Why invest in a 401k? Tax people please explain.

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Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 2:26 pm

So, I currently make roughly $55k per year. Assume I'm maxing out my Roth IRA each year ($5,500 /year after taxes). Also, assume I'll see a rate of return around 10% on my retirement investments. I anticipate needing around the equivalent of $50k per year in today dollars when I retire (some of this will come from my pension). I've been putting money into my employer's 401k equivalent plan, but now I'm wondering whether it is a mistake. The employer doesn't match a single dollar, and it's not like I'm in a higher tax bracket now than I will be during retirement. I'm thinking maybe it would make more sense to just invest after tax dollars into mutual funds. Furthermore, the investment options under my employer's 401k plan is obviously much more limited than what I can invest in on my own, and my employer's plan is managed by t-rowe, which really sucks relative to Vanguard with respect to fees. Although, most importantly, I'm questioning whether I'll actually wind up paying more taxes in the long-run by having money in my employer 401k plan. The money that goes into my employer's 401k plan will be taxed as ordinary income when I retire (although, the state I live in does not tax that, so that's a savings of 3-5%). So that's roughly the same tax I'm paying now on the entire amount of my retirement fund including all the interest that accrues all these years. Alternatively, I could pay taxes on the income now, but only pay long-term capital gains taxes when I sell after retirement, if I invest on my own. Taxes on long-term capital gains are much lower than taxes ordinary income (I believe federal tax is only 15% in long-term capital gains, versus probably around 20-25% on ordinary income tax). Does it make more sense to simply ditch the 401k and invest money on my own in my situation?

The only things I can think of that favor the 401k is the lack of state income tax on distribution of the 401k and the fact that the money is protected from my creditors (e.g. if I get into a car accident that's my fault, the judgment creditor couldn't get at my 401k unlike with if I invested on my own). But the savings on federal income tax seem to outweigh that, since the capital gains will only get taxed at 15% (or less?), whereas federal tax on ordinary income is probably closer to 20-25% on $50k. Thoughts? I'm obviously going to do my own research/consult with a tax expert, but so far, what I've read seems to favor investing on my own (since I'm assuming I'll be seeing the about the same income at retirement that I'm currently making). Am I missing something here?

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KMart
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Re: Why invest in a 401k? Tax people please explain.

Postby KMart » Mon Feb 23, 2015 2:31 pm

You can invest in a Roth IRA as opposed to investing after-tax dollars. A Roth essentially is after-tax dollars but that income won't be taxed when distributed. I would not recommend using after-tax and mutual funds to fund a retirement.
Last edited by KMart on Mon Feb 23, 2015 2:47 pm, edited 1 time in total.

legends159
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Re: Why invest in a 401k? Tax people please explain.

Postby legends159 » Mon Feb 23, 2015 2:41 pm

401K has better tax benefits than taxable investments because you're using pre-tax money to fund the investments so the ordinary tax vs. capital gains tax you speak of is moot. In taxable investments you've paid the ordinary tax upfront since you're using post-tax money to fund investments and then you'll need to pay capital gains tax when you sell. In the 401K you only pay ordinary tax when you later take disbursements - in effect you're only taxed once.

Secondly - with taxable investments you're paying taxes whenever there are distributions (i.e., dividends if you are buying mutual funds). The 401K however grows tax free - you only pay tax at the end, not every time there's a distribution.

TL;DR - taxable investment = taxed twice and periodically. 401K = taxed once.

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 2:43 pm

imKMart wrote:You can invest in a Roth 401k as opposed to investing after-tax dollars. A Roth essentially is after-tax dollars but that income won't be taxed when distributed. I would not recommend using after-tax and mutual funds to fund a retirement.


I'm not sure exactly what you mean by "Roth 401k," but your explanation of it sounds like you're talking about a Roth IRA. I'm already investing $5,500 per year towards my Roth IRA, but that's the maximum yearly contribution towards an IRA. That's not going to be enough money to retire off of, so the question is where do I put the rest of the money? It seems like in my situation that there isn't a whole lot of advantages to investing the remaining money into my employer's 401k, but maybe I'm missing something? It seems like 401k plans are advantageous where the employer matches some of the money, or, at least, where your income is significantly higher now than it will be at retirement (not really practical in my case, since I think I'm going to need at least $50k /year in today dollars during retirement, which is partially going to be funded through my employer's pension plan).

