Don't Shoot. Questioning 401k

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StevenNJ1
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Don't Shoot. Questioning 401k

Post by StevenNJ1 »

I've been reading a lot on this forum and I get the general consensus of how conservative and retirement-focused this community is. I've used feedback from folks here to fight our bad 401k program at my previous job and made lots of great changes.

As I elect to participate in my new 401k plan (no match offered), I question myself.

I understand that putting money away pre-tax, saves me in taxes, especially now as my taxes are through the roof. However, who knows what the taxes are going to be in 25 years when I start to withdraw money from 401k? What if they are even higher? Do I have to be retired with no new income to fully benefit from 401k withdrawals?

People that began contributing into their 401k 15 years ago and are starting to withdraw now... is their bracket now lower because they have no new income and thus their taxes are lower?

I genuinely want to understand why avoiding taxes on $15k or so that I put away every year now, will allow me to pay a lot less in taxes 25 years from now.
livesoft
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Re: Don't Shoot. Questioning 401k

Post by livesoft »

Do you fill out your own tax returns? That is sort of a prerequisite to understanding what's going on. And I don't mean just clicking in tax software, but instead at least reading all of Form 1040 (it is only front and back, so 2 pages) and understanding what each line with a dollar amount on it means, so that's probably only one-third of the lines, since two-thirds are empty.

PS: I hope my response didn't wound you and you are still standing.
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Gropes & Ray
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Re: Don't Shoot. Questioning 401k

Post by Gropes & Ray »

You are avoiding taxes at your highest marginal rate right now. Let's say that's 28%. When you withdraw, you will withdraw starting at an effective rate of 0%. Then 10%, then 15% then 25%, etc. as you withdraw enough to move up through the tax brackets. Unpredictable things can happen to change your rates - marriage, divorce, disability, increased or reduced rates or brackets - but for the most part, if you are a high income earner, you want to avoid your highest marginal rate now and pay taxes in the lower brackets later.
2 Tasty
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Re: Don't Shoot. Questioning 401k

Post by 2 Tasty »

You are correct in that 401(k)s could end up being a poorer choice with regards to taxes than a taxable account due to potentially much higher marginal tax rates in retirement (and also high fees, but this part will be ignored). By my calculations, assuming an average hold period of 30 years, one's marginal tax rate would have to increase from 30% to 40% to negate the tax benefits. (If you haven't yet calculated the numbers yourself, I recommend doing so.)

However, even if higher marginal tax rates in the future were likely, 401(k)s would still be a good bet for three reasons:

(1) most people have less income in retirement and hence a lower marginal tax bracket,

(2) tax-deferred growth, and

(3) money in a tax-deferred account gives one more options down the road (for example, as a bridge to retirement or supplementary income for a lower paying job).

Edit: I punched in some numbers to look at the effects of high fees (1% higher than one could get elsewhere). Under this assumption, one would lose out in the 401(k) even if one's marginal tax rate in retirement was equal to that in his working years.
Last edited by 2 Tasty on Wed Jan 04, 2017 12:24 pm, edited 1 time in total.
mhalley
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Re: Don't Shoot. Questioning 401k

Post by mhalley »

The future is unknowable. All you can do is act on what you know now. If taxes are higher when you have to take out your 401k money, at least you will have been saving on autopilot and have money to be taxed. There is no guarantee that investing in taxable would be better, they could always convert the cap gains and dividend tax to be equivalent to earned income tax.
The only way to hedge your bets is to diversify your investments by having money in taxable, pre tax and post tax accounts.
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goingup
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Re: Don't Shoot. Questioning 401k

Post by goingup »

Hopefully by the time you retire you will have a large nest egg consisting of a 401K ready to be rolled over, a Roth IRA, possibly a tIRA and a taxable account. Each will be very valuable to you. Quite possibly the 401K will be the largest account because of the yearly contribution limits and the magic of automated savings.

