401k/Retirement savings advice

I have been thinking a bit about 401ks as of late. Basically, I get that the point of having a 401k is employer matching, and deferred taxation. However, I’m confused as to how much of a benefit it is. I’m 22, single, unmarried, and make 52k a year. Furthermore, I am on the road for his job, so I have no food, housing, or car expenses. Obviously the wise thing to do at this point is to start banking a lot of money for retirement and future expenses. Here’s what I see as the benefits/costs of a 401k:

Benefits

Employer matching
Before tax income

Costs

It costs money to access the savings in the 401k.
If you borrow against the 401k, I don’t think you can change jobs without having to repay the loan or pay stiff penalties
Beyond the costs, it is simply more difficult to access money in a 401k
Relatively limited investment options

So far this year I have been just putting in the amount my company matches, simply because I needed some cash on hand to cover expenses until I was reimbursed, and I was saving up for Lasik. Now I have enough cash on hand, and the Lasik is paid for, so I need to start investing something for my future. I think the key point is gaming the system to minimize my tax liability over the future. The tax brackets (adjusting for my deductions) are:

10% of the income between $8,951 and $16,975,

15% of the income between $16,976 and $41,500,

25% of the income between $41,501 and $87,800,

28% of the income between $87,801 and $173,500,

The obvious observation is that there is a big tax at 41.5k, but only a small one at 87.8k. That means, to me, is that I want to maximize my take home income in the <41.5k bracket, and minimize it in the brackets above. In other words, I should be saving now for future expense, and then put away more and more money in the 401k as my income goes up. Basically, my plan is to put enough in the 401k to get down to the <41.5k bracket, and sock the rest away for future expenses. That will allow me to use my savings to avoid paying interest on loans, and reduce the overall payments. Thus, when I am making more like 60k in a few years, I would have more free income to put into the 401k. Hopefully enough to continue to keep my income out of the 25% tax bracket.

Any thoughts?

My thought is that you’d be foolish not to contribute at least enough to maximize the employer match. Let’s say they match dollar-for-dollar up to 3% of your salary (which is what I’ve seen several places). If you contribute only that much, you get an immediate 100% return on your investment, in addition to the fact that you’re contributing pre-tax money, so you should see only roughly a 2% drop in your paycheck. Beyond that, you may want to contribute to a Roth IRA, because one theory is that you’re better off taking the income tax hit now and then not being taxed on four decades of capital gains.

Though that depends on what the market does - if the market has a decent yield (and today in not the day to look, I’m not looking!) over that time, you get that yield compounded on the money that you have in the account that wasn’t initially taxed. Compounded interested can make a huge difference.

We ran a lot of scenarios in tax class - the Roth was usually the loser unless the yield was really low, simply because you get that compounding.

Oh yes, I have been keeping up the minimum amount they match (1/2 up to 6%), because as you say, not doing that is like taking a 3% pay cut.

Can you elaborate on this? It shouldn’t matter when I get taxed. If I invest Y get a 25% return, and am taxed 25%, it doesn’t matter when it’s taxed. If it’s taxed before I invest it, then the math is: [Y*(1-.25)](1.25)=.9375Y. If it’s taxed when I take it out it’s: [Y(1.25)]*(1-.25)=.9375Y.

It sounds like Dangerosa has more numbers on this and may disagree, but if you’re just 22, then the money you contribute to a retirement account is going to grow for up to 45 years. So the initial contribution should be (might be?) dwarfed by the compound return and you’re better off paying taxes on the contribution now so that you can withdraw the future amount tax-free.

That said, I didn’t start saving until I was 30 or so, and even then, mostly in the company 401k, to which I’ve been contributing the legal maximum.

The idea behind a Roth being a bad idea is this…

Lets say you have $10,000 a year to put towards retirement. If you invest it in a traditional 401k you invest $10,000. That $10,000 compounds…

If you put it in a Roth, you put in say - $7,500 - because you don’t have $10,000 to put in, you paid taxes up front so can afford to invest less. So you have to run the compounding on $7,500.

Both investments have the same yield. At the end you pay taxes on the 401k (and who knows what that rate will be 40 years from now) and nothing on the Roth.

If you can afford to eat the taxes up front, and invest $10k in the Roth, then the Roth is probably going to be a better deal - depending on what tax rates are.

There is a recommendation in the tax world, however - never pay taxes today you can delay until tomorrow. You are betting that tax policy stays very similar to what it is now - by the time you retire, it could be a lot more beneficial to have the 401k or a lot worse to have it - tax policy isn’t a static thing.

The other advice is take all the free money you can. Don’t let that 3% employer contribution slip through your fingers whatever you do.