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KMart
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Re: Why invest in a 401k? Tax people please explain.

Postby KMart » Mon Feb 23, 2015 2:45 pm

legends159 wrote:The 401K however grows tax free - you only pay tax at the end, not every time there's a distribution.

TL;DR - taxable investment = taxed twice and periodically. 401K = taxed once.

You also can't have distributions for 40-ish years (depending on OP's age). Something to think about although not necessarily a bad thing; you shouldn't withdraw from your nest egg for awhile anyway.

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Re: Why invest in a 401k? Tax people please explain.

Postby legends159 » Mon Feb 23, 2015 2:46 pm

Here's the waterfall of investment strategies for tax purposes:

1. Max 401K up to employer match
2. Max IRA
3. Max rest of 401K
4. Max other tax-advantaged vehicles if desired/applicable (HSA's, 529 college plans, Muni bonds etc.)
5. Taxable Investments
Last edited by legends159 on Mon Feb 23, 2015 2:47 pm, edited 1 time in total.

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KMart
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Re: Why invest in a 401k? Tax people please explain.

Postby KMart » Mon Feb 23, 2015 2:46 pm

Anonymous User wrote:
imKMart wrote:You can invest in a Roth 401k as opposed to investing after-tax dollars. A Roth essentially is after-tax dollars but that income won't be taxed when distributed. I would not recommend using after-tax and mutual funds to fund a retirement.


I'm not sure exactly what you mean by "Roth 401k," but your explanation of it sounds like you're talking about a Roth IRA. I'm already investing $5,500 per year towards my Roth IRA, but that's the maximum yearly contribution towards an IRA. That's not going to be enough money to retire off of, so the question is where do I put the rest of the money? It seems like in my situation that there isn't a whole lot of advantages to investing the remaining money into my employer's 401k, but maybe I'm missing something? It seems like 401k plans are advantageous where the employer matches some of the money, or, at least, where your income is significantly higher now than it will be at retirement (not really practical in my case, since I think I'm going to need at least $50k /year in today dollars during retirement, which is partially going to be funded through my employer's pension plan).

You're right - the result of doing too many things at once. I'd stick with the 401k to avoid income + cap gains tax.

Sorry about that!

legends159
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Re: Why invest in a 401k? Tax people please explain.

Postby legends159 » Mon Feb 23, 2015 2:50 pm

There is also a Roth 401K (if your company allows it) which uses post-tax money to fund your 401K account (never pay tax on that money again). It's good for those who think they will be in a higher tax bracket upon retirement. There's a lot of debate around Traditional 401K vs Roth 401K (like Traditional IRA vs Roth IRA) but I would say for most, a traditional 401K is better; or do a mix if you'd like (I do Traditional for 401K and Roth for IRA).

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 2:54 pm

legends159 wrote:401K has better tax benefits than taxable investments because you're using pre-tax money to fund the investments so the ordinary tax vs. capital gains tax you speak of is moot. In taxable investments you've paid the ordinary tax upfront since you're using post-tax money to fund investments and then you'll need to pay capital gains tax when you sell. In the 401K you only pay ordinary tax when you later take disbursements - in effect you're only taxed once.

Secondly - with taxable investments you're paying taxes whenever there are distributions (i.e., dividends if you are buying mutual funds). The 401K however grows tax free - you only pay tax at the end, not every time there's a distribution.

TL;DR - taxable investment = taxed twice and periodically. 401K = taxed once.


This isn't exactly accurate though. You're taxed once on your ordinary income now (i.e. your pay check reflect tax deductions), and then you're taxed once on the long-term capital gains when you sell the stocks. So for example, if you make $50k /year and your taxed at 25% by the federal government, then you keep $37,500 after taxes. Say you put that entire $37,500 into the stock market (assume no dividends, for the sake of simplicity) and sell several years later for $60,500, you're only long-term capital gains tax on the $30,000 (i.e .the capital gain). If you placed the entire pretax $50,000 into a 401k for those sames years, and that grew to $80,000, you'd pay ordinary income tax and that entire $80,000. You might wind up paying more on taxes by paying ordinary income taxes on that $80k than you would by paying ordinary income tax on $50,000 and capital-gains tax on $22,500.

However, for mutual funds, you do pay taxes on dividends and also flow0through capital gains taxes (i.e. when the fund manager buys/sells stocks). These can be mitigated, though, by buying funds where there's less buying and selling and not very many dividends.

