Not trying to pick on you, but the math seems odd to me - that you deduct for your 401k and your net take-home increases. Unless your employer did something really funny for withholding, I’m confused. Between Federal and State the top-end of my income is hit by about 40% tax (33% + roughly 6.5%), which means for every $1 I put in the 401k I avoid 40 cents of tax. I don’t see how that could make my net paycheck go up.
If you’re at the very bottom of a tax bracket and the 401k deduction knocks you into a lower one, it can work out.
Yes, this is what happened to me. It was my first post-college job, making very little (18k, if I remember correctly.) My 401(k) deductions dropped me to the next lower bracket.
I apologize in advance for my ignorance on the subject, but some things about 401k money, withdrawal, and taxes have always confused me:
Say I contribute regularly to my 401k for 40 years, and there’s $1 million in there when I retire. The day after my retirement, what happens to that money? Is it all kicked out of the 401k account and into my normal bank account (or other post-retirement accounts?) Or does it sit there in perpetuity, waiting for me to withdraw it in little bits every year thereafter?
As far tax rates go: say that as a 65-year-old, my marginal tax rate is 25%. Is the entire million dollars taxed at 25%, even if I move it all at once into a brokerage account and reinvest it into S&P500 mutual funds? Or is it incumbent upon me to withdraw my retirement money in smaller chunks?
And what exactly is “my tax rate when I retire?” That seems like an easily-manipulated number. Wouldn’t it benefit me to quit my job the year before I retire, and spend a year at some low-paying job to reduce my final tax rate? Or does the government average out my tax rate over the last few years of employment? What if I retire at 50, but don’t take my 401k money until I’m 60, living off of non-retirement savings for those 10 years. My tax rate for the last 10 years will have been zero! Surely I don’t then get to take my 401K money out tax-free!
When you retire, your 401(k) account remains unchanged. Investments in the account continue to grow tax free. You withdraw as much or as little as you like/need at any particular point in time, and you pay taxes on the amounts you withdraw at ordinary income rates. This is true until you turn 70.5 years old. At that point, there are mandatory distributions you must take from your 401(k).
Since the tax code is progressive, you can influence your tax rate in retirement by controlling the amount of money you withdraw each year.
Thanks for the reply! That makes a lot of sense.
But, if what you’re saying is true, then why does it matter what your “tax rate at retirement” is/was? Presumably, by definition, retirees aren’t earning much non-retirement, non-SS money. You make it sound like the tax rate on your 401k is entirely dependent on how much you take out each year in distributions, as opposed to what your salary was when you retired.
Your tax rate depends on your income each year - not your income in retirement.
Lets say I have $1 million in my 401k. For the first three years I take out $20k, and live off that and social security - I’m probably at the lowest bracket (I could look it up, but I’m not going to). The third year I meet a handsome young guy who convinces me to live it up (and take him along) and I withdraw $200,000…I pay taxes at the $200,000 bracket.
A lot of people like Roths, because they pay the taxes now and they are betting that they make MORE money in retirement. Roths are pretty cool - particularly if you are young - but put enough money in a traditional 401k to get any employer match first.
(I’m actually not a huge fan of Roths because you are also betting the tax code doesn’t change to give you a really low tax rate on 401k disbursements - if Congress were to make a deal to say - means test Social Security - but in exchange not tax the first $50k of 401k disbursements a year - you’d have made the wrong bet.)
401(k) distributions are considered ordinary income and are directly added to any other income you may have in that tax year. Taxwise, there’s nothing special about a 401(k) distribution taken in retirmenet so long as you follow all the distribution rules. It’s just a line item on Form 1040 that’s mixed in with all your other sources of income (wages, interest, whatever you may have…). If you don’t have much else in the way of income at retirement, then yes, your tax rate will largely be based upon how much you withdraw in any particular year. What you were making before you retired isn’t relevant to the rate at which you get taxed in retirement.
There are two potential reasons why your tax rate at retirement matters (that I can think of). First, you have to plan for the taxes and make sure you save enough so that even after taxes, you’ll have enough money in retirement. Second, depending on your current tax rate, it may be more worthwhile to invest in a Roth IRA instead of a 401(k). With a Roth IRA, you get no immediate tax break today, but like the 401(k) the money in the account will grow tax free. In retirement, no taxes need to be paid at all on qualified Roth IRA distributions. So you can pay the taxes now (Roth IRA), or later (401(k)), and you want to pay the taxes when your tax rate will be lowest. Of course, it’s hard to estimate your tax rate at retirement; you never know what the tax code is going to look like in the future.
