Start the savings or pay down my student loans?

[disneysteve]

Another point to consider is that 401k contributions come off "the top" at contribution time (meaning the full amount is taxed at marginal rate), but fill in from the "bottom" at withdrawal time.

Say married couple makes $165K, putting them in 28% tax bracket. Entire $15K 401k contribution would have been taxed at 28%, so contributing saves them $4200 now.

At withdrawal, taking out the same $15K will not be taxed at 28%. In fact, first ~18K or so is taxed at 0% (due to exemptions and deductions). Even assuming they take out $165K from 401k in retirement, most of the withdrawal will not be taxed at 28%. Most likely, they will be taking out less due to mortgage paydown, no kids, etc.

YES YES YES
what she (he?) said.

Take the deductions now if you are in a high bracket. Meaning put 16500 into 401k and save $4600.
Then put the remaining monies you can afford to invest in a Roth (up to 5k per year). Because I don't think you are eligible for a deductable IRA.

Jim and noppenbd, I have a question about all of that. Our tax system is tiered meaning the first dollar earned is not taxed at the same rate as the last dollar earned. By that reasoning, wouldn't you save less in taxes on the first dollar that goes into the 401k than you would on the last dollar? In other words, is the tax savings from the 401k contribution made in January less than the savings from the contribution made later in the year? Do you actually save 25% (or whatever your top rate is) on the entire year's worth of contributions or do you save whatever amount that income would have been taxed at? Hope that question makes sense.

[sweeps]

Another point to consider is that 401k contributions come off "the top" at contribution time (meaning the full amount is taxed at marginal rate), but fill in from the "bottom" at withdrawal time.

You can't have it both ways. If you're calling the deduction upfront off the top, the later withdrawal doesn't go to the bottom. Even if you do count the withdrawal at the bottom, that shifts the rest of your income up, right? It's a misleading thing to say.

Say married couple makes $165K, putting them in 28% tax bracket. Entire $15K 401k contribution would have been taxed at 28%, so contributing saves them $4200 now.

This is potentially misleading as well. First even though a couple's gross income bracket may be 28%, the real question is what is their net income. Even before a 401k deduction is counted, there are likely other deductions in play that bring the couple to a lower bracket. In other words, they may only be paying 25% on that last dollar. It's an even more dramatic situation dropping down from the 25% bracket to the 15% bracket.

Even if the couple were really paying 28% on that last dollar, it's possible that they are barely in the 28% bracket. And most of their 401k deduction would be in the 25% bracket.

[noppenbd]

I would say the opposite: first dollar you put in would have been taxed at highest projected rate (without any 401k contributions), if 401k contributions bring you below a threshold, they become less valuable.

Let's say projected taxable income for the year is 73.5K, assuming no 401k contributions. Since 15%/25% tax threshold is around 66K, the first 7.5K of 401k contributions you put in saves you $1875 (.25*7.5K). The next 7.5K only saves you $1125 (.15*7.5K). So maybe it is better to put 7.5K in the 401k and the 7.5K in a Roth. Doesn't matter whether it's parallel or serial (meaning spread the 401k and Roth contributions over the whole year, or first half of year contribute to 401k, second half to Roth). Tax savings is the same either way.

[noppenbd]

You can't have it both ways. If you're calling the deduction upfront off the top, the later withdrawal doesn't go to the bottom. Even if you do count the withdrawal at the bottom, that shifts the rest of your income up, right? It's a misleading thing to say.

It's not misleading. Let's say a person's taxable income is in the middle of 28% tax bracket all their life, so every 401k contribution made saved them 28%. Assume no other income in retirement. Let's say they withdraw enough so that their taxable income is exactly the same in retirement. My point is that their taxes will be less than 28% of that amount, because of progressive taxation. Meaning first X amount is taxed at 10%, next Y amount is taxed at 15%, next Z amount is taxed at 25%, etc. Do you agree? Therefore the majority of the 401k dollars will not be taxed at 28%. And some will not be taxed at all (due to exemptions and deductions). Look at your effective tax rate now, if you are in 25% tax bracket, you are not paying 25% of gross, AGI, or even taxable income.

This is potentially misleading as well. First even though a couple's gross income bracket may be 28%, the real question is what is their net income. Even before a 401k deduction is counted, there are likely other deductions in play that bring the couple to a lower bracket. In other words, they may only be paying 25% on that last dollar. It's an even more dramatic situation dropping down from the 25% bracket to the 15% bracket.

Even if the couple were really paying 28% on that last dollar, it's possible that they are barely in the 28% bracket. And most of their 401k deduction would be in the 25% bracket.

Sorry, I should have said their taxable income is $165K. Even if they are in middle of 25% bracket the calculation still holds. The only thing that would change it is if other income (social security, pension, etc) is a significant fraction of retirement income. So at lower incomes, where SS is a higher percentage of income, the results might not be as dramatic.