It doesn't pay to get too clever about peering into the future of US tax rates. Save the dollars you can right now. :beer
swaption
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Re: Don't Shoot. Questioning 401k

Post by swaption »

Gropes & Ray wrote:You are avoiding taxes at your highest marginal rate right now. Let's say that's 28%. When you withdraw, you will withdraw starting at an effective rate of 0%. Then 10%, then 15% then 25%, etc. as you withdraw enough to move up through the tax brackets. Unpredictable things can happen to change your rates - marriage, divorce, disability, increased or reduced rates or brackets - but for the most part, if you are a high income earner, you want to avoid your highest marginal rate now and pay taxes in the lower brackets later.
Agree. I kind of look at it this way, if my big "mistake" is that I end up in a higher than expected tax bracket in retirement, then I'm ok with that. The important part is that I benefit substantially to the extent I am in a lower tax bracket, which is the expected outcome.
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JDCarpenter
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Re: Don't Shoot. Questioning 401k

Post by JDCarpenter »

To answer only your last question (about those who have put in "15 years ago" and are now starting to withdraw)

We are nearing retirement (this year). Have multiple seven figures in 401k/IRA accounts--nearly all of which was put in at the highest marginal rates from 1984 to the present.

We will be withdrawing/converting for many years at 0-2X% marginal rates (~18% effective). The tax arbitrage alone makes it a winner. Plus the protection against creditors (not needed yet!), and the tax deferred growth...
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tadamsmar
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Re: Don't Shoot. Questioning 401k

Post by tadamsmar »

StevenNJ1 wrote:I've been reading a lot on this forum and I get the general consensus of how conservative and retirement-focused this community is. I've used feedback from folks here to fight our bad 401k program at my previous job and made lots of great changes.

As I elect to participate in my new 401k plan (no match offered), I question myself.

I understand that putting money away pre-tax, saves me in taxes, especially now as my taxes are through the roof. However, who knows what the taxes are going to be in 25 years when I start to withdraw money from 401k? What if they are even higher? Do I have to be retired with no new income to fully benefit from 401k withdrawals?

People that began contributing into their 401k 15 years ago and are starting to withdraw now... is their bracket now lower because they have no new income and thus their taxes are lower?

I genuinely want to understand why avoiding taxes on $15k or so that I put away every year now, will allow me to pay a lot less in taxes 25 years from now.
Well, you can move to a state with no income tax.

True that you can't be sure about projecting the current tax rates.

A retired in-law of mine has the same complaint about 401K tax avoidance and it's a real issue in his case. His wife is still working as a contractor because she not want to retire at the required age limit and she left her entire Federal TSP in the SP500 fund after the 2008 crash and it grew about 4 fold and is soon subject to RMDs. He has a good pension. They are in a higher tax bracket because they have a high income while he is retired.
Gropes & Ray
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Re: Don't Shoot. Questioning 401k

Post by Gropes & Ray »

tadamsmar wrote:A retired in-law of mine has the same complaint about 401K tax avoidance and it's a real issue in his case. His wife is still working as a contractor because she not want to retire at the required age limit and she left her entire Federal TSP in the SP500 fund after the 2008 crash and it grew about 4 fold and is soon subject to RMDs. He has a good pension. They are in a higher tax bracket because they have a high income while he is retired.
May I be cursed with such problems!
alfaspider
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Re: Don't Shoot. Questioning 401k

Post by alfaspider »

Your tax rate in retirement is likely to be lower for a few reasons:

1) Your income is much more manipulable compared to your working years. You can choose which investments generate income, and time sales of investments to maximize tax advantages.

2) The global trend is towards consumption taxes (i.e. VAT) rather than income taxes. While I'm not sure the U.S. will necessarily pick up a VAT soon, the lower foreign tax rates will put some pressure on the U.S. to keep rates from increasing significantly over where they are now.

3) Most people have lower income in retirement regardless of any tax planning strategies- you don't generally replace 100% of your working-life income.