I could be wrong about this (and let me know if I am), but at least this is my understand of how taxes work on these various funds.

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MidwestLifer
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Re: Why invest in a 401k? Tax people please explain.

Postby MidwestLifer » Mon Feb 23, 2015 2:58 pm

Something to consider, though: If you're putting the funds into a 401(k), it's getting put in pre-tax, so your capital base that you earn returns on will be larger, and thus earnings will be larger.
For example, let's say you're putting $10k into your 401(k). You decide to stop doing that, and instead invest on your own. That $10k will get taxed (at say, 25%), so you only get $7.5k to invest. Assuming you're making gains on your investments, a 6% return on the 401(k) will make you more than it will on the $7.5k post-tax investment. Allow that to compound over 30 years and you should see a significant difference, great enough to make up the taxation difference.

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 2:59 pm

legends159 wrote:Here's the waterfall of investment strategies for tax purposes:

1. Max 401K up to employer match
2. Max IRA
3. Max rest of 401K
4. Max other tax-advantaged vehicles if desired/applicable (HSA's, 529 college plans, Muni bonds etc.)
5. Taxable Investments


I've read this online, but the underlying assumption to this strategy is that you make more money now than you will need during retirement. So the idea is that you're avoiding paying as much in taxes now, because deferring $18,000 per year towards your 401k reduces your adjusted gross income by that amount, and when you retire you'll be in a lower tax bracket, so in the long-term you'll actually save money. It's not as clear to me that this strategy works quite as well when you assume you're currently making the same amount of income you'll need when you retire. It sounds I might actually be taxed less by paying ordinary income tax now and merely capital gains tax later on your capital gains when you sell ?

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Helioze
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Re: Why invest in a 401k? Tax people please explain.

Postby Helioze » Mon Feb 23, 2015 3:00 pm

Kahn academy has a pretty good explanation of 401k's and other retirement vehicles

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 3:05 pm

MidwestLifer wrote:Something to consider, though: If you're putting the funds into a 401(k), it's getting put in pre-tax, so your capital base that you earn returns on will be larger, and thus earnings will be larger.
For example, let's say you're putting $10k into your 401(k). You decide to stop doing that, and instead invest on your own. That $10k will get taxed (at say, 25%), so you only get $7.5k to invest. Assuming you're making gains on your investments, a 6% return on the 401(k) will make you more than it will on the $7.5k post-tax investment. Allow that to compound over 30 years and you should see a significant difference, great enough to make up the taxation difference.


I think you have a good point regarding the capital case. But will it be great enough to make up for the taxation difference? Could you provide a real-world example using those numbers and actual effective tax rates an each account at the end of the 30 years? (Bear in mind that the 401k account will be taxed as ordinary income on the entire amount, whereas the personal investment will be taxed as ordinary income only on the initial $10k, but merely as a capital gain for entire amount of interest that accrues across those 30 years (which capital gains tax is much lower than ordinary income tax)).

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 3:06 pm

Helioze wrote:Kahn academy has a pretty good explanation of 401k's and other retirement vehicles


I'll be sure to check that out---thanks!

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MidwestLifer
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Re: Why invest in a 401k? Tax people please explain.

Postby MidwestLifer » Mon Feb 23, 2015 3:07 pm

Idk man I feel like you could run the numbers on an Excel spreadsheet in ten minutes.

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Re: Why invest in a 401k? Tax people please explain.

Postby TTTooKewl » Mon Feb 23, 2015 3:10 pm

Anonymous User wrote:
imKMart wrote:You can invest in a Roth 401k as opposed to investing after-tax dollars. A Roth essentially is after-tax dollars but that income won't be taxed when distributed. I would not recommend using after-tax and mutual funds to fund a retirement.


I'm not sure exactly what you mean by "Roth 401k," but your explanation of it sounds like you're talking about a Roth IRA. I'm already investing $5,500 per year towards my Roth IRA, but that's the maximum yearly contribution towards an IRA. That's not going to be enough money to retire off of, so the question is where do I put the rest of the money? It seems like in my situation that there isn't a whole lot of advantages to investing the remaining money into my employer's 401k, but maybe I'm missing something? It seems like 401k plans are advantageous where the employer matches some of the money, or, at least, where your income is significantly higher now than it will be at retirement (not really practical in my case, since I think I'm going to need at least $50k /year in today dollars during retirement, which is partially going to be funded through my employer's pension plan).