If your company’s plan offers any kind of reasonable contribution matching, you should probably at least contribute enough to get the full match. Most 401(k) plans are rarely so terrible that you should pass up free money in favor of a Roth IRA. But once you’ve gotten the full match, you need to decide whether to put additional money into your 401(k) or put it into a Roth IRA.
I think you may not understand how the United States progressive taxes work. It’s not like when you cross a bracket all of your money is at the new tax, only the part on the other side.
Say one pays 15% on income up to $20,000, and 25% over that. Assume no deductions or adders. A person making $21,000 pays $3,000 + $250 = $3,250 in taxes. Their net take-home is $17,750 - divide this by 52, and you get $341.34 per week.
Now assume they put $2,000 into a 401k. They now have $19,000 that’s taxed, so their taxes are $2,850 (all their income is now in the lower bracket). Their net take-home is $16,150. Divide this by 52, and you get $310.58 per week.
This is why it’s hard why the claim of a higher net take-home is odd. I’m not saying it’s impossible - the employer may have had some sort of non-linear withholding formula. But on the surface, it doesn’t seem to work out.
I’m not sure how it worked, but maybe the lower income affecting state taxes had something to do with it? As far as I know the company I worked for at the time used standard witholding. Also, I’m not saying my check went from $800 to $1000 or anything, but I distinctly remember it being a few dollars higher. If I have time, I may dig through some old boxes to see if I kept any check stubs from back then.
I did a quick search and found this (PDF file) which supports my claim.
That PDF is pulling a bit of trickery by assuming you will save $3000 no matter what. In that instance, yes, being able to save $3000 as a deduction to your gross income is better than saving $3000 after-tax dollars. The savings of $810 is just $3000*27%, the taxes you avoided by deferring them. But that $33,500 figure in the second case is not really “take home pay” as most people would define it; i.e. the dollar amounts printed on the paychecks you deposit at the bank. The real take home pay in the second scenario is $36,500, which is more than the $34,310 figure given for the pre-tax savings plan. All the chart is demonstrating is that it is better to save for retirement using a pre-tax savings plan than a taxable account (which is certainly quite true). But you didn’t have to save the $3000 in a taxable account in the second case; you might, for instance, save the $3000 in a Roth IRA (which is also a better way to save for retirement than a taxable account).
Despite the slightly smaller paychecks, regular 401(k) contributions are still typically a good idea though.
That’s a good point, which I missed. In my case I wasn’t switching from post-tax deduction to pre-tax.
Just to add a slightly contrarian viewpoint to this:
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Ignore utterly any back of the envelope calculation that ignores inflation. The magic of compouding works both ways and one of the easiest tricks for saving advocates is to conveniently forget to include inflation in their calculations. I’ve not seen a single calculation in this thread that assumes inflation which makes them all worthless. Sure it’s great to imagine having a million dollars when you retire until you realise that a million dollars then will buy you a burger and coke.
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Ignore any assumed rates of return that don’t talk about risk premiums. Yes, it’s possible to get 10% year over year for 60 years but guess what, it’s incredibly risky. There’s a reason treasury bonds are much lower returns than that stock market and there’s a reason why people still buy them. Risk is extraordinarily complicated and even the best quants in the world got it wrong to the tune of almost a trillion dollars this year but that doesn’t give you an excuse to ignore it. Any calculation that has a confident 10% exponential curve is not worth your money.
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The two major ways to financial independance are “spend less” and “earn more”, figure out which route you want to go down. The alternative to saving is to invest in yourself at an early age. Get more education, move to a more expensive city with more job opportunities, sink some money into starting your own business, travel the world and learn about foreign cultures, take a low paying internship that leads to valuable experience and contacts. These are all valid alternatives to saving for the right person in the right circumstances. Some of the decisions you’re making now could be the difference between working at a job you love, earning a comfortable salary and working at a job you hate making barely enough to survive. Saving is not automatically the right option at every turn.
