education, there’s no 10% penalty. All you pay is the $2,400 you calculated for 2009.

4

I was using effective tax rate, i.e. total % of income going to state/federal income taxes. I just assumed a number that seemed reasonable.

I looked at what my maximum pre-tax contribution was and assumed that it was legally the same for everyone.

I think this is just a semantic difference. I prorated the savings over the entire year to get an effective savings.

True, but assume for the sake of the discussion that the decision to leave has already been made.

Not necessarily. Assuming that I withdraw my savings at retirement I will still have to pay taxes. Likely higher than the 10%+small tax rate I would if I withdrew it now.

True, but this money could immediately move into a Roth IRA or allow higher 401k deductions in the future.

I thought no job=no 401k.

5

If you leave your job you keep your 401(k) account. You can’t continue to make contributions to it but earnings continue to grow tax-deferred.

6

Couple of observations:

  1. There’s definitely no global 35%-of-salary cap on contributions. One year, I dropped my contributions to zero in the early part of the year for some reason or another, and then near the end of the year, I upped it to 50% in order to make up the lost contributions. I had a couple of really small paychecks.

  2. Every 401(k) program I’ve had requires you to pay back any outstanding 401(k) loans when your employment with the company ends. So you still have your 401(k) account, but you can no longer make contributions to it, and you definitely can’t borrow against it. If you don’t pay it back when you leave your job (and I think you have 90 days), it is considered a disbursement and you get hit with the corresponding taxes.

7

Good point, I didn’t know that.

8

Couple of questions:

In the year that you aren’t working, are you going to liquidate your entire 401(k) and your entire 15K savings in either scenario? If not, what residual value will you try to conserve?

9

I put some numbers together taking into account only federal tax, and looking only at tax on gross income, not adjustments like deductions. The answer surprised me: Both scenarios yielded the same net available cash once all is said and done.

In Scenario 1, you leave your 401(k) contributions at the current rate, and preserve your savings while spending your salary. Then in the following year, you spend all your savings, and all of your 401(k).

In Scenario 2, you dump as much of your salary into your 401(k) as you can, and compensate by spending your savings. The following year, you spend your 401(k) and what’s left of your savings.

In both scenarios you pay taxes and penalty on the withdrawal from your 401(k). (Obviously no tax liability regarding the savings account).

I did not take into account gains or losses realized in the 401(k) during the last quarter and following year, or interest earned on the savings account.



Savings		 $10,000 					
401(k)		 $15,000 					
Gross income	 $60,000 	 $15,000 	per quarter			
Marginal tax rate	25%	$32,550 	 to 	 $78,850 
Marginal tax rate	15%	  $8,025 		 $32,550 
Marginal tax rate	10%	 under 		   $8,025 
Penalty on early w/d	10%					
						
			Scenario 1	Scenario 2		
Last Quarter:						
401(k) contributions:	 $900 		 	$5,250 		
Taxable income		 $14,100 		 $9,750 		
Tax on gross income	 $3,525 		 $2,438 		
Net income		 $10,575 		 $7,313 		
Spent from savings	 $-   		 	$4,350 		

Following year						
Spent from savings	 $10,000 		 $5,250   		
Withdrawal from 401(k)	 $15,900 		 $20,250 		
Tax on 401(k) w/d	 $1,984 		 $2,636 		
Penalty on 401(k) w/d	 $1,590 		 $2,025 		
Net from 401(k)		 $12,326 		 $15,589 		

Net income + net 401(k)	 $22,901 		 $22,901
10

This is creative and I agree this is the best scenario if you are going to school. I have the impression that the subject needs the money to live on, not just for direct education-related expenses (and education was only one of the possible options on the table in the OP; none of this helps if you take the time off to have a baby).

11

Plans have a percentage limit that is set by the employer, and so can vary substantially. The government sets a dollar cap which applies to all plans, which is $16,500 in 2009, plus another $5,500 if you are aged 50+.

12

It makes sense because you are taking income from the 25% bracket and moving it to the 15% bracket for next year. With the 10% penalty that adds up to the same 25% tax rate. Your analysis helped immesnly, but it missed the opportunity that I was talking about. Basically the goal would be to transfer income from the 25% tax bracket to the 10%+10% penalty bracket. Thus if I, put in an extra $8,025 in my 401k during 2009 simply to withdraw it in 2010 I would save 5%. Once I take out more than that I hit the 15% tax bracket and thus lose the savings.

13

Actually I take that back. I believe you’ve made a mistake. In the last quarter you have a net income of 10,575 in scenario 1 and in scenario 2 you have a net income of 7,313 plus 4,350 in savings expenditure for a total of 11,663. If you had equal expenditures for that 1st year you would find scenario two has a savings of $1,088.

14

I agree that I made an error. To elaborate, I did not take tax savings into account when I figured how much of your savings you would have to tap into in the first year to compensate for additional 401(k) contributions.

However, the error washes out in the second year because the savings spent there must increase the same amount as the error in the first year.

But it doesn’t matter anyway because the timing of spending the savings account doesn’t affect the tax situation.

15

If it’s for a baby, you can avoid the 10% penalty by citing the medical expenses. If their really good insurance covers the baby, then we’ll cite the COBRA premiums.

It’s not always true after the fact, in January, but if you talk to me in October? Where there’s a will, there’s a way. :slight_smile:

16

PS I worked this up in Excel. The spreadsheet can be downloaded from

www.seiglefamily.com/data/401kloophole.xls

17

Hmmm, I’m going to have to noodle on this one for a while.

18

If you’re not working, though, you most likely cannot borrow against the 401(k). In fact, when you leave a job, you have to pay back all outstanding loans or pay the tax / penalty on the amount you don’t pay back.