Is maxing out my 401k a bad idea?

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cjcerny
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Is maxing out my 401k a bad idea?

Post by cjcerny »

I've been contributing $18k yearly to my 401k plan for a few years now. It recently dawned on me that my marginal tax rate might be higher (currently 25%) when I have to withdraw that money because of a large potential inheritance and because of receiving Social Security. If I have $300 or $400k in a 401k at 59 1/2 and receive a $1 million inheritance around that time along with about $2000k/month of Social Security at age 70, will I likely break into a higher marginal bracket? If so, would I be better off not maxing out the 401k at this point in my life? The inheritance is never a sure thing, but about as sure as one gets for being 15 years into the future.
lack_ey
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Re: Is maxing out my 401k a bad idea?

Post by lack_ey »

Don't forget that with a 401k you get a tax deferral until decades later with tax-free compounding all the way. It's not just about current and future tax rates.

Maybe future tax brackets are higher, but at the current levels it doesn't seem like you'd be anywhere near the 28% bracket in retirement. If you're in the 25% now, forget about it.

Also, if you're in a position in retirement where you're worried about taxes, you're probably doing okay and it doesn't really matter. That's not to say you shouldn't plan on what is likely or might happen on the upside, but I'd worry more about the more unfavorable possible outcomes because the marginal utility of money tends to diminish the more you have.
jpelder
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Re: Is maxing out my 401k a bad idea?

Post by jpelder »

It's probably better than a taxable account. Tax-advantaged accounts are pretty much always better than taxable, since you only get taxed once on the money, instead of paying income and capital gains taxes on it.

Do you have any Roth space, either backdoor Roth IRA or mega-backdoor Roth IRA? This may help you balance your taxable income in later years. Besides, having enough money to pay more in taxes isn't the worst thing in the world!
Hazel-Rah
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Re: Is maxing out my 401k a bad idea?

Post by Hazel-Rah »

Maxing out your 401k is never a bad idea.

You have 100% control of your savings rate. You have zero percent control over any of your aging relatives health or end of life financial decisions.
DSInvestor
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Re: Is maxing out my 401k a bad idea?

Post by DSInvestor »

If you inherited $1MM in a taxable account, that would throw off maybe 20K of Dividends. 20K QDI + 24K Social security would not put you in a high tax bracket. If you had that today as a single filer taking standard deduction and exemption, you'd have AGI of 23K and taxable income of 13,200 putting you at the bottom of the 15% bracket with ZERO Fed tax liability. Adding 20K of Traditional withdrawal increases Fed tax by 4.8K resulting in approx 25% average tax on the extra 20K income.

If you were married filing jointly taking std deduction and 2 exemptions, you'd be in 10% bracket with a ZERO Fed tax liability. Adding 20K of Traditional withdrawal increases Fed tax by $900. This represents about 5% average tax on that 20K of extra withdrawal income.

I ran my numbers with Taxcaster 2015: https://turbotax.intuit.com/tax-tools/c ... taxcaster/

Under current tax rules, Qualified Dividend Income (QDI) and Long Term Capital Gains (LTCG) are stacked on top of ordinary income (social security, pension, Traditional withdrawals).

Deductions and exemptions are adjusted for inflation.

I suggest that you max out Traditional 401k, Roth IRA via backdoor if necessary, then save in taxable accounts.
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Re: Is maxing out my 401k a bad idea?

Post by Twins Fan »

Sounds like a rough problem to have, OP. :happy

As DSI pointed out, the inheritance doesn't automatically put you in a higher tax bracket. And, just too many unknowns in the future to say for sure one way or the other. Go with the best plan you know for now, which is keep maxing out the 401k.

Do you have a Roth 401k option? Maybe 50/50 there if you're too concerned about it.
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grabiner
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Re: Is maxing out my 401k a bad idea?

Post by grabiner »

DSInvestor wrote:If you inherited $1MM in a taxable account, that would throw off maybe 20K of Dividends. 20K QDI + 24K Social security would not put you in a high tax bracket.
And if it's not all in stock and you do happen to be in a fairly high tax bracket, you can put the bond portion in munis and not go up another bracket higher. (This won't help with the phase-in of SS taxation; muni income is not taxed but is counted for SS taxation until you reach the point where the maximum 85% of SS is taxed.)
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Watty
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Re: Is maxing out my 401k a bad idea?

