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

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

Postby TTTooKewl » Mon Feb 23, 2015 3:57 pm

shadowofjazz wrote:
legends159 wrote:
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%.


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. 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.


Not true. The important number to look at is the end result, comparing $8.25k to $8.1375k -- not the amount of tax paid. The reason line 1 has a higher tax total is because the initial investment was larger ($10k vs. $7.5k), resulting in greater appreciation, which was then taxed.

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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 4:02 pm

TTTooKewl wrote:
shadowofjazz wrote:
legends159 wrote:
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%.


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. 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.


Not true. The important number to look at is the end result, comparing $8.25k to $8.1375k -- not the amount of tax paid. The reason line 1 has a higher tax total is because the initial investment was larger ($10k vs. $7.5k), resulting in greater appreciation, which was then taxed.
I edited my response slightly, but with those numbers the growth amounts are different and when you look at the final effective tax rate the investment is still better. But biglaw isn't going to be at 25%, this all doesn't account for state taxes, and employer contributions changes everything.

The part I added:
shadowofjazz wrote: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.

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

Postby 15 styx » Mon Feb 23, 2015 4:26 pm

When signing up for a 401k came up I said yes. I thought I was contributing $500 a month, turns out I signed up for $500 a paycheck (that slip-up did help me to receive a bigger tax refund this year). I heard that the firm “matched” my 401k contribution. True, it does, but as I’ve learned not for the first year. So, should I decrease my contribution until they “match?”

I also wonder if I’m not better off reducing my tuition debt rather than messing with the 401k (during this non-match period). As is, I am paying substantially more than I have to, to get out from under this tuition debt.

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

Postby legends159 » Mon Feb 23, 2015 4:30 pm

15 styx wrote:When signing up for a 401k came up I said yes. I thought I was contributing $500 a month, turns out I signed up for $500 a paycheck (that slip-up did help me to receive a bigger tax refund this year). I heard that the firm “matched” my 401k contribution. True, it does, but as I’ve learned not for the first year. So, should I decrease my contribution until they “match?”

I also wonder if I’m not better off reducing my tuition debt rather than messing with the 401k (during this non-match period). As is, I am paying substantially more than I have to, to get out from under this tuition debt.


Contribute up to the match then stop and devote all (non emergency-fund) resources to paying off debt first - that's guaranteed interest of ~6.8%. No other investment gives a guaranteed rate that high.

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

Postby Anonymous User » Mon Feb 23, 2015 4:37 pm

shadowofjazz wrote: Odds are a 401k/your chosen taxable investment won't have 10% growth per year.


It's not as unlikely as you think. Historically, large cap stocks have averaged a rate of return of around 10% across any 25 year period after the great depression. Small cap stocks have averaged around 12%. If you factor out the average rate of inflation of 3%, it's more like 7-9% actual returns, though.

shadowofjazz wrote: Also, odds are you will be in a much higher tax bracket if doing biglaw after a few years.


I fuckin wish. I was in the class of 2011, so I got shut out of biglaw, despite having great grades from a t10 (but I was also a transfer). I'd be pretty happy if I could move onto another PLSF qualifying job that pays like $75k /year.

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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 4:44 pm

Shadowofjazz, why would you care about effective tax rates over the end amount of money you have? If I told you you could take job A that pays $200k at a tax rate of 30% or job B that pays $150k at a tax rate of 27%, do you really think you're taking job B?

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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 6:21 pm

MidwestLifer wrote:Shadowofjazz, why would you care about effective tax rates over the end amount of money you have? If I told you you could take job A that pays $200k at a tax rate of 30% or job B that pays $150k at a tax rate of 27%, do you really think you're taking job B?
I was thinking more long-term with potential policy changes. Assuming your income bracket and the rate for that bracket will remain the same is silly. If say the income tax rate is 25% now, but is changed up to more than 35.6% 30 years from now (for the same income bracket, not because of changing brackets--also not COMPLETELY far-fetched if the gov't debt levels don't start to go down), then the effective tax rates shed more light on how your investment will do. The taxable investment in this case will outperform the 401(k) if income taxes rise to that level. Also, this doesn't include state income taxes on the 401(k) in year 30 or the taxable investment or Roth IRA in year 0, nor does it account for state capital gains taxes in year 30. Also doesn't account for 401(k) fees, minimum disbursement at age 70.5, as well as no penalty-free withdrawals until 59.5. The taxable investment account would allow for more liquidity which has its own value.