Caveat: if you are currently in a very low tax bracket (perhaps because you are just starting out), you would probably be better off putting the money in a Roth IRA (if you aren't already maxing one out) as the current deduction for the 401k would be of minimal value to you.
bcjb
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Re: Don't Shoot. Questioning 401k

Post by bcjb »

JDCarpenter wrote:To answer only your last question (about those who have put in "15 years ago" and are now starting to withdraw)

We are nearing retirement (this year). Have multiple seven figures in 401k/IRA accounts--nearly all of which was put in at the highest marginal rates from 1984 to the present.

We will be withdrawing/converting for many years at 0-2X% marginal rates (~18% effective). The tax arbitrage alone makes it a winner. Plus the protection against creditors (not needed yet!), and the tax deferred growth...
I haven't needed this yet either, but I'm glad someone mentioned the protection from creditors. (Emphasis added.)
DSInvestor
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Re: Don't Shoot. Questioning 401k

Post by DSInvestor »

If you contribute to Traditional 401k now, you get a big tax benefit for year of contribution and the investments are shielded from taxation until you withdraw or convert later, many years later.

If you do not contribute to Traditional 401k, you do not get the tax benefit (at your highest marginal brackets) and you invest in taxable with after-tax money. The investments in taxable accounts are not shield from taxation (i.e. dividends and capital gains are taxable).

If tax rates are higher when you retire, they'd be higher no matter whether you contributed to Traditional 401k or not. At least with the Trad401k, you received some tax benefit up front.

IMO, you should consider maxing out Traditional 401k, Roth IRA (using backdoor if necessary) and then invest in taxable accounts. This way, you've max out tax deductions and have tax diversification in Traditional, Roth and taxable accounts to give you lots of flexibility to control your tax situation in retirement.

I lived in states with high state income tax while working and now reside in a state with no state income tax. Traditional 401k contributions helped me reduce state income tax while working and I can now withdraw without paying state income tax.
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Ged
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Re: Don't Shoot. Questioning 401k

Post by Ged »

StevenNJ1 wrote: is ... bracket now lower
While I was working my marginal rate often exceeded 30%. Now that I'm retired it's 15%. It's possible it might creep up into the 25% bracket occasionally however I still expect the bulk of my 401K withdrawals to be taxed at the 15% rate. Furthermore if there is long term care later on I expect that the medical deductions may push me into a lower than 15% bracket.
retiredjg
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Re: Don't Shoot. Questioning 401k

Post by retiredjg »

StevenNJ1 wrote:I genuinely want to understand why avoiding taxes on $15k or so that I put away every year now, will allow me to pay a lot less in taxes 25 years from now.
Here's another reason that I did not see mentioned.

Presumable all of the money you are putting into the 401k is deferring tax at your current "through the roof rate". If you are straddling the tax bracket line, it is might be deferred at "through the roof" and 1 step down from "through the roof".

If you do not have a pension, as you take the money out of your 401k/IRA to live on, some may not have any tax at all. Some will be taxed at 10% (or whatever the lowest rate is when you retire), some at 15%, some at 25%, and so on. The "overall effective rate" of the money coming out might be 20% or something like that. Compare "through the roof" to that idea and see what you think.
Dandy
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Re: Don't Shoot. Questioning 401k

Post by Dandy »

It is not only not paying the tax on the 15K during the year it is contributed. You are not paying any tax on that 15K earnings each and every year until the last dollar is withdrawn from your 401k via RMDs -- that could be until you die.

So, concern about retiree tax brackets is a valid concern but don't sell short the benefits of the tax deductions/deferrals.
KlangFool
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Re: Don't Shoot. Questioning 401k

Post by KlangFool »

livesoft wrote:Do you fill out your own tax returns? That is sort of a prerequisite to understanding what's going on. And I don't mean just clicking in tax software, but instead at least reading all of Form 1040 (it is only front and back, so 2 pages) and understanding what each line with a dollar amount on it means, so that's probably only one-third of the lines, since two-thirds are empty.

PS: I hope my response didn't wound you and you are still standing.
+1.

