Does investing in a 401k actually save any money?

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RenoJay
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Does investing in a 401k actually save any money?

Post by RenoJay »

Let's assume overall tax rates stay the same for 30 years since none of us has a crystal ball. Let's further assume that someone who is in the 33% marginal tax bracket during his working career will be in the 28% tax bracket when he retires. Let's further assume he's an index fund investor and over the course of 30 years he contributes $100k to an index fund within his 401k and, upon retirement, it's worth $400k due to appreciation and dividends.

If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.

So while getting some tax deferral along the way (which will feel good at the time), isn't he essentially giving up a 15% tax for the right to pay a much higher 28% tax in this scenario? What am I missing here that makes 401ks so wonderful??? (Assume no employer match for this situation.)
dissonance
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Re: Does investing in a 401k actually save any money?

Post by dissonance »

Tax free growth.
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RenoJay
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Re: Does investing in a 401k actually save any money?

Post by RenoJay »

yzhang12 wrote:Tax free growth.
But that's my question. Is there any "tax free" growth? It seems you get tax deferred growth in exchange for massively overpaying the taxes down the road which eliminates the benefit. Am I wrong?
SpecialK22
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Re: Does investing in a 401k actually save any money?

Post by SpecialK22 »

This investor also receives a significant tax break up front by putting money in the 401k. I believe you forgot to add this in.
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Re: Does investing in a 401k actually save any money?

Post by YDNAL »

RenoJay wrote:Let's assume overall tax rates stay the same for 30 years since none of us has a crystal ball. Let's further assume that someone who is in the 33% marginal tax bracket during his working career will be in the 28% tax bracket when he retires. Let's further assume he's an index fund investor and over the course of 30 years he contributes $100k to an index fund within his 401k and, upon retirement, it's worth $400k due to appreciation and dividends.

If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.

So while getting some tax deferral along the way (which will feel good at the time), isn't he essentially giving up a 15% tax for the right to pay a much higher 28% tax in this scenario? What am I missing here that makes 401ks so wonderful??? (Assume no employer match for this situation.)
Yes, no crystal ball.

Tax issues - personal in nature - shouldn't be generalized with an example (what if) or generalization. That said, HERE is a 2011 thread discussing more *what ifs* regarding this question.
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fposte
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Re: Does investing in a 401k actually save any money?

Post by fposte »

Also, in many states there's no state income tax on 401k distributions.
cusetownusa
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Re: Does investing in a 401k actually save any money?

Post by cusetownusa »

RenoJay wrote:
If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.
This is not true...In your example you are making contributions with a marginal tax rate of 33%...so by making the contributions you save 33%. However, when you withdraw just because you are in the 28% marginal tax bracket doesn't mean that all if it is taxed at 28%...you have to fill up the lower tax brackets first. So some money will be going in at 33% and coming out at say 10%.

SOmeone smarter than me can explain this better.
niceguy7376
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Re: Does investing in a 401k actually save any money?

Post by niceguy7376 »

I am no expert but let me provide some that I think makes it worthwhile.
1. Immediate tax break. Maybe with contributions, you might go down from 28% to 25%.
2. I dont need to withdraw the whole amount when I retire. Just the RMD at min and whatever more you want. So not all withdrawls are at 28%. Some at 0%, some at 15%, some at 25% and if still left, then at 28%. I dont know how much RMD will be if we have 400k in 401k (as per your example).

3. If i do taxable investing, the dividends (assuming no capital gains during working time) will be taxed at a lower level than your income but is it the max 15% even if you are in 28%? I dont know.
bberris
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Re: Does investing in a 401k actually save any money?

Post by bberris »

The answer is yes for most people, but it depends. The big benefit is that you contribute at your marginal rate, probably 25 % or higher, but your withdrawals will be at least partially tax free (personal exemptions + standard deduction) and low tax 15 % bracket to 73,000. So lower taxes in retirement with up to 93,000 income if you have no other income. If your income is higher remember that the higher brackets only apply to the amount over that.

That said, I think the general opinion of posters is to undervalue taxable investing and overvalue Roth.
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Re: Does investing in a 401k actually save any money?