[sweeps]

It's not misleading. Let's say a person's taxable income is in the middle of 28% tax bracket all their life, so every 401k contribution made saved them 28%. Assume no other income in retirement. Let's say they withdraw enough so that their taxable income is exactly the same in retirement. My point is that their taxes will be less than 28% of that amount, because of progressive taxation. Meaning first X amount is taxed at 10%, next Y amount is taxed at 15%, next Z amount is taxed at 25%, etc. Do you agree? Therefore the majority of the 401k dollars will not be taxed at 28%. And some will not be taxed at all (due to exemptions and deductions). Look at your effective tax rate now, if you are in 25% tax bracket, you are not paying 25% of gross, AGI, or even taxable income.

Ok, I see what you're saying. But you're assuming no other income in retirement -- which I would say is unlikely (consider pension income, annuity income, interest income, capital gains, rental income, etc.). And still, each 401k contribution from each year goes to the top. Granted, the first few years of contributions probably wouldn't be taxed at all -- again assuming no other income -- but each subsequent contribution goes to the top. So I guess I don't disagree with what you're saying, but I would call it misleading.

[noppenbd]

Let me put it a different way. If you are square in the middle of 28% tax bracket your whole life, you can put X in a 401k or 0.72X in a Roth 401k. Either approach gives you the same spending. In second case you prepay all your 401k taxes at 28%. Let's say account grows by factor of 50. In first case you have 50X in the 401k, in the second case you would have 36X in the Roth 401k.

Now you withdraw those dollars in retirement. Due to progressive system, even if your income stays exactly the same, and you stay right in the middle of 28% bracket, you will not pay 28% taxes on all of those withdrawals. Far from it. Effective tax rate might be somewhere around 10-15% of AGI. So your 401k is "worth" 85-90% of 50X, which is more than 36X in the Roth 401k.

[noppenbd]

Ok, I see what you're saying. But you're assuming no other income in retirement -- which I would say is unlikely (consider pension income, annuity income, interest income, capital gains, rental income, etc.). And still, each 401k contribution from each year goes to the top.

I agree it goes on the top, but for most of us, it is on top of a pretty small stack (I am guessing SS is only going to replace maybe 20-25% of my income tops).

[sweeps]

Did you count growth of your pre-tax vs. after-tax dollars? A $15,000 (pre-tax) contribution grows to a much larger value over time than a $12,000 (post-tax) contribution.

I understand and tend to agree with what you're saying, but it is based on a specific assumption -- no other income in retirement. Different assumptions could change the results dramatically. Don't get me wrong -- I actually prefer funding my 401k over a Roth IRA -- but I'm concerned about basing the case on a particular situation.

[jIM_Ohio]

Jim and noppenbd, I have a question about all of that. Our tax system is tiered meaning the first dollar earned is not taxed at the same rate as the last dollar earned. By that reasoning, wouldn't you save less in taxes on the first dollar that goes into the 401k than you would on the last dollar? In other words, is the tax savings from the 401k contribution made in January less than the savings from the contribution made later in the year? Do you actually save 25% (or whatever your top rate is) on the entire year's worth of contributions or do you save whatever amount that income would have been taxed at? Hope that question makes sense.

I had a long reply typed and it got lost in cyber space. Let's see if I can do it again.



Look at exemptions and std deductions to get your answer.

401k contribution cannot be more than earned income (by law) and some taxes come out (like FICA and medicare) before 401k and taxes are calculated. In reality it is impossible to put in 100% into 401k, even if the plan allowed it. With me so far?

Next, taxes are always calculated by April 15 following the year they were earned. No way payroll is going to know about interest, tax credits, other income from spouse and similar. For example some couples where both work and 1 is self employed person might have the working spouse have enough taxes withheld for both spouses (so estimated tax payments are not needed). The only way this gets resolved is at tax time.



So when tax is calculated or something (like a deductable IRA) is taken away, it always comes off the top. Meaning if I have $70,900 in taxable income, then come tax time I put $3000 into a deductable IRA, you will see the tax bill drop from $10,100 to $9,350- seeing the $750 in tax savings "come off the top". All deductions work this way- mortgage interest, student loan interest, and the list goes on.

When you withdraw money from the 401k/IRA there is no other "income" to add it to. So it has to start at the bottom.
Reference Room

Use that link for where the numbers came from if you question where I came up with bracket limits or exemption amounts- using 2009 tables.

The tax table lists $67900 as the income which is capped at 15% bracket. The tax owed on $67900 is $9350 (10% tax of first $16700 and 15% of the difference between $67,900-16,700).

If someone withdraws $67900 from a 401k/IRA they will NOT owe $9350. Assuming married filing jointly.

$67900 withdrawn (gross income)
$10700 std deduction (reduces amount taxed)
$3650 exemptions times 2 spouses

$49900 is taxed (taxable income) and the tax owed is $1670+ 15%*($49900-$16700)= $6650.

That is much less than the $9350 shown on the tax table. This is because the $67900 on table is taxable income, but the withdraw from 401k/IRA is gross income.

If you look at the tax difference ($9350-$6650)=$2700... then look at total deductions ($18000), then look at highest effective tax bracket (15%), you can see that $18,000*15%=$2700. The reductions always come off the top (deductions come off the top).