As a law student, my knowledge is fairly rudimentary, but perhaps I can help clarify things. A 401K, whether a traditional- or Roth-style account, will yield the same tax advantages as an IRA -- i.e., in the case of a traditional 401K, being taxed once as ordinary income upon distribution (and no tax up front due to the deduction); instead of, in the case of a taxable investment, being taxed as ordinary income up front (because no deduction) and again upon distribution as capital gains (and also periodically throughout the life of the investment upon the distribution of dividends or sale of stock). One primary difference between an IRA and 401K is the 401K's higher cap on annual contributions.

Summarized above is why many professionals, and posters in this thread, say that 401K > taxable investment. Just as with an IRA (which obviously doesn't have an employer match), that conclusion is true whether or not your employer is offering any match on contributions. If there's a match, simply all the better. With all that said, it is possible the limitations / fees applicable to your employer's 401K program are harsh enough to warrant choosing a taxable investment instead. I think only an investment professional with an understanding of your personal situation and the details of your investment options could really give you a satisfactory answer to that question.

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 3:17 pm

MidwestLifer wrote:Idk man I feel like you could run the numbers on an Excel spreadsheet in ten minutes.


Ugh, figuring out taxes is a nightmare with how these tax brackets are calculated. (E.g. you pay 10% tax on income up to $8,925, plus 15% tax on income for every dollar you make after $8,925 up to $36,250, plus 25% tax on income for every dollar you make after $36,250 up to $87,850; and shit gets even more confusing when you start throwing around capital gains taxes, etc.) Argh, I used to be able to this type of shit before going to law school lol.

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Re: Why invest in a 401k? Tax people please explain.

Postby legends159 » Mon Feb 23, 2015 3:19 pm

Anonymous User wrote:
MidwestLifer wrote:Something to consider, though: If you're putting the funds into a 401(k), it's getting put in pre-tax, so your capital base that you earn returns on will be larger, and thus earnings will be larger.
For example, let's say you're putting $10k into your 401(k). You decide to stop doing that, and instead invest on your own. That $10k will get taxed (at say, 25%), so you only get $7.5k to invest. Assuming you're making gains on your investments, a 6% return on the 401(k) will make you more than it will on the $7.5k post-tax investment. Allow that to compound over 30 years and you should see a significant difference, great enough to make up the taxation difference.


I think you have a good point regarding the capital case. But will it be great enough to make up for the taxation difference? Could you provide a real-world example using those numbers and actual effective tax rates an each account at the end of the 30 years? (Bear in mind that the 401k account will be taxed as ordinary income on the entire amount, whereas the personal investment will be taxed as ordinary income only on the initial $10k, but merely as a capital gain for entire amount of interest that accrues across those 30 years (which capital gains tax is much lower than ordinary income tax)).


Super simplistic example but let's say have $10,000 to either put into 401K or in taxable investments. Let's also assume a 10% annual return and 25% tax.

401K = $10K + 10% growth = $11K - 25% tax = $8.25K
Taxable = $10K - 25% tax = $7.5K + 10% growth = $8.25K - 15% capital gains = 8.1375K

Notice whether you're taxed at the beginning or the end doesn't matter - it's the double tax with taxable accounts that give you a lower return.

Also - we're assuming capital gains tax in 20-30 years when you retire will remain 15%.

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 3:25 pm

TTTooKewl wrote:
Anonymous User wrote:
imKMart wrote:You can invest in a Roth 401k as opposed to investing after-tax dollars. A Roth essentially is after-tax dollars but that income won't be taxed when distributed. I would not recommend using after-tax and mutual funds to fund a retirement.


I'm not sure exactly what you mean by "Roth 401k," but your explanation of it sounds like you're talking about a Roth IRA. I'm already investing $5,500 per year towards my Roth IRA, but that's the maximum yearly contribution towards an IRA. That's not going to be enough money to retire off of, so the question is where do I put the rest of the money? It seems like in my situation that there isn't a whole lot of advantages to investing the remaining money into my employer's 401k, but maybe I'm missing something? It seems like 401k plans are advantageous where the employer matches some of the money, or, at least, where your income is significantly higher now than it will be at retirement (not really practical in my case, since I think I'm going to need at least $50k /year in today dollars during retirement, which is partially going to be funded through my employer's pension plan).