Post by livesoft »

There are few things not quite right with the OP's scenario as discussed many times. Mainly, please compare apples to apples or really money to money. Tax deferment is a BIG deal and so are the various tax brackets.

Start with $9,000

K puts $9,000 in 401(k) and does not pay income taxes yet on the $9,000.

T puts $3,000 in their check to the IRS and puts the $6,000 left in the same funds that K uses. See already the effect of that 33% marginal income tax bracket?

In retirement, one has to guess their taxes because even if the marginal tax bracket is 28%, some of the "cashing in" of K and T may be taxed at 0%. Do I need to go into the details?
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cheese_breath
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Re: Does investing in a 401k actually save any money?

Post by cheese_breath »

Don't overlook potential savings of having it withdrawn from your pay and deposited in the 401K before you ever see it. You may be less tempted to spend it than if you received it in your pay check.
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Re: Does investing in a 401k actually save any money?

Post by MossySF »

When you invest in taxable, you pay income tax and capital gains tax. When you invest in 401k/IRA, you only pay income tax.

The key to understanding the above statement -- multiplication is commutative. This means it doesn't matter you take 33% off before you invest or 33% off after 40 years of investment. The formulas below demonstrate this principle:

($1 * 1.10^40) * (1-.33) = $30.23 <-- 401K/IRA formula
($1 * (1-.33) ) * 1.10^40 = $30.23 <-- Roth 401K/IRA formula

So in a taxable account, you pay tax first before investing in it making the starting point look just like the Roth formula. Then you pay additional tax on the gains -- assuming you don't plan to simply die and leave the investments to your heirs. Assume in 40 years, capital gains is still 15%:

($1 * (1-.33) ) * 1.10^40 = $30.23
$1 + ($30.23 - $1) * (1-.15) = $25.85 <-- taxable formula
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Re: Does investing in a 401k actually save any money?

Post by dbr »

cusetownusa wrote:
RenoJay wrote:
If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.
This is not true...In your example you are making contributions with a marginal tax rate of 33%...so by making the contributions you save 33%. However, when you withdraw just because you are in the 28% marginal tax bracket doesn't mean that all if it is taxed at 28%...you have to fill up the lower tax brackets first. So some money will be going in at 33% and coming out at say 10%.

SOmeone smarter than me can explain this better.
That's pretty good. Maybe somebody can find a link to those charts that tfb had that show how income is stacked for purposes of assessing taxes.
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Re: Does investing in a 401k actually save any money?

Post by JustinR »

RenoJay wrote:Let's assume overall tax rates stay the same for 30 years since none of us has a crystal ball. Let's further assume that someone who is in the 33% marginal tax bracket during his working career will be in the 28% tax bracket when he retires. Let's further assume he's an index fund investor and over the course of 30 years he contributes $100k to an index fund within his 401k and, upon retirement, it's worth $400k due to appreciation and dividends.

If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.

So while getting some tax deferral along the way (which will feel good at the time), isn't he essentially giving up a 15% tax for the right to pay a much higher 28% tax in this scenario? What am I missing here that makes 401ks so wonderful??? (Assume no employer match for this situation.)
I don't understand the example. Aren't you paying more (33%) while working and less (28%) when retired? That supports the 401k saving money...
target2030
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Re: Does investing in a 401k actually save any money?

Post by target2030 »

How about Saferty ? I would like to have significant savings in retirement accounts that are safe from law-suits and such..

Your 401K is safe from creditors (including judgement creditors):

http://www.nolo.com/legal-encyclopedia/ ... ounts.html
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Re: Does investing in a 401k actually save any money?

Post by TradingPlaces »

RenoJay wrote:Let's assume overall tax rates stay the same for 30 years since none of us has a crystal ball. Let's further assume that someone who is in the 33% marginal tax bracket during his working career will be in the 28% tax bracket when he retires. Let's further assume he's an index fund investor and over the course of 30 years he contributes $100k to an index fund within his 401k and, upon retirement, it's worth $400k due to appreciation and dividends.

If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.