And, OP will be greatly benefitted from this exercise.

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Bogel0048
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Re: Don't Shoot. Questioning 401k

Post by Bogel0048 »

2 Tasty wrote: By my calculations, assuming an average hold period of 30 years, one's marginal tax rate would have to increase from 30% to 40% to negate the tax benefits.
To the OP - If you are seriously concerned about your potential gain or loss from participating in your 401(k) I suggest you build a spreadsheet and test out a range of scenarios based on the current tax brackets. The brackets may change by the time you retire, but you can only go with what you know, which is the current brackets.

My wife and I maxed-out our employer-based savings opportunities because my accountant father always told me a tax deferred is a tax avoided, but I find 2 Tasty's calculations to be very reassuring on that score. As it turns out, once our RMDs begin our annual income in retirement will exceed our peak income before we retired. Our marginal tax rate in retirement will be as high or higher than it was while we were working, but it won't be 30% to 40% higher. Plus, as others have pointed out, by saving money in our employer plans in the first place we are now living with the "mistake" of having more than we really need during retirement.
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teen persuasion
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Re: Don't Shoot. Questioning 401k

Post by teen persuasion »

alfaspider wrote:
Caveat: if you are currently in a very low tax bracket (perhaps because you are just starting out), you would probably be better off putting the money in a Roth IRA (if you aren't already maxing one out) as the current deduction for the 401k would be of minimal value to you.
That depends. In some situations the lowered AGI can help you qualify for (greater) refundable credits, like EITC. For us, the phaseout rate on the EITC is ~21%, marginal fed bracket is 10%, state matches EITC (at 30%) for 6.3%, state tax bracket is 4%. So $100 contributed to a traditional 401k increases our refunds by $41.30. Even when we cross to the zero fed bracket, it is worth continuing traditional 401k contributions.

I then turn around and use the refunds to max Roth IRAs (trad IRAs don't increase EITC). So using the traditional 401k increases our total retirement contributions.
sc9182
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Re: Don't Shoot. Questioning 401k

Post by sc9182 »

Additional points: you can loan yourself money upto $50K for down-payment of your house (many large 401ks allows this feature -- though it carries loan own risks as well as rewards)

To implement much-preached AA strategy - lot easier to monies/funds move-around, or move in-out of funds, ETFs and stocks in tax advantaged accounts (401K, or later moved to a IRA etc ..), than brokerage account(s). Try "AA" strategy with already-grown brokerage accounts - and you 'pay' the consequences NOW! Also - have you tried REIT assets in 'brokerage" accounts and considered their tax-treatment ?

Just read forums or internet that who/how one manages to save - lets say 500K or cool million in their 'what' account: 401K/IRAs or checking-accounts ? (brokerage accounts could carry large sums too - but require quite some discipline to build larger/7-figure portfolios; most often these 'brokerage-accounts' appear to built 'after (or in parellel-with' AFTER topping-up their 401K contributions).

Money you can't touch/withdraw, would most-likely will grow un-hindered without succumbing to next 'scam' or 'pyramid-scheme' or 'a drummed-up real-estate deal' or to fund 'friends/relative's next-big business-idear: MiSpace' -- ie, protects from the vultures out there (in addition to offering ERISA protection from creditors :-) !! Some people say - they have limited choice in 401K plans - believe it for its worth - at times, "less but decent" choice(s) may be more prudent compared to 'vulture/unknown-risky' choice !!

Lot of people talking about potentially higher "tax-bracket" but if you do get creative - you can tilt towards "more" dividends/preferred-stocks, than "selling funds/stocks" upon withdrawal period. Again - if you over-save and turn-lucky that your future-business endeavors turn successful that your post-retirement income and tax-bracket is higher -- you got happier-problem to deal with !! If you are currently or know for sure that in-future you will be 2-3+ millionaire (outside of 401K/IRAs; also adjust for inflation based on your current age) by the time you retire -- then the allure of 401K may be less appealing to you particularly if the free-money "match" is strictly not available.