As a law student, my knowledge is fairly rudimentary, but perhaps I can help clarify things. A 401K, whether a traditional- or Roth-style account, will yield the same tax advantages as an IRA -- i.e., in the case of a traditional 401K, being taxed once as ordinary income upon distribution (and no tax up front due to the deduction); instead of, in the case of a taxable investment, being taxed as ordinary income up front (because no deduction) and again upon distribution as capital gains (and also periodically throughout the life of the investment upon the distribution of dividends or sale of stock). One primary difference between an IRA and 401K is the 401K's higher cap on annual contributions.

Summarized above is why many professionals, and posters in this thread, say that 401K > taxable investment. Just as with an IRA (which obviously doesn't have an employer match), that conclusion is true whether or not your employer is offering any match on contributions. If there's a match, simply all the better. With all that said, it is possible the limitations / fees applicable to your employer's 401K program are harsh enough to warrant choosing a taxable investment instead. I think only an investment professional with an understanding of your personal situation and the details of your investment options could really give you a satisfactory answer to that question.


The thing that gets confusing is that you don't pay tax again on the initial investment, but only on the capital gain (i.e. your ordinary income isn't taxed twice). But I suspect I'll probably just stick with the 401k simply because figuring out taxes on the taxable investment is too confusing and difficult (especially when you toss in the fact that you get hit with capital gains tax if you want to move your investment into a different fund (since that's considered a distribution), whereas it's entirely untaxed to do that with the 401k).

legends159
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Re: Why invest in a 401k? Tax people please explain.

Postby legends159 » Mon Feb 23, 2015 3:28 pm

Anonymous User wrote:
legends159 wrote:401K has better tax benefits than taxable investments because you're using pre-tax money to fund the investments so the ordinary tax vs. capital gains tax you speak of is moot. In taxable investments you've paid the ordinary tax upfront since you're using post-tax money to fund investments and then you'll need to pay capital gains tax when you sell. In the 401K you only pay ordinary tax when you later take disbursements - in effect you're only taxed once.

Secondly - with taxable investments you're paying taxes whenever there are distributions (i.e., dividends if you are buying mutual funds). The 401K however grows tax free - you only pay tax at the end, not every time there's a distribution.

TL;DR - taxable investment = taxed twice and periodically. 401K = taxed once.


This isn't exactly accurate though. You're taxed once on your ordinary income now (i.e. your pay check reflect tax deductions), and then you're taxed once on the long-term capital gains when you sell the stocks. So for example, if you make $50k /year and your taxed at 25% by the federal government, then you keep $37,500 after taxes. Say you put that entire $37,500 into the stock market (assume no dividends, for the sake of simplicity) and sell several years later for $60,500, you're only long-term capital gains tax on the $30,000 (i.e .the capital gain). If you placed the entire pretax $50,000 into a 401k for those sames years, and that grew to $80,000, you'd pay ordinary income tax and that entire $80,000. You might wind up paying more on taxes by paying ordinary income taxes on that $80k than you would by paying ordinary income tax on $50,000 and capital-gains tax on $22,500.


If you do the math in your example you still come out ahead with the 401K.

401K = $60,000 (80K - 25% tax)
Taxable = $57,050 (60,500 - 3,450 cap gains)

TTTooKewl
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Re: Why invest in a 401k? Tax people please explain.

Postby TTTooKewl » Mon Feb 23, 2015 3:30 pm

legends159 wrote:
Anonymous User wrote:
MidwestLifer wrote:Something to consider, though: If you're putting the funds into a 401(k), it's getting put in pre-tax, so your capital base that you earn returns on will be larger, and thus earnings will be larger.
For example, let's say you're putting $10k into your 401(k). You decide to stop doing that, and instead invest on your own. That $10k will get taxed (at say, 25%), so you only get $7.5k to invest. Assuming you're making gains on your investments, a 6% return on the 401(k) will make you more than it will on the $7.5k post-tax investment. Allow that to compound over 30 years and you should see a significant difference, great enough to make up the taxation difference.