So while getting some tax deferral along the way (which will feel good at the time), isn't he essentially giving up a 15% tax for the right to pay a much higher 28% tax in this scenario? What am I missing here that makes 401ks so wonderful??? (Assume no employer match for this situation.)
I have an easy solution for you. Put both scenarios in spreadsheet, do some sensitivity analysis, and then once finished, come back and report it here. You will learn, and we will learn.
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Re: Does investing in a 401k actually save any money?

Post by TradingPlaces »

I think the OPs scenario is constructed in such a way that 401K will definitely come out ahead, especially with the 28% bracket in retirement being below the 33% bracket while working.

But what about the following:

- 33% while working, but 40% in retirement (either due to over-saving, or due to tax law change), AND
- income or asset test for Social Security.

Combine that with what OP said about lower dividend / interest tax rate than ordinary income, and the case for 401K is less clear.

In general, IMO, 401K has one big hole: contributions vs. growth should be taxed differently when withdrawing money. [OT comments removed by admin LadyGeek]

One would argue that the second bullet will affect both cases the same. [OT comments removed by admin LadyGeek]
Last edited by TradingPlaces on Fri Nov 21, 2014 11:01 am, edited 1 time in total.
john94549
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Re: Does investing in a 401k actually save any money?

Post by john94549 »

Just focusing on state income taxes, in many states, Social Security benefits are taxed not at all, or only in part. Accordingly, the tax bite of 401K withdrawals in retirement (as to state income tax) may well be less than the tax advantage when contributing. It's more pronounced in states with extremely progressive marginal rates. In addition, I know of at least one state (three guesses) which taxes capital gains as ordinary income.
Last edited by john94549 on Fri Nov 21, 2014 11:05 am, edited 1 time in total.
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Re: Does investing in a 401k actually save any money?

Post by CantPassAgain »

cusetownusa wrote:
RenoJay wrote:
If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.
This is not true...In your example you are making contributions with a marginal tax rate of 33%...so by making the contributions you save 33%. However, when you withdraw just because you are in the 28% marginal tax bracket doesn't mean that all if it is taxed at 28%...you have to fill up the lower tax brackets first. So some money will be going in at 33% and coming out at say 10%.

SOmeone smarter than me can explain this better.
That's pretty much it. When you are putting money in it starts at your highest tax bracket. When you take out later you start with your lowest tax bracket, which is even less than 10%. It's 0% because of deductions and exemptions.
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Re: Does investing in a 401k actually save any money?

Post by dbr »

TradingPlaces wrote:I think the OPs scenario is constructed in such a way that 401K will definitely come out ahead, especially with the 28% bracket in retirement being below the 33% bracket while working.

But what about the following:

- 33% while working, but 40% in retirement (either due to over-saving, or due to tax law change), AND
- income or asset test for Social Security.

One would argue that the second bullet will affect both cases the same. [OT comments removed by admin LadyGeek]
I don't think there is a tax scenario anywhere in which a change to the assumptions cannot reverse the decision as to what is best. (Well, ok, maybe something can be created, but this isn't it). What this does imply is that some thought has to be put into estimating the likelihood of various things. I think people do overestimate their retirement tax costs. Among other things many aspects of the tax code are indexed for future inflation, but some are not. It is also a legitimate concern that tax code can change. Again one must balance the extreme scenarios against the likelihood they will actually happen.

It might be reasonable to compare how different the outcome could be assuming different things. It might be there is not that much difference and that the certainty of avoiding taxes now is worth the chance on the future.
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Re: Does investing in a 401k actually save any money?

Post by TradingPlaces »

bberris wrote:The answer is yes for most people, but it depends. The big benefit is that you contribute at your marginal rate, probably 25 % or higher, but your withdrawals will be at least partially tax free (personal exemptions + standard deduction) and low tax 15 % bracket to 73,000. So lower taxes in retirement with up to 93,000 income if you have no other income. If your income is higher remember that the higher brackets only apply to the amount over that.

