Makes No Sense to Contribute to 401K, right?

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Chicago60
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Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Tue Dec 20, 2016 4:25 pm

I am a sole proprietor with no employees. Assume 100K of sole proprietor income in 2016 after all expenses. Also assume another 100K of income from interest, dividends, and capital gains. I already opened a Roth 401K at Vanguard for 24K (over 50 years old) and was contemplating contributing to the employer portion of a new 401K. Here's the rub: I have a sizeable tIRA and plan on converting a portion up to the top of the 28% tax bracket (MFJ). I thought that by contributing to the 401K and reducing sole proprietor income, I would save 1/2 the taxes on my social security and Medicare, but just researched it and found that was not the case.

So, under these circumstances, it makes no sense to add to one retirement account (401K) if I am planning on reducing a different retirement account (tIRA), correct? Or, would it?

Dottie57
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Re: Makes No Sense to Contribute to 401K, right?

Post by Dottie57 » Tue Dec 20, 2016 4:30 pm

Chicago60 wrote:I am a sole proprietor with no employees. Assume 100K of sole proprietor income in 2016 after all expenses. Also assume another 100K of income from interest, dividends, and capital gains. I already opened a Roth 401K at Vanguard for 24K (over 50 years old) and was contemplating contributing to the employer portion of a new 401K. Here's the rub: I have a sizeable tIRA and plan on converting a portion up to the top of the 28% tax bracket (MFJ). I thought that by contributing to the 401K and reducing sole proprietor income, I would save 1/2 the taxes on my social security and Medicare, but just researched it and found that was not the case.

So, under these circumstances, it makes no sense to add to one retirement account (401K) if I am planning on reducing a different retirement account (tIRA), correct? Or, would it?
Do you want to save more for retirement?
Do you want tomreduc income taxes.

401k is very good at both.

Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Tue Dec 20, 2016 4:34 pm

Thanks for the reply, but I am not sure you answered my inquiry. If I added 30K to the 401K, then my income will be reduced by that same 30K. And, I will have 30K more space within the 28% tax bracket to convert from my tIRA to Roth. Won't the net effect be the same?

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Watty
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Re: Makes No Sense to Contribute to 401K, right?

Post by Watty » Tue Dec 20, 2016 4:40 pm

For every $1,000 you contributed to the 401k couldn't you convert an additional $1000 of the tIRA to the Roth in the 28% tax bracket?

Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Tue Dec 20, 2016 4:43 pm

Watty wrote:For every $1,000 you contributed to the 401k couldn't you convert an additional $1000 to the Roth?
I think so, exactly. So, if I am not saving social security and medicare taxes by adding to a 401K, then I should simply NOT contribute to the 401K and use the extra space converting.

niceguy7376
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Re: Makes No Sense to Contribute to 401K, right?

Post by niceguy7376 » Tue Dec 20, 2016 4:56 pm

Chicago60 wrote:
Watty wrote:For every $1,000 you contributed to the 401k couldn't you convert an additional $1000 to the Roth?
I think so, exactly. So, if I am not saving social security and medicare taxes by adding to a 401K, then I should simply NOT contribute to the 401K and use the extra space converting.
So you want to save 15.3% SS+ medicare by not contributing to 401k but pay 28% + any state tax!!!
if u dont contribute to 401k, where will the extra space come from?

but i also see that u have a roth 401k, which means you need to revisit your question for clear understanding. Because if you contrib to roth 401k(or not contrib to roth 401k), since it is after taxes and hence you might reach your 28% limit through income only leaving nothing for conversion.

Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Tue Dec 20, 2016 8:02 pm

I am paying the federal tax rate of 28% regardless, no?

ved
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Re: Makes No Sense to Contribute to 401K, right?

Post by ved » Tue Dec 20, 2016 8:31 pm

If I am understanding it correctly,
Are you asking if contributing to 401k (and reducing taxable income), and then converting an equal amount from tIRA to a RothIRA (and thus increasing taxable income) is worth it?

If so, then yes, it is worth it, because in effect you are increasing your Roth space - and any earning on that is tax free.

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Re: Makes No Sense to Contribute to 401K, right?