You can't have it both ways. If you're calling the deduction upfront off the top, the later withdrawal doesn't go to the bottom. Even if you do count the withdrawal at the bottom, that shifts the rest of your income up, right? It's a misleading thing to say.

This is potentially misleading as well. First even though a couple's gross income bracket may be 28%, the real question is what is their net income. Even before a 401k deduction is counted, there are likely other deductions in play that bring the couple to a lower bracket. In other words, they may only be paying 25% on that last dollar. It's an even more dramatic situation dropping down from the 25% bracket to the 15% bracket.

Even if the couple were really paying 28% on that last dollar, it's possible that they are barely in the 28% bracket. And most of their 401k deduction would be in the 25% bracket.

Sweeps- see my example above.

Another way to put above is what is max withdraw from IRA which is taxed at 15%.

For a married couple:
$67900+$10700+$7300=$85,900.
The tax they will owe on the $85,900 is $9350.
This means on an 85.9k withdraw, $9.3k of federal tax is owed. This means that $76k of income can be spent.


Going back several posts ago, I made the comment that taxes will go down in retirement for most people, unless you plan to spend more in retirement than you did while working.

Look at the 76k in spending income above. That is about what my family spends each year. To "earn" that spending we actually make close to 110k.

7.45% of the 110k goes to SS and medicare
some goes to our 401k
some goes to our Roth (not included in the 76k of spending)
about 1/3 of the 76k goes to our mortgage.

My point is we need to "earn" more to do the same thing while working than when retired, you will need to earn less to do the same thing.

Paid for house
save 7.45% on SS/medicare
work related expenses decrease

I am in 25% tax bracket (until my mortgage interest kicks in) to get the 76k of spending I need now. In retirement I can do the same spending and be in 15% bracket.

[LivingAlmostLarge]

Nice breakdown Jim. I've always run the number similiarly. But also have been told you might plan withdrawals and purchases based on taxes in retirement. Plus a lot of states have no state income taxes during retirement!

That's a huge bonus for those in high income tax states now.

[noppenbd]

Did you count growth of your pre-tax vs. after-tax dollars? A $15,000 (pre-tax) contribution grows to a much larger value over time than a $12,000 (post-tax) contribution.

Yes, I did. You put in X into a 401k, and .72X into a Roth 401k. If the value of each account grows by a factor of 50, X becomes 50X, and .72X becomes 36X.

The reality is, it is a rare person who socks away enough to be in the 25-28% tax bracket in retirement anyway. You would have to have probably 40K in SS combined with a 3M nest egg to get 120K yearly income in retirement. So 95-99% of people are not going to be in 28% tax bracket in retirement (whether they want to or not).

[LivingAlmostLarge]

If you are in the 28% bracket, it's also likely you would have been making way more than $120k while working!

[jIM_Ohio]

120k for a single person is in 28% tax bracket- for single filers anything over 82,250 of taxable income is taxed at 28% for 2009.

[isthisused]

will future taxes be higher or will future deductions be lower? There is more than one way for gov't to get their tax revenue.

If a person is in 15 percent bracket the Roth is a great move.
If a person's marginal bracket is 25 percent or higher, I will usually recomend take your deduction NOW and worry about taxes later. That deduction may not always be there.

Those pundits you listen to are still working... they may not be the best people to take retirement advice from...

That is a good point as were the points in your earlier post that somehow I didnt read before my post. I do not think he is eligible at this time for a roth but I do believe the income limit goes away in a couple years so the money could be put into a traditional IRA and then converted after the income limit goes away, could it not?? What about the taxing of social security benefits?

· If you file a federal tax return as an “individual,” and your combined income* is between $25,000 and $34,000, you may have to pay taxes on 50 percent of your Social Security benefits. If your combined income* is more than $34,000, up to 85 percent of your Social Security benefits is subject to income tax.
· If you file a joint return, you may have to pay taxes on 50 percent of your benefits if you and your spouse have a combined income* that is between $32,000 and $44,000. If your combined income* is more than $44,000, up to 85 percent of your Social Security benefits is subject to income tax.

[jIM_Ohio]

That is a good point as were the points in your earlier post that somehow I didnt read before my post. I do not think he is eligible at this time for a roth but I do believe the income limit goes away in a couple years so the money could be put into a traditional IRA and then converted after the income limit goes away, could it not?? What about the taxing of social security benefits?

· If you file a federal tax return as an “individual,” and your combined income* is between $25,000 and $34,000, you may have to pay taxes on 50 percent of your Social Security benefits. If your combined income* is more than $34,000, up to 85 percent of your Social Security benefits is subject to income tax.
· If you file a joint return, you may have to pay taxes on 50 percent of your benefits if you and your spouse have a combined income* that is between $32,000 and $44,000. If your combined income* is more than $44,000, up to 85 percent of your Social Security benefits is subject to income tax.

If your bracket is 28% or higher I would look for tax avoidance more than "tax me now" plans. No need to do a Roth conversion at 28% when you could do the same conversion in retirement at 15% or 25%.