Investment Type| Initial Investment | 30 Years Later @ 10%/yr | Taxes (35.6%) | After-Tax Income
401(k) | $10,000| $174,494| $62,129 | $112,365
Taxable Investment | $7,500 | $130,870 | $18,505| $112,365
Roth IRA | $7,500 | $130,870 | $0 | $130,870

If taxes go down (say the debt is managed properly), then the 401(k) remains the better option. If capital gains go down, then the taxable investment could be better. There are a lot of different variables to consider when investing, and assuming rates will remain the same is just one (very unlikely) possibility. All that being said, the 401(k) will generally be the better investment option if things don't change too much from current rates. But maybe I'm pessimistic in thinking that things won't stay nice like they are now. 30 years ago, the top marginal tax rate was 70% and the highest capital gains rate was 28%...and that's just the federal rate. Who's to say that can't happen again?

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

Postby legends159 » Mon Feb 23, 2015 6:39 pm

shadowofjazz wrote:
MidwestLifer wrote:Shadowofjazz, why would you care about effective tax rates over the end amount of money you have? If I told you you could take job A that pays $200k at a tax rate of 30% or job B that pays $150k at a tax rate of 27%, do you really think you're taking job B?
I was thinking more long-term with potential policy changes. Assuming your income bracket and the rate for that bracket will remain the same is silly. If say the income tax rate is 25% now, but is changed up to more than 35.6% 30 years from now (for the same income bracket, not because of changing brackets--also not COMPLETELY far-fetched if the gov't debt levels don't start to go down), then the effective tax rates shed more light on how your investment will do. The taxable investment in this case will outperform the 401(k) if income taxes rise to that level. Also, this doesn't include state income taxes on the 401(k) in year 30 or the taxable investment or Roth IRA in year 0, nor does it account for state capital gains taxes in year 30.

Investment Type| Initial Investment | 30 Years Later @ 10%/yr | Taxes (35.6%) | After-Tax Income
401(k) | $10,000| $174,494| $62,129 | $112,365
Taxable Investment | $7,500 | $130,870 | $18,505| $112,365
Roth IRA | $7,500 | $130,870 | $0 | $130,870

If taxes go down (say the debt is managed properly), then the 401(k) remains the better option. If capital gains go down, then the taxable investment could be better. There are a lot of different variables to consider when investing, and assuming rates will remain the same is just one (very unlikely) possibility. All that being said, the 401(k) will generally be the better investment option if things don't change too much from current rates. But maybe I'm pessimistic in thinking that things won't stay nice like they are now. 30 years ago, the top marginal tax rate was 70% and the highest capital gains rate was 28%...and that's just the federal rate. Who's to say that can't happen again?


Fair point, but probably not advisable to forego 401K tax advantage now based on the possibility of taxes increasing substantially in the future. You can always tax plan in the future when you take out distributions (i.e., move to a state w/o income tax, make donations etc.).

There's 3 possibilities with taxes in the future:

Tax rate goes down - 401K wins out
Tax rate stays the same - 401K wins out

Tax rate goes up (significantly) - 401K loses

in 2/3 options - 401K wins out. Also in 1/3 of those situations - the tax rate would have to go up significantly for you to be in a better position foregoing the 401K for taxable investments. Finally - let's not discount the effect that periodic taxation will hurt your ROI when you factor in the effect of compounding (though this could be ameliorated with tax loss harvesting).