The set of 401K benefits is ever-expanding non-exhaustive list, of course.
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Re: Don't Shoot. Questioning 401k

Post by alfaspider »

teen persuasion wrote:
alfaspider wrote:
Caveat: if you are currently in a very low tax bracket (perhaps because you are just starting out), you would probably be better off putting the money in a Roth IRA (if you aren't already maxing one out) as the current deduction for the 401k would be of minimal value to you.
That depends. In some situations the lowered AGI can help you qualify for (greater) refundable credits, like EITC. For us, the phaseout rate on the EITC is ~21%, marginal fed bracket is 10%, state matches EITC (at 30%) for 6.3%, state tax bracket is 4%. So $100 contributed to a traditional 401k increases our refunds by $41.30. Even when we cross to the zero fed bracket, it is worth continuing traditional 401k contributions.

I then turn around and use the refunds to max Roth IRAs (trad IRAs don't increase EITC). So using the traditional 401k increases our total retirement contributions.
I suppose EITC is a good point. Although I suspect very few people who qualify for the EITC are socking significant money into their 401k.
2 Tasty
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Re: Don't Shoot. Questioning 401k

Post by 2 Tasty »

KlangFool wrote:
livesoft wrote:Do you fill out your own tax returns? That is sort of a prerequisite to understanding what's going on. And I don't mean just clicking in tax software, but instead at least reading all of Form 1040 (it is only front and back, so 2 pages) and understanding what each line with a dollar amount on it means, so that's probably only one-third of the lines, since two-thirds are empty.

PS: I hope my response didn't wound you and you are still standing.
+1.

And, OP will be greatly benefitted from this exercise.

KlangFool
I'll +1 to this. Until I started doing taxes based on the IRS forms, it was a quick mindless slog and I was paying through the nose for that level of ignorance. With a little bit of study and planning, our effective tax rate has essentially been halved. (A big part of that is thanks to the 401(k).)
Fresh Air
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Re: Don't Shoot. Questioning 401k

Post by Fresh Air »

Another possible benefit to the 401k is FAFSA reporting, if you have (or may eventually have) college-bound children. 401k balances do not count as assets, while brokerage investments do. Depending on the size of the accounts, this could make a large financial difference when that time comes around.

Good luck with your planning.
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Re: Don't Shoot. Questioning 401k

Post by KlangFool »

alfaspider wrote:
teen persuasion wrote:
alfaspider wrote:
Caveat: if you are currently in a very low tax bracket (perhaps because you are just starting out), you would probably be better off putting the money in a Roth IRA (if you aren't already maxing one out) as the current deduction for the 401k would be of minimal value to you.
That depends. In some situations the lowered AGI can help you qualify for (greater) refundable credits, like EITC. For us, the phaseout rate on the EITC is ~21%, marginal fed bracket is 10%, state matches EITC (at 30%) for 6.3%, state tax bracket is 4%. So $100 contributed to a traditional 401k increases our refunds by $41.30. Even when we cross to the zero fed bracket, it is worth continuing traditional 401k contributions.

I then turn around and use the refunds to max Roth IRAs (trad IRAs don't increase EITC). So using the traditional 401k increases our total retirement contributions.
I suppose EITC is a good point. Although I suspect very few people who qualify for the EITC are socking significant money into their 401k.
alfaspider,

Yes, but we are in Boglehead forum. Many posters are not normal.

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StevenNJ1
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Re: Don't Shoot. Questioning 401k

Post by StevenNJ1 »

Thank you to all that contributed. This was a very good read.
Appreciate it.
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22twain
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Re: Don't Shoot. Questioning 401k

Post by 22twain »

Gropes & Ray wrote:You are avoiding taxes at your highest marginal rate right now. Let's say that's 28%. When you withdraw, you will withdraw starting at an effective rate of 0%. Then 10%, then 15% then 25%, etc. as you withdraw enough to move up through the tax brackets.
That's a good point. I never thought to calculate that difference for our situation until I saw this.