I think you have a good point regarding the capital case. But will it be great enough to make up for the taxation difference? Could you provide a real-world example using those numbers and actual effective tax rates an each account at the end of the 30 years? (Bear in mind that the 401k account will be taxed as ordinary income on the entire amount, whereas the personal investment will be taxed as ordinary income only on the initial $10k, but merely as a capital gain for entire amount of interest that accrues across those 30 years (which capital gains tax is much lower than ordinary income tax)).


Super simplistic example but let's say have $10,000 to either put into 401K or in taxable investments. Let's also assume a 10% annual return and 25% tax.

401K = $10K + 10% growth = $11K - 25% tax = $8.25K
Taxable = $10K - 25% tax = $7.5K + 10% growth = $8.25K - 15% capital gains = 8.1375K

Notice whether you're taxed at the beginning or the end doesn't matter - it's the double tax with taxable accounts that give you a lower return.

Also - we're assuming capital gains tax in 20-30 years when you retire will remain 15%.


Just for the sake of accuracy, the top long-term capital gains rate right now is 20%, not 15%, though it doesn't sound like OP will be subject to the 20% rate, which is only applicable to those in the 39.6% ordinary income bracket. The 15% long-term rate applies to those in the 25%, 28%, 33%, and 35% ordinary income brackets. For those in lower brackets, long-term capital gains are not taxed.

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 3:32 pm

legends159 wrote:
Anonymous User wrote:
MidwestLifer wrote:Something to consider, though: If you're putting the funds into a 401(k), it's getting put in pre-tax, so your capital base that you earn returns on will be larger, and thus earnings will be larger.
For example, let's say you're putting $10k into your 401(k). You decide to stop doing that, and instead invest on your own. That $10k will get taxed (at say, 25%), so you only get $7.5k to invest. Assuming you're making gains on your investments, a 6% return on the 401(k) will make you more than it will on the $7.5k post-tax investment. Allow that to compound over 30 years and you should see a significant difference, great enough to make up the taxation difference.


I think you have a good point regarding the capital case. But will it be great enough to make up for the taxation difference? Could you provide a real-world example using those numbers and actual effective tax rates an each account at the end of the 30 years? (Bear in mind that the 401k account will be taxed as ordinary income on the entire amount, whereas the personal investment will be taxed as ordinary income only on the initial $10k, but merely as a capital gain for entire amount of interest that accrues across those 30 years (which capital gains tax is much lower than ordinary income tax)).


Super simplistic example but let's say have $10,000 to either put into 401K or in taxable investments. Let's also assume a 10% annual return and 25% tax.

401K = $10K + 10% growth = $11K - 25% tax = $8.25K
Taxable = $10K - 25% tax = $7.5K + 10% growth = $8.25K - 15% capital gains = 8.1375K

Notice whether you're taxed at the beginning or the end doesn't matter - it's the double tax with taxable accounts that give you a lower return.

Also - we're assuming capital gains tax in 20-30 years when you retire will remain 15%.


Awesome! This is precisely what I was looking for. Thanks!!

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Re: Why invest in a 401k? Tax people please explain.

Postby Anonymous User » Mon Feb 23, 2015 3:38 pm

TTTooKewl wrote:
legends159 wrote:
Anonymous User wrote:
MidwestLifer wrote:Something to consider, though: If you're putting the funds into a 401(k), it's getting put in pre-tax, so your capital base that you earn returns on will be larger, and thus earnings will be larger.
For example, let's say you're putting $10k into your 401(k). You decide to stop doing that, and instead invest on your own. That $10k will get taxed (at say, 25%), so you only get $7.5k to invest. Assuming you're making gains on your investments, a 6% return on the 401(k) will make you more than it will on the $7.5k post-tax investment. Allow that to compound over 30 years and you should see a significant difference, great enough to make up the taxation difference.


I think you have a good point regarding the capital case. But will it be great enough to make up for the taxation difference? Could you provide a real-world example using those numbers and actual effective tax rates an each account at the end of the 30 years? (Bear in mind that the 401k account will be taxed as ordinary income on the entire amount, whereas the personal investment will be taxed as ordinary income only on the initial $10k, but merely as a capital gain for entire amount of interest that accrues across those 30 years (which capital gains tax is much lower than ordinary income tax)).


Super simplistic example but let's say have $10,000 to either put into 401K or in taxable investments. Let's also assume a 10% annual return and 25% tax.