That said, I think the general opinion of posters is to undervalue taxable investing and overvalue Roth.
I think this line of reasoning is not fully correct. If you got such a large marginal tax rate for your 401K, likely, you are getting close to the maximum of social security, and that can be $25K a year. Thus, at a minimum, you can forget about parts of the exemption, deduction, and the beginning of the 15% tax rate. I see you assume Married Filing Joint (for the $73K to make sense), thus consider each spouse getting $25K in SS old age benefits per year, and that's if they activated the benefit at 67. At 70, add another 32% to it.

I think social security is not fully taxed, but someone with better knowledge of this can chime in correct the $93K estimate. Best source I could find is if your "combined income" (technical term) exceeds a certain threshold, then 85% of your SS benefits are taxed for federal purposes.
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Re: Does investing in a 401k actually save any money?

Post by mptfan »

dbr wrote:
cusetownusa wrote:
RenoJay wrote:
If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.
This is not true...In your example you are making contributions with a marginal tax rate of 33%...so by making the contributions you save 33%. However, when you withdraw just because you are in the 28% marginal tax bracket doesn't mean that all if it is taxed at 28%...you have to fill up the lower tax brackets first. So some money will be going in at 33% and coming out at say 10%.

SOmeone smarter than me can explain this better.
That's pretty good. Maybe somebody can find a link to those charts that tfb had that show how income is stacked for purposes of assessing taxes.
It is explained, with charts, in Chapter 10 of the Boglehead's Guide to Retirement Planning.
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Re: Does investing in a 401k actually save any money?

Post by The Wizard »

I've explained this before, the issue of having a good base amount in tax-deferred 401k and IRA accounts, enough to fill up low brackets in retirement using a 4% or RMD safe withdrawal rate.
That tax deferred balance might be between $1M and $3M for many individuals, so that your marginal tax bracket in retirement is close to that in your later working years.
Beyond that, better to start saving more in your taxable account...
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Re: Does investing in a 401k actually save any money?

Post by vesalius »

The Case Against Roth 401(k)
Can you save too much, pre-tax?
Try these articles. The tax brackets in the chart are outdated, but the message is still applicable.
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Re: Does investing in a 401k actually save any money?

Post by rkhusky »

This wiki page has a year-by-year numerical table that compares taxable vs. Roth, Deductible IRA, and Non-deductible IRA. A 401K would be like the Deductible IRA.
http://www.bogleheads.org/wiki/Non-dedu ... tional_IRA
It should lay to rest the "converting cap gains into income" fears. You can reproduce the spreadsheet to look at other sets of parameters.
Last edited by rkhusky on Fri Nov 21, 2014 12:01 pm, edited 1 time in total.
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Re: Does investing in a 401k actually save any money?

Post by dimdum »

Don't forget company match, that free money. Many companies match 3-6% of your contribution, that itself is enough reason to invest in 401k.

A person making 100K with 4.5% matching will get $4500 each year.
4500x30 = 135,000 FREE $$
Add 5% growth =320K over 30 years growth just in company contribution.
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Re: Does investing in a 401k actually save any money?

Post by PaddyMac »

Not sure if it's been mentioned yet, but deferring tax now may help with keeping dividends that you are getting from a taxable account in the 0% tax bracket. That's what I'm hoping will happen with us this year: I'm saving enough in our 401k to keep us in the 15% tax bracket, which then allows us to qualify for a Roth IRA and to get our dividend income from our taxable account at 0% tax rate. It's almost too good to be true, so I'm almost not minding having less income this year!
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Re: Does investing in a 401k actually save any money?

Post by retiredjg »

TradingPlaces wrote:- 33% while working, but 40% in retirement (either due to over-saving, or due to tax law change)....
Again...having a marginal rate of 40% does not mean that everything is taxed at 40%. Some is not taxed, some taxed at 10%, 15%, 25%, 33% and 35% before you even get to taxing some at 40%.
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Re: Does investing in a 401k actually save any money?

Post by retiredjg »

dbr wrote:That's pretty good. Maybe somebody can find a link to those charts that tfb had that show how income is stacked for purposes of assessing taxes.
Here is the thread with the income stack charts.

http://www.bogleheads.org/forum/viewtop ... 10&t=86849
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Re: Does investing in a 401k actually save any money?

