Finanplan, Patrick, Alex: Sorry for the delay. I'm going to try to handle both Alex & Patrick's responses, because I think there's commonality between them.
patrick wrote:[Edited this paragraph] For starters, I'll point out that if you really do expect to be in a higher (or even the same) tax bracket in retirement, the Roth 401K is clearly the best choice versus investing outside, since it has no taxes at all on gains within it or on withdrawals...
Agreed, it's just situational. There are people who do retire in a lower tax bracket, but it's not often by choice over time.
patrick wrote:...However, if we want to compare the 401K with the taxable account when tax rates might be higher, let's look at some rough approximate calculations to see what could happen.
For starters, note that the tax rate on capital gains within the 401K is zero-- much better than outside!...
The capital gains rate for 401(k) is not
zero. There is no capital gains treatment.
patrick wrote:...So if you want a proper comparison, you must compare the income tax rate at retirement (the only one that applies to the 401K) with the combination of ordinary income tax while working and dividend taxes all along. As a hypothetical example, let's say you had an investor 30 years away from retirement, considering what to do with $10000, in the 28% tax bracket (15% for dividends/capital gains) while working, and investing in something that pays 2% a year in qualified dividends (after expenses) and rises 5% a year in price, with capital gains not realized until retirement.
In the traditional 401K, the investment becomes $76122.55...
The other part you're missing: The $2,800 tax tag from year one compounded over time to ~21,314 over time... Net value would be $54,808
I know what you're saying, but I think you and Alex ran past my point - or maybe I wasn't as thorough as I should have been... So let me see if I can kill two birds with one stone here...
patrick wrote:In the taxable account, you have to pay 28% in taxes at the start so you can only invest $7200. And then you have to keep paying dividend taxes every year, plus capital gains taxes at the end. After 30 years this would have grown to $50380.08 (after taking out 15% of the dividend amount, or 0.3% of the whole amount, for dividends each year). But when you sell it you still have capital gains to pay, the result being another $4832.95 in capital gains taxes, leaving you with only $45547.13 left...
There's another tax-free place to put money that's not a ROTH and that's not being taxed every year... It's his choice of where it goes (tax-free account or taxable) since it's already been exposed to income taxes. If the features he desires are something tax-free he could only really choose Munis, a ROTH(k) if he has access to one, or Whole Life.
If he goes with Whole Life, it will eliminate other losses that are occurring that he's not "feeling" - these are difficult to calculate and quantify: The sum of the term insurance premiums lost, the growth which could have occurred over the same 30 years off those premiums had they not been lost, loss of death benefit, and how loss of death benefit impacted his cash flow flow off the other asset he's accumulated (stocks, bonds, M/Fs, 401k, IRA, Real Estate, ROTHs, Pensions, Annuities)... The power is in the death benefit.
Back on point - it's not a matter of 'taxable account vs. tax deferred.' People want certain features of having a taxable asset (liquidity, tax strategy, basis, additional asset selection, collateral use, etc) and that's why they choose them... But I think it's unfair to assume this $7,200 can't go into a tax-free asset.
patrick wrote:The result is that your tax rate must increase to a little over 40% in order for the traditonal 401K to be at a disadvantage. This means you have to skip multiple tax brackets, more than doubling your income! Of course there are many details I left out in my rough estimate, but in many cases (such as state taxes, and the fact that if your income is that high you'll probably jump to the 20% capital gains tax bracket) they will make the 401K advantage even larger.
I know what you're saying, but there's a lot of factors here... Rates *could* actually go that high over time people do progress through brackets, and brackets will change ranges.... Highest bracket used to be 94%. I don't think it'll ever hit that again, but anything I say would be a guess, at best.
Don't worry about your estimates... Afterall, our crystal balls are equally as worthless
Tax rates, brackets, and rules are going to change non-stop... But, IMHO, my advice sets people up for greater long-term flexibility on what tax laws could change to over time because of strategy, diversifying the taxable treatment of our assets, and having death benefit to unlock wealth in our assets.
It may be situational but it is very hard to think of a realistic situation in which taxes increase enough to disadvantage the 401K. Of course, there is a completely different reason the taxable account could be better -- when your employer's 401K has excessively high costs and you will be staying with that employer for a long time.
patrick wrote:A higher tax bracket in retirement is possible but not normal. It's certainly not the same as having a higher standard of living in retirement!
Stuff breaking and needing to be replaced always happens, retired or not. Business deductions, if part of the cost of doing business, weren't part of income anyway (the corresponding expenses are gone when no longer operating the business). And the mortgage deduction is only for the interest and only a deduction, not a credit. If you lose the deduction because you paid off the house, then you can support an even greater standard of living on the same income since the tax gain from the deduction is much less than the total mortgage payment that you now no longer need!
"Normal" isn't a good thing when it comes to finances. People are retiring living off of bare minimums (low incomes) and rely on social security. It happens all the time to the people who own the majority of wealth in this country.
The other costs of living (stuff breaking and needing replacement) still require additional income.
The business is/was a method of reducing taxes that you would have otherwise had to pay had you not owned a business... Barring true business expenses, there are many deductible personal benefits that carry over to someone's personal balance sheet & cash flow that disappear. Business owned automobiles, health insurance premiums, "other things" deducted through the business that the CPA allows for...
The mortgage interest deduction is exactly how it sounds - a deduction for the interest you pay for a mortgage (not a credit) - I'm very aware... But the paying off the house = higher standard of living is entirely not true.... Sometimes it makes since to continually pay down on the house, rather than tying up a bunch of potentially income-producing capital into a non-producing asset. Yes, it frees up future cash flow, but it's robbing you of what that cash was doing somewhere else in your financial strategy & the deductible interest... If you have a 8% asset and that was your only capital to pay off your home, why on earth would someone use it to pay off their low interest-rate mortgage? (Rhetorical question - don't answer it because it'll further get things off topic, LOL)
Everything is situational, but there are many assumptions that you speak of that simply aren't always a reality...