The actual return will probably be bigger, but did you take into account the 10-30% of taxes when withdrawing the regular IRA? I’ve always seen it the opposite. Contribute up to matching on a 401K, put the max in a Roth, then back to either a 401k or regular IRA.

Roths are also nice if you plan on being rich when you retire. :slight_smile: For example, in my case, my kids will be gone, my house should be paid off, etc, so I’ll have a lot less deductions and will probably be in a higher tax bracket than I currently am in, even if I make the same money.

Do you expect to make the same amount of money for the rest of your life? Do you expect taxes to never go up in the next 40 years?

Actually, after rereading your OP, it seems like you are overthinking this wayyyy to much. You want the 401k to save on taxes and get the employer match, that’s it. No need to make things more complicated then that. It might be interesting to think of ways to game the system but it is a waste of time if you’re doing it to make more money. You are better off spending your time figuring out a asset allocation plan.

BTW the money in a 401k is SUPPOSE to be hard to get to. All those cons you listed are put there on purpose to discourage people from treating it like a checking account. The exception (#4 poor choice of funds) is something which would require a length post. Basically, it is a bitter pill you may have to swallow in order to get the match and tax benefits. You can try asking your employer to switch to index funds.

Yeah, this is really the heart of my OP. What should I be doing in order to minimize my tax payments and the interest I will have to pay on loans. I’m inclined to think that taxes will be higher when I retire than I would be paying now. At least, I think that will be the case for the next 5 years.

Yes, I understand the 401k is to save on taxes, but I want to make sure that I do actually save on taxes instead of simply deferring them for 40 years. As for asset allocation, I expect the vast majority of it will be in index funds. I sure as shit don’t know anything about stocks beyond the fact that the aggregate value of them all will go up, and I’m not sure anyone else knows more than that.

I concur - you should banish all thoughts of loans/withdrawals from your mind. Not even a factor, don’t even think about it. I know it might be difficult at this point in your life to think of committing to retirement, but that’s what this is all about.

Think about it - any loan or withdrawal you would make would be stealing from your older retired self. The older retired self would have much less opportunity to rebuild this money (no income - fewer years, etc.)

So, the strategy should be to invest in 401k to the maximum of your company match, and then invest some regular money in whatever (mutual funds, stocks, roth) for your liquid needs (the money you might need to spend).

You are not just saving on taxes, you are investing that savings. Also, the basic priniciple is that you are deferring the taxes until you would paying at a lower rate (lower income + over 65 rate).

Not real numbers:

Taxes now = $1
Money in pocket = $0

vs

401k now = $1 invested for 40 years = ~$60 (double every 7 years)

Taxes later = ~$60 x WAG 15% = $9
Money in pocket = $51

Obviously if I don’t save anything I’m not going to have much retirement income. My point, to use your example, is this:

1 Now - 15% taxes = .85 * 60 (your return) is $51
1 Now * 60=60 -15% taxes is $51

It simply doesn’t matter when I pay taxes on my investment. All that matters is reducing the overall tax level.

The key to the Roth is you may be paying 15% taxes now, but if you expect to be in the 25-28% bracket later when you withdraw the money, you are better off paying the taxes now. Other than that the Roth is a good option if you have already maxed out the 401(k) [maxed out not just the match but the limit] but still have money to save. Your principle in the Roth is also more accessible for things like down payments.

If you can afford it now, why shouldn’t you put the maximum allowed into both your 401k and Roth IRA? The more you put in and the earlier, the more comfortable you’ll be when you retire.

This is my feeling, exactly. Increase your income while decreasing your tax liability. Where’s the downside?

I have the option of a Roth 401K and I’m using that instead of the traditional.

Is it a good idea? I don’t know, but I’m betting that tax rates will be much higher in 35-40 years when I reach retirement than they are currently. Right now tax rates are historically low.

  1. Don’t access it till you retire.
  2. Don’t borrow against it.
  3. (see #1)
  4. Limited yes but nearly every plan I’ve see had at the very least a conservative bond fund, an index fund, an international fund, and a large cap growth fund. Enough to be somewhat diverse.

A couple other things to remember. You probably won’t have the same job forever. When you leave that company, you can roll the 401k funds over into an IRA and then you will have greater investment choices.

Presumably, once you reach retirement age, your income will be lower then what you need now (ie. your house is paid off) so what you need for your annual income will be lower, pushing you into a lower tax bracket. So 15% taxes then is not realistic. It’s not like you’re going to hit retirement age, take out your 401k in a lump sum at 65 + 1day and store all that money in jars buried in the yard for the rest of your life. You’re going to be slowly drawing that money out of an account throughout your retirement and only paying taxes on the x amount a year you draw.

Since the Roth is already taxed the principle is available for emergencies without penalty. It makes a nice rainy day fund in case of loss of job.