Post by jane1 » Tue Dec 20, 2016 8:40 pm

Your question essentially comes down to whether you want to increase your tax-deferred, which you may end up paying >28% upon withdrawal with RMDs or put it in taxable (where LTCG and QD would be taxed at 15% + 3.8% NIIT or STCG and OD at ordinary rate).

It would depend on your current age, your current mix of assets (Tax free, tax deferred, taxable) and your long term goal for your assets. If you plan to leave a large estate, having funds in taxable where your heirs can get a step up in basis is good. If you plan to give away to charity during your lifetime, IRA funds as QCD is good. Feel free to post specifics and people may be able to give your better advice.

Have you optimized your current portfolio in terms of placing bonds (except muni) in tax-deferred, etc. 100K from dividends, CG, interest implies either a very sizable portfolio or inefficient fund placement.

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Re: Makes No Sense to Contribute to 401K, right?

Post by grabiner » Tue Dec 20, 2016 11:12 pm

ved wrote:If I am understanding it correctly,
Are you asking if contributing to 401k (and reducing taxable income), and then converting an equal amount from tIRA to a RothIRA (and thus increasing taxable income) is worth it?

If so, then yes, it is worth it, because in effect you are increasing your Roth space - and any earning on that is tax free.
This is equivalent to contributing to a Roth 401(k) in the first place, which has a clear benefit because it converts taxable investments into tax-free investments. However, it has two potential advantages:

You can withdraw conversions from the Roth IRA within five years tax-free and penalty-free; you can't do that with the Roth 401(k) while you are still with the same employer. (When you leave the employer, you can roll the Roth 401(k) into a Roth IRA.)

If you get rid of your entire traditional IRA by converting it to a Roth (or by rolling it into an employer plan), you may be able to contribute to a backdoor Roth IRA.
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MikeG62
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Re: Makes No Sense to Contribute to 401K, right?

Post by MikeG62 » Wed Dec 21, 2016 9:26 am

Chicago60 wrote:Thanks for the reply, but I am not sure you answered my inquiry. If I added 30K to the 401K, then my income will be reduced by that same 30K. And, I will have 30K more space within the 28% tax bracket to convert from my tIRA to Roth. Won't the net effect be the same?
From a tax liability point of view, it feels like a wash to me - defer tax on $30K of income put into the 401k and then create a tax liability on $30K of tIRA money converted to a Roth. You end up with the same amount of $ in your tax deferred accounts when you are done. However, you also end up with $30K in a Roth which has all the benefits that accrue funds invested in a Roth. So that seems like a good idea to me.

I don't see how you can get the same $30K into a Roth without increasing your tax liability any other way than by what you are proposing.
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niceguy7376
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Re: Makes No Sense to Contribute to 401K, right?

Post by niceguy7376 » Wed Dec 21, 2016 9:41 am

OP is talking about ROTH 401k and not trad 401k.

So if he contributes to Roth 401k, he already paid 28% taxes on that contribution
If he converts Trad IRA to ROTH IRA, he pays 28& taxes on that conversion too.

MikeG62
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Re: Makes No Sense to Contribute to 401K, right?

Post by MikeG62 » Wed Dec 21, 2016 2:22 pm

niceguy7376 wrote:OP is talking about ROTH 401k and not trad 401k.
OP was talking about opening a new 401K in addition to his Roth 401k. OP can chime in and clarify if I've misread things.

OP's original post says, "...was contemplating contributing to the employer portion of a new 401K". He then says, "I thought that by contributing to the 401K and reducing sole proprietor income...". Seems to me he is talking about a traditional (pre-tax) 401k that would be in addition to his Roth 401k.

OP could also open a SEP IRA and make the tax deductible contribution (profit share). Don't think he needs multiple individual 401k's, although its largely six of one half dozen the other.
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Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Wed Dec 21, 2016 4:41 pm

MikeG62 wrote:
Chicago60 wrote:Thanks for the reply, but I am not sure you answered my inquiry. If I added 30K to the 401K, then my income will be reduced by that same 30K. And, I will have 30K more space within the 28% tax bracket to convert from my tIRA to Roth. Won't the net effect be the same?
From a tax liability point of view, it feels like a wash to me - defer tax on $30K of income put into the 401k and then create a tax liability on $30K of tIRA money converted to a Roth. You end up with the same amount of $ in your tax deferred accounts when you are done. However, you also end up with $30K in a Roth which has all the benefits that accrue funds invested in a Roth. So that seems like a good idea to me.