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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 7:32 pm

legends159 wrote:
shadowofjazz wrote:
MidwestLifer wrote:Shadowofjazz, why would you care about effective tax rates over the end amount of money you have? If I told you you could take job A that pays $200k at a tax rate of 30% or job B that pays $150k at a tax rate of 27%, do you really think you're taking job B?
I was thinking more long-term with potential policy changes. Assuming your income bracket and the rate for that bracket will remain the same is silly. If say the income tax rate is 25% now, but is changed up to more than 35.6% 30 years from now (for the same income bracket, not because of changing brackets--also not COMPLETELY far-fetched if the gov't debt levels don't start to go down), then the effective tax rates shed more light on how your investment will do. The taxable investment in this case will outperform the 401(k) if income taxes rise to that level. Also, this doesn't include state income taxes on the 401(k) in year 30 or the taxable investment or Roth IRA in year 0, nor does it account for state capital gains taxes in year 30.

Investment Type| Initial Investment | 30 Years Later @ 10%/yr | Taxes (35.6%) | After-Tax Income
401(k) | $10,000| $174,494| $62,129 | $112,365
Taxable Investment | $7,500 | $130,870 | $18,505| $112,365
Roth IRA | $7,500 | $130,870 | $0 | $130,870

If taxes go down (say the debt is managed properly), then the 401(k) remains the better option. If capital gains go down, then the taxable investment could be better. There are a lot of different variables to consider when investing, and assuming rates will remain the same is just one (very unlikely) possibility. All that being said, the 401(k) will generally be the better investment option if things don't change too much from current rates. But maybe I'm pessimistic in thinking that things won't stay nice like they are now. 30 years ago, the top marginal tax rate was 70% and the highest capital gains rate was 28%...and that's just the federal rate. Who's to say that can't happen again?


Fair point, but probably not advisable to forego 401K tax advantage now based on the possibility of taxes increasing substantially in the future. You can always tax plan in the future when you take out distributions (i.e., move to a state w/o income tax, make donations etc.).

There's 3 possibilities with taxes in the future:

Tax rate goes down - 401K wins out
Tax rate stays the same - 401K wins out

Tax rate goes up (significantly) - 401K loses

in 2/3 options - 401K wins out. Also in 1/3 of those situations - the tax rate would have to go up significantly for you to be in a better position foregoing the 401K for taxable investments. Finally - let's not discount the effect that periodic taxation will hurt your ROI when you factor in the effect of compounding (though this could be ameliorated with tax loss harvesting).
I agree that currently if you take that stance the Traditional 401(k) is the best (as long as you will be in a lower tax bracket later on), I just don't have a good outlook on where tax rates will be 30 years from now. In any case, for the first few years of biglaw before you cross the next tax threshold and if you think you'll stay at at least that tax rate moving forward, a Roth IRA (or 401(k) if your firm offers it) might be the best move. If you can self-direct the investments, then all the more reason to do a Roth IRA, since any gains (dividends, real estate income, etc.) will not be taxed.

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

Postby NonTradLawHopeful » Mon Feb 23, 2015 7:45 pm

Browsing through the first few posts I see many people saying Roth IRA's are taxed through capital gains. As long as you are 59 1/2 years old or older, the Roth IRA is withdrawn COMPLETELY TAX FREE! No capital gains taxes on it since it is a tax-free retirement account. If you plan on being in a higher tax bracket when you are older than you are right now, it makes sense to max out the Roth IRA first.

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

Postby Tiago Splitter » Mon Feb 23, 2015 11:21 pm

NonTradLawHopeful wrote:Browsing through the first few posts I see many people saying Roth IRA's are taxed through capital gains.

Not sure where you saw that.

Anyways, being tax-diversified is a good strategy for reasons that should be clear after reading this thread. If you're all in pre-tax investments you're at the whim of tax rates when you need the money at retirement. But if you have a mix of taxable, Roth, and pre-tax stuff you can time distributions and sales to minimize the tax hit depending on how things look for you in any given year.

Not to mention that if you need anything for an emergency you're looking at a 10% penalty on the pre-tax money until 59.5.




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