During our final years of normal salaries, we had a combined gross income of around $120K so we were in the 25% bracket (MFJ). Each $10K of salary deferred into our 403(b)s saved $2.5K of taxes.

After we're both collecting SS and taking RMDs from our 403(b)s, we'll have a combined gross income of around $120 again. Since we're required to take those RMDs, it doesn't make any sense to assign them to any specific tax bracket, so just lump everything together and figure the effective rate. Exemptions and the standard deduction are about $20K. The tax on the remaining $100K (using 2017 rates) is about $16.5K which is about 14% of the $120K gross, or $1.4K per $10K.

If we need to take out an additional $10K on top of that, it would increase our taxes by $2.5K. But it's rather unlikely that we'll need to do that, given our current spending rate, even after adding the taxes.
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blueberry
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Re: Don't Shoot. Questioning 401k

Post by blueberry »

I'm a recent retiree and I'm really happy to have both taxable and tax deferred accounts. It feels safe and powerful to be able to tweak income and capital gains (or, anticipating this since still < 59), depending on tax rules.

I appreciate being able to rebalance my tax deferred account without any tax repercussions. Also, the dividend reinvestment in that account has really contributed to its growth.

I appreciate my taxable for the dividends it's producing so zero thought income, as well as being something I can periodically gift to my child.

It's too bad your employer doesn't match. Sounds like you've been able to change an employers plan before so maybe you could apply yourself to this problem.

-bb
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dziuniek
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Re: Don't Shoot. Questioning 401k

Post by dziuniek »

StevenNJ1 wrote:I've been reading a lot on this forum and I get the general consensus of how conservative and retirement-focused this community is. I've used feedback from folks here to fight our bad 401k program at my previous job and made lots of great changes.

As I elect to participate in my new 401k plan (no match offered), I question myself.

I understand that putting money away pre-tax, saves me in taxes, especially now as my taxes are through the roof. However, who knows what the taxes are going to be in 25 years when I start to withdraw money from 401k? What if they are even higher? Do I have to be retired with no new income to fully benefit from 401k withdrawals?

People that began contributing into their 401k 15 years ago and are starting to withdraw now... is their bracket now lower because they have no new income and thus their taxes are lower?

I genuinely want to understand why avoiding taxes on $15k or so that I put away every year now, will allow me to pay a lot less in taxes 25 years from now.
There's no better alternatives.

Taxable account? You don't know what the tax rates on dividends and capital gains will be in 25 years either. Heck, maybe they'll be higher than w-2 income!

Real estate? It's also unknown how that will be taxes in 25 years.

There is no good alternative.

So maybe ROTH would be good? Who knows! Maybe they'll change that half way through your 25 year waiting period!
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Re: Don't Shoot. Questioning 401k

Post by goodenyou »

StevenNJ1 wrote:I've been reading a lot on this forum and I get the general consensus of how conservative and retirement-focused this community is. I've used feedback from folks here to fight our bad 401k program at my previous job and made lots of great changes.

As I elect to participate in my new 401k plan (no match offered), I question myself.

I understand that putting money away pre-tax, saves me in taxes, especially now as my taxes are through the roof. However, who knows what the taxes are going to be in 25 years when I start to withdraw money from 401k? What if they are even higher? Do I have to be retired with no new income to fully benefit from 401k withdrawals?

People that began contributing into their 401k 15 years ago and are starting to withdraw now... is their bracket now lower because they have no new income and thus their taxes are lower?

I genuinely want to understand why avoiding taxes on $15k or so that I put away every year now, will allow me to pay a lot less in taxes 25 years from now.
If you are high earner (high marginal tax bracket), and you plan on being a lower spender in your retirement, you will benefit by being in a lower bracket in retirement. If you make a lot, save a lot and later spend a lot it may be a wash. If taxes go up in the future and you need a lot of money for consumption, you lose. A higher earner who wants to get to the "finish line" faster by saving more with the expectation a spending less in retirement wins.
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