Post by DonCamillo »

Having a way to reduce your taxable income during your peak earning years can also affect many penalties and phaseouts that apply to higher income taxpayers. I am thinking of many things, like medical and standard deductions, deductibility of business expenses, avoiding surcharges on medicare, eligibility for financial aid and some government benefits.
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Re: Does investing in a 401k actually save any money?

Post by Nestegg_User »

john94549 wrote:Just focusing on state income taxes, in many states, Social Security benefits are taxed not at all, or only in part. Accordingly, the tax bite of 401K withdrawals in retirement (as to state income tax) may well be less than the tax advantage when contributing. It's more pronounced in states with extremely progressive marginal rates. In addition, I know of at least one state (three guesses) which taxes capital gains as ordinary income.

Hmmm... New Jersey, Pennsylvania and Hawaii have unique aspects as relates to capital gains....NJ doesn't allow any losses in cap gains, Hawaii has a unique alternative tax on all capital gains, and PA (and AL) have some unique rules as to limitations of capital losses, etc.


As for the rest of the thread... [for us] the use of 401k allows the money deposited to not be in the 33% + rate, with the eventual withdrawal over some time at probably 25% rate... SS situation not changed (all at 85% as lower brackets will be filled by pension). The use of 401k also is place for certain assets that would throw off too much taxable income otherwise (REITS, taxable bonds, etc) which could push us into higher brackets if realized as taxable.
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Re: Does investing in a 401k actually save any money?

Post by john94549 »

Nearing, the hint is my ZIP code, 94549. It's CA. CA taxes capital gains as ordinary income.
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Re: Does investing in a 401k actually save any money?

Post by Ketawa »

SpecialK22 wrote:This investor also receives a significant tax break up front by putting money in the 401k. I believe you forgot to add this in.
+1. OP missed that someone investing $100k in a Traditional 401k would only be able to invest $67k in taxable if facing a 33% marginal tax rate.
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Re: Does investing in a 401k actually save any money?

Post by Nestegg_User »

The "Individual Income tax Provisions for the States" (2012 version) did not give any difference for CA from federal... and since I certainly don't live there ... wouldn't have noted it. It just shows that even if you've looked at some source..it may be outdated or incorrect...you have to go to each states Dept. of Treasury to get the current info... and we are likely to be more fluid in this as each state needs to "constructively recognize revenue from disparate sources" :wink:
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Re: Does investing in a 401k actually save any money?

Post by cheese_breath »

john94549 wrote:Nearing, the hint is my ZIP code, 94549. It's CA. CA taxes capital gains as ordinary income.
So does Michigan.
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Re: Does investing in a 401k actually save any money?

Post by czeckers »

A number of people have already pointed out that investing $100K pretax money in a 401K is equivalent to to $67K of after-tax dollars so the initial investment is different because of taxes.

Another issue is that the owner of the taxable account will also have to pay annual taxes on the dividends. This will decrease the growth rate of the taxable account.

Thus, in the taxable account, you will have less money invested, and growing at a slower rate (due to taxes) than in the 401K.

As was also mentioned, the 401K contributions reduce your taxes at your marginal rate (33% in this example). However, withdrawals, assuming no other sources of income, are taxed at your average tax rate.

Using the 2014 tax rates for someone who is married, filing jointly, that means that the first $18,150 withdrawn is taxed at 10%, the next $55,649 is taxed at 15%, the next $75,049 at 25%, and then 28% for the money in the marginal bracket (up to another $77,999).

Lets say you take out $200,000 which is in the 28% tax bracket per the OP's example:

You pay $1,815 tax on the first $18,150 (10% bracket)
You pay $8,347 tax on the next $55,649 (15% bracket)
You pay $18,762 tax on the next $75,049 (25% bracket)
You pay $14,322 tax on the last $51,149 (28% bracket)

Total tax bill = $43,246 = 21.6% of $200,000

This is not that much more than the 20% capital gains tax rate that you will have to pay on the withdrawals from the taxable account. My example also overstates the tax paid on the 401K account because I didn't include the $12,400 standard deduction. And remember, the taxable account would've had 1/3 fewer contributions and a slower rate of growth because of ongoing taxes. Tax deferrement is a very BIG Deal

Hope this helps.