I don't see how you can get the same $30K into a Roth without increasing your tax liability any other way than by what you are proposing.
Thanks, Mike. Seems like a wash to me as well. I was contemplated doing the 401K employer contribution because, based on my erroneous thinking as discussed above, I thought I was saving 1/2 of the 15.2% taxes on social security and Medicare, but that is wrong.

Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Wed Dec 21, 2016 4:43 pm

MikeG62 wrote:
niceguy7376 wrote:OP is talking about ROTH 401k and not trad 401k.
OP was talking about opening a new 401K in addition to his Roth 401k. OP can chime in and clarify if I've misread things.
Precisely. I opened my employee-portion Roth 401K earlier in the year, and the question is whether to fund the employer portion 401K (or not).

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Re: Makes No Sense to Contribute to 401K, right?

Post by pkcrafter » Wed Dec 21, 2016 5:05 pm

opened a Roth 401K at Vanguard for 24K
Was this a conversion? You didn't contribute 24k in a single year to a new Roth, did you? Sorry, have to ask just to clarify.

Paul
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Re: Makes No Sense to Contribute to 401K, right?

Post by MikeG62 » Wed Dec 21, 2016 5:09 pm

Chicago60 wrote:
MikeG62 wrote:
From a tax liability point of view, it feels like a wash to me - defer tax on $30K of income put into the 401k and then create a tax liability on $30K of tIRA money converted to a Roth. You end up with the same amount of $ in your tax deferred accounts when you are done. However, you also end up with $30K in a Roth which has all the benefits that accrue funds invested in a Roth. So that seems like a good idea to me.
Thanks, Mike. Seems like a wash to me as well. I was contemplated doing the 401K employer contribution because, based on my erroneous thinking as discussed above, I thought I was saving 1/2 of the 15.2% taxes on social security and Medicare, but that is wrong.
May still be worth doing as you will be increasing the balance in your Roth by $30K, which is almost always a good idea. It's like you found a way to move $30K into your Roth without negative tax consequences (at least not immediately). Granted it is not helping you bleed down the balance in your tax deferred account (tIRA), but $30K per year is probably only going to offset investment gains anyway. It's not like that is going to allow you to whittle it down significantly.

I think I'd do it if I were in your shoes.

Also, you could do a SEP IRA instead of another solo 401K. "May" be faster to set up.
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adman_c
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Re: Makes No Sense to Contribute to 401K, right?

Post by adman_c » Wed Dec 21, 2016 5:19 pm

It's not a huge difference, but if the OP is in Illinois (guessing based on username) he or she will save Illinois income tax by deducting 30k of income and then converting 30k of tIRA to Roth. Illinois does not charge income tax on IRA withdrawals, and Roth conversions are treated as withdrawals.

Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Wed Dec 21, 2016 6:45 pm

pkcrafter wrote:
opened a Roth 401K at Vanguard for 24K
Was this a conversion? You didn't contribute 24k in a single year to a new Roth, did you? Sorry, have to ask just to clarify.

Paul
Not a conversion, and yes, I opened a Roth 401K in 2016 as the employee part of the 401K. I am over the age of 50.

Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Wed Dec 21, 2016 6:47 pm

adman_c wrote:It's not a huge difference, but if the OP is in Illinois (guessing based on username) he or she will save Illinois income tax by deducting 30k of income and then converting 30k of tIRA to Roth. Illinois does not charge income tax on IRA withdrawals, and Roth conversions are treated as withdrawals.
Excellent point, thanks. Maybe THAT'S what I was thinking of to save a bit on taxes (3.75% Ill tax of the amount I can have my sole proprietorship contribute to a 401K) and not the 1/2 of the Social Security/Medicare.

Chicago60
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Re: Makes No Sense to Contribute to 401K, right?

Post by Chicago60 » Wed Dec 21, 2016 6:51 pm

grabiner wrote:
ved wrote:If you get rid of your entire traditional IRA by converting it to a Roth (or by rolling it into an employer plan), you may be able to contribute to a backdoor Roth IRA.
Not possible, but thanks for the thought. My IRA is at $2 million. Hence, why I want to begin converting to Roth IRA up to the top of the 28% bracket.

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