401K = $10K + 10% growth = $11K - 25% tax = $8.25K
Taxable = $10K - 25% tax = $7.5K + 10% growth = $8.25K - 15% capital gains = 8.1375K

Notice whether you're taxed at the beginning or the end doesn't matter - it's the double tax with taxable accounts that give you a lower return.

Also - we're assuming capital gains tax in 20-30 years when you retire will remain 15%.


Just for the sake of accuracy, the top long-term capital gains rate right now is 20%, not 15%, though it doesn't sound like OP will be subject to the 20% rate, which is only applicable to those in the 39.6% ordinary income bracket. The 15% long-term rate applies to those in the 25%, 28%, 33%, and 35% ordinary income brackets. For those in lower brackets, long-term capital gains are not taxed.


Actually, I had a question about that. If I were to take out a $50k distribution during each of retirement, would my capital gain tax rate be 15% on the entire $50k, or only on $13,750 (i.e. $50k - $36,250---$36,250 is the cap before breaking into the 25% ordinary income tax bracket)?

TTTooKewl
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Re: Why invest in a 401k? Tax people please explain.

Postby TTTooKewl » Mon Feb 23, 2015 3:50 pm

Anonymous User wrote:Actually, I had a question about that. If I were to take out a $50k distribution during each of retirement, would my capital gain tax rate be 15% on the entire $50k, or only on $13,750 (i.e. $50k - $36,250---$36,250 is the cap before breaking into the 25% ordinary income tax bracket)?


I don't feel comfortable enough with my grasp of the material to give you an answer. But I believe the capital gains brackets work progressively, just as the ordinary income brackets do. Also, you are assuming the $50k is 100% appreciated money. You would only be subject to capital gains taxes on the appreciation. You are also only taxed on your 'taxable income,' which, assuming the $50k was your only source of income, would be less than $50k. (You would, at minimum, be able to take your standard deduction; and, presumably, your personal exemption(s) before arriving at your "taxable income.")

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Yardbird
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Re: Why invest in a 401k? Tax people please explain.

Postby Yardbird » Mon Feb 23, 2015 3:51 pm

Anonymous User wrote:
legends159 wrote:
Anonymous User wrote:
MidwestLifer wrote:Something to consider, though: If you're putting the funds into a 401(k), it's getting put in pre-tax, so your capital base that you earn returns on will be larger, and thus earnings will be larger.
For example, let's say you're putting $10k into your 401(k). You decide to stop doing that, and instead invest on your own. That $10k will get taxed (at say, 25%), so you only get $7.5k to invest. Assuming you're making gains on your investments, a 6% return on the 401(k) will make you more than it will on the $7.5k post-tax investment. Allow that to compound over 30 years and you should see a significant difference, great enough to make up the taxation difference.


I think you have a good point regarding the capital case. But will it be great enough to make up for the taxation difference? Could you provide a real-world example using those numbers and actual effective tax rates an each account at the end of the 30 years? (Bear in mind that the 401k account will be taxed as ordinary income on the entire amount, whereas the personal investment will be taxed as ordinary income only on the initial $10k, but merely as a capital gain for entire amount of interest that accrues across those 30 years (which capital gains tax is much lower than ordinary income tax)).


Super simplistic example but let's say have $10,000 to either put into 401K or in taxable investments. Let's also assume a 10% annual return and 25% tax.

401K = $10K + 10% growth = $11K - 25% tax = $8.25K
Taxable = $10K - 25% tax = $7.5K + 10% growth = $8.25K - 15% capital gains = 8.1375K

Notice whether you're taxed at the beginning or the end doesn't matter - it's the double tax with taxable accounts that give you a lower return.

Also - we're assuming capital gains tax in 20-30 years when you retire will remain 15%.


Awesome! This is precisely what I was looking for. Thanks!!
So the total tax in line 2 above is 2.5K+0.1125K or 2.6125K. Total tax from line 1 is 2.75K. With no employer matching, the taxable investment is the better option with those assumed growth values IF you're just looking at the final amount you pay to the govt.

But the amount you realize differs ($11K total under line 1, 10.75K total under line 2), so your effective tax rates on those are (25% for line 1, 24.31% for line 2). But you'd be holding these long term anyways so this is all pointless. Odds are a 401k/your chosen taxable investment won't have 10% growth per year. Also, odds are you will be in a much higher tax bracket if doing biglaw after a few years.
Last edited by Yardbird on Mon Feb 23, 2015 4:00 pm, edited 1 time in total.




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