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Would you rather be skydiving in Costa Rica today or playing golf in Costa Rica 50 years from now? There’s something to be said about having experiences when you’re young. You can’t take any of this stuff with you and you have to decide for yourself just what you value more?
Yes, in most cases, the correct thing to do is to place a relatively significant chunk of your earnings in savings, especially with employer contribution. But at the same time, I think it’s good to have a wider perspective on what the other options are.
To follow up on the comment about going to back to school – if you are saving for your own future education you might want to look at 529 plans. These are tax-deferred plans that you withdraw from for education (as opposed to retirement). They’re really for parents looking to invest for their kids, but at least in NY state I could open one for myself with low-risk (ie, short-term) investments. There’s lots of details but its worth reading up on if school is in the future.
I am still with everyone else, though, that the tax savings of the 401k are too good to pass up, even if you are saving for school too. One thing to keep in mind is that it’s very hard to save anything when you are in school, so tucking something away can sorta make up for the years when you contribute zero. Obviously YMMV and you have to consider your own situation, just adding a few things to consider.
If you are going to save, 401(k) and/or an IRA is the best way to do it. Saving for retirement is important, and why not do it the most rewarding way possible (invest, and early).
This is why investing early is important, and keeping a cautious watch on market trends as you get closer to retirement. At 26, the recent massive stock market drops don’t bother me too much, because I know that in 30-40 years it’ll all even out. But, in 25 - 30 years, I’ll start moving my investments to lower risk funds to be less vulnerable to things like this.
Saving is an important thing to do no matter what. That’s not to say you should save every spare penny you have, but you also shouldn’t neglect that as an important part of your finances. I spent plenty of money recently on fun stuff (this time around, port and a nice digital camera for myself) but I make sure to allocate some money for savings and some for retirement. It’s all about balance.
Somewhat of a false dilemma. You can do both. Again, it’s about figuring out what will work within your means. Skydiving or not, you still need a retirement fund.
You should diversify between all options. Split what you’ve got in a way that makes sense to you and makes you happy, but don’t forget that you’re going to want to retire someday. You’re also going to want to have fun now, and have a few bucks in savings in case your car breaks down. It’s all important.
The point of the link that I posted was to show that the cost of not saving young is enormous. Inflation does not negate the fact that early saving is exponential compared to saving later on. It’s not meant to be a “oh, save only $2000 for 11 years and you’ll retire a millionaire” type thing.
This is by far the best retirement calculator I’ve seen: http://fireseeker.com/
Yes, for the multitude of reasons you posted, retirement is bloody expensive. I’m in my 20s and we both max out our 401K/TSPs, IRAs, and in addition to that, save 40% gross of what’s left over. We’d save more, but we’re paying a MBA tuition from the remaining 60% in addition to mortgage and blah. Even with these savings, we estimate retiring at 55, and that’s assuming we have no kids (unlikely). 62 is more realistic with children.
Every retirement scenario that doesn’t assume the S&P will make 10% year over year on average requires extraordinary savings to maintain a certain standard of life. My grandparents are what I would consider “the average Joe, perhaps wiser”. They had a pension and SS and a house fully paid off – but they struggled to make ends meet. (Please note that for those of us in the 21st century without pensions, building up a nest egg that generates an equivalent income and keeps up with inflation is expensive as hell.) They never ate out. Their fun was gardening and their idea of a special treat was when frozen pizza was on sale. They died with some money, but not much ($8000). 25 years doing that is bloody loooong. I’ve had enough of poverty in college, and it sucked royally, kthx.
Just putting other viewpoints out there as well.
Keep in mind also that you may likely live a LOT longer than people used to plan for. My grandparents were cautious savers, had his union pension, etc. They figured they’d live out their 70’s in Florida. Well, Grandma’s 93 now, and Grandpa died a few years ago at 91. We’re living longer and longer lives, and generally speaking the last few years are the most expensive. They never planned on having to stretch for all these years, or on Grandpa’s stroke that put him in a wheelchair and assisted living, etc. They thought they’d die in their early 80’s or so - everybody else in their families did!
You make many good points but remember that inflation is a constant no matter how you choose to manage your money. Inflation is important for understanding how much your money will be worth, but it will not help you when doing an A/B comparison of scenarios. That is, if $1M from a 401(k) will buy you a burger & coke, but you only really saved $100K in a money market account, you’re *really *screwed.