Post by Watty »

cjcerny wrote:If I have $300 or $400k in a 401k at 59 1/2 and receive a $1 million inheritance around that time along with about $2000k/month of Social Security at age 70, will I likely break into a higher marginal bracket?
To make the math easy assume you have a two million dollar portfolio(in today's dollars) with the inheritance when you are 65. The 4% safe withdrawal rate will only give you $80,000 in initial withdrawals and some of that could be from a Roth or taxable account so your taxable income could be much less than that. With $24,000 in Social security that is only $104,000 which would be unlikely to put you above the 25% tax bracket(under the current laws) even if you are single. With personal exemptions and the standard deduction a married couple would be just above the 15% tax bracket with $105K in taxable income.

http://www.obliviousinvestor.com/2016-t ... r-updates/

The taxation of the social security gets tricky at any income level but you would have that problem even without an inheritance. You might want to play around with the spreadsheet here to see how your numbers might work out.

https://www.bogleheads.org/wiki/Social_ ... calculator

There can be all sorts of special situations where taxes could be an issue but with decades until that will happen it is too early to predict them.

I would keep maxing out all your deductible retirment retirement accounts.

Later on you might do a lot of Roth conversions before you start Social Security if that would help.
randomguy
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Re: Is maxing out my 401k a bad idea?

Post by randomguy »

cjcerny wrote:I've been contributing $18k yearly to my 401k plan for a few years now. It recently dawned on me that my marginal tax rate might be higher (currently 25%) when I have to withdraw that money because of a large potential inheritance and because of receiving Social Security. If I have $300 or $400k in a 401k at 59 1/2 and receive a $1 million inheritance around that time along with about $2000k/month of Social Security at age 70, will I likely break into a higher marginal bracket? If so, would I be better off not maxing out the 401k at this point in my life? The inheritance is never a sure thing, but about as sure as one gets for being 15 years into the future.
Not even close. Lets see what happens in that case. Let assume your a single guy and these are all in todays dollars. You take 50k/yr out of the 401(k) from 60-70. How much tax are you paying? 5.7k. Thats 11.4% even though you are in the 25% bracket. Thats a lot less than 15% (lets ignore state taxes) you got as a deduction. What about the 1 million dollar inheritance? Taxes on spending that are zero as you have no gains. When you get to 70, you will have spend the most of the 401(k). Lets say you start living it up and have 24k/ss and 76k of LTGC. What is your tax? 8.3k. That is 8%. And note how inflated that is by assume 0 cost basis for the inheritence. Make that basis like 50% and taxes plummet.

In reality things are even better. You wouldn't spend the 401(k). You would spend the inheritence and convert the 401(k) to a ROTH. The taxes are the same but your income at 70, might be something like 24k ss, 26k roth, 50k inheritence (with lets say a cost basis of 25k). What are your federal taxes on that? 0. Yep you have 100k of spendable cash and you are paying 0 dollars to the feds. Probably means you paid too much between 60-70:)


Now if you were getting the inheritance as an IRA things would be some what different. But it is somewhat hard to get that big of IRA as an inheritance. The donator has to die young (to prevent RMDs from converting the money to taxable) and the gains have to be pretty decent. It can definitely happen. In that case you could take out like 100k/yr between 60-70 and pay 18%. That is pretty darn close to 15%. If you have any income that counts as OI or you touch the 25% bracket (remember you aren't deducting 18k anymore:)), it is likely to be a lower number.

As always run your own numbers.
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Toons
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Re: Is maxing out my 401k a bad idea?

Post by Toons »

Tax Free,Tax Deferred Compounding is an essential for building wealth.
Taxes are like a ball and chain when it comes to investing outside of the tax deferred component. :happy
"One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity" –Bruce Lee
bberris
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Re: Is maxing out my 401k a bad idea?

Post by bberris »

Even if your marginal rate is higher than your current, not all of your 401k withdrawals will necessarily be at that marginal rate.

But most of the advice posted here exaggerates the benefit of tax deferral, and ignores the benefits of low current tax rates on dividends and capital gains for assets in a taxable account. A 401k converts capital gains and dividends, taxed at 0 or 15 % into ordinary income which might be taxed at much higher rates.
randomguy
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Re: Is maxing out my 401k a bad idea?

Post by randomguy »

bberris wrote:Even if your marginal rate is higher than your current, not all of your 401k withdrawals will necessarily be at that marginal rate.

But most of the advice posted here exaggerates the benefit of tax deferral, and ignores the benefits of low current tax rates on dividends and capital gains for assets in a taxable account. A 401k converts capital gains and dividends, taxed at 0 or 15 % into ordinary income which might be taxed at much higher rates.
Care to tell us what that tax advantage is? Paying the lower rates is great but getting there is expensive.:) Seriously paying 15% out of tax deferred works out the same as paying 15% initially and 0% later. You need something to change in your tax situation to make it work out. For people in the 25% bracket it is even worse. For example lets look at a 25%er
tax deferred
10k @ 7% for 30 years = 76k.
taxable
7.5k @7% for 30 years = 57k pay 15% taxes on the gains and you are at 49.5k

You would need to be in the 35% for that to work out.
wolf359
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Re: Is maxing out my 401k a bad idea?

Post by wolf359 »

Maxing out a 401k isn't a bad idea, but it's not ALWAYS the best move. For example, if you intend to start a business, or buy a house, you may want to have significant taxable savings.

However, for long-term retirement money, it's very hard to beat a 401k.
bberris wrote:A 401k converts capital gains and dividends, taxed at 0 or 15 % into ordinary income which might be taxed at much higher rates.
This isn't exactly true. A 401k contribution is ordinary income. If you don't put it in the 401k, you have to pay ordinary income tax on it. Otherwise the tax is deferred.

It is true that if you paid taxes, put the proceeds into a taxable account, and invested it, that the capital gains and dividends may be taxed at more favorable rates. However, those capital gains, dividends, and interest are taxed EVERY YEAR. Most people who are in the position to max out their 401k are not in the 0% capital gains tax bracket.

If you're going to pay the taxes, it's better to put it into a Roth IRA or 401k Roth, where you get the benefits of tax-free compounding.
bberris
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Re: Is maxing out my 401k a bad idea?

Post by bberris »

I didn't say never contribute to a 401k, just that it depends. And a high cost 401k can tip the balance
Dividends and capital gains can be taxed at 0 % with rather high incomes. Married couple, two kids, with maximum 401k and HSA contributions taking the standard deduction :

12,600 std ded
12,000 personal exemption
36,000 401k
6,700 hsa
75,000 up to 25 % bracket (so under this amount no taxes on divs and cap gains)
This couple earns $142,000
I know I cheated by using the 401k. The 401k helps you achieve the 0 tax on investments.
randomguy
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Re: Is maxing out my 401k a bad idea?

Post by randomguy »

bberris wrote:I didn't say never contribute to a 401k, just that it depends. And a high cost 401k can tip the balance
Dividends and capital gains can be taxed at 0 % with rather high incomes. Married couple, two kids, with maximum 401k and HSA contributions taking the standard deduction :

12,600 std ded
12,000 personal exemption
36,000 401k
6,700 hsa
75,000 up to 25 % bracket (so under this amount no taxes on divs and cap gains)
This couple earns $142,000
I know I cheated by using the 401k. The 401k helps you achieve the 0 tax on investments.
What you said was
But most of the advice posted here exaggerates the benefit of tax deferral, and ignores the benefits of low current tax rates on dividends and capital gains for assets in a taxable account
People are not ignoring the tax advantage of LTGC. There just isn't one for most people. 0% LTGC & divs sounds great. But your investing 15% less money. That puts you in the same spot.

There are cases where taxable wins. OP hasn't mentioned anything to suggest that he is in those cases. Plan on retiring at 70 with a huge pension and a ton of the advantages of leveraging the graduated tax system go away. The ability to deduct at marginal (say 25% for the couple making 180k) and pay effective on the way out (~15% on 150k of income for a married couple) is huge.
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