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Re: Does investing in a 401k actually save any money?

Post by nisiprius »

Last time I looked, it seemed that the advantages of a 401(k) came from three sources:

a) The company match
b) Nontaxable compounding
c) The assumption of a lower tax bracket in retirement

The disadvantages were limited choice and high-cost funds in the plan.

The conclusion I came to was that it was still a no-brainer that a 401(k) was going to be better than taxable investing. However, the amount of the advantage was far less than you used to see in illustrations from the 1990s. Nontaxable compounding is meaningful but it is by no means gigantic, if you make what today are considered realistic assumptions for investment return. The tax break on dividends narrows the gap.

Most of my life has been spent in jobs where the company match was extremely stingy. But a friend of mine whose employer makes a 100% match up to 10% of salary would be foolish to spend any time at all considering whether or not to contribute up to the match.

The assumption that the tax bracket in retirement will be lower than during the career still seems pretty reasonable to me.

If the company match is stingy, there's a case to be made for prioritizing a Roth ahead of the 401(k), but the limits on a Roth suggest that you should be saving more for retirement than you are allowed to contribute to a 401(k).
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Re: Does investing in a 401k actually save any money?

Post by dm200 »

To address only one aspect (and assumption) about the long term benefit of 401k (or any other similar) tax deferred savings/investment -

The tax free (actually deferred) compounding of a 401k (or other similar) tax deferred savings/investment can actually be beneficial even if the marginal tax rate goes up. I did many of these calculations a few years ago and the break even, increased marginal tax rate at pulling the money out of the 401k depends on many factors. My "key" conclusion, though, and often either not properly cited by proponents of 401k use or even misstated, is that you do NOT need to assume or have a lower marginal tax rate in retirement for there to be a benefit. I was actually a bit surprised when I did the calculations.
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Re: Does investing in a 401k actually save any money?

Post by dbr »

dm200 wrote:To address only one aspect (and assumption) about the long term benefit of 401k (or any other similar) tax deferred savings/investment -

The tax free (actually deferred) compounding of a 401k (or other similar) tax deferred savings/investment can actually be beneficial even if the marginal tax rate goes up. I did many of these calculations a few years ago and the break even, increased marginal tax rate at pulling the money out of the 401k depends on many factors. My "key" conclusion, though, and often either not properly cited by proponents of 401k use or even misstated, is that you do NOT need to assume or have a lower marginal tax rate in retirement for there to be a benefit. I was actually a bit surprised when I did the calculations.
Presumably a factor in that is the previously mentioned possibility that marginal cost on withdrawing from the 401K was not all at the persons marginal tax rate together with possibilites of other tax considerations, phase-outs, etc. that might have affected both tax cost calculations.
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Re: Does investing in a 401k actually save any money?

Post by Caduceus »

The best thing to do is spend 30 minutes playing around with various assumptions in Excel, making sure you account for the correct initial contribution when comparing taxable and tax-deferred options, a reasonable estimate of the differential dividend tax drag by investing in a taxable account, and what your beginning and ending tax rates would be. I think it's hard to think about it in the abstract until you see those numbers changing simultaneously on a spreadsheet as you modify one, two or many assumptions at the same time.
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Re: Does investing in a 401k actually save any money?

Post by ArthurO »

I am in 28% bracket and I choose to do ROTH 401k, I pay my taxes now, bite the bullet and the growth is completely tax free, except employer match which is 100% match of my contributions so about $18000 per year... but that's free money so I will have to pay tax on that plus earnings when time comes...

I don't like deferring taxes, they are lowest now in long time and with deficits they have nowwhere to go but up.
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Re: Does investing in a 401k actually save any money?

Post by BogleBoogie »

Why are comments being removed by ADMIN? Were they inappropriate? Didn't seem so based on the context of the text remaining? I'm curious...
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Re: Does investing in a 401k actually save any money?

Post by JoMoney »

- Might have better/lower cost investments available in some 401k plans
- 401k/ERISA plans offer shielding from various types of liability claims
- You can sell / exchange / trade / rebalance assets within a plan and not incur any taxes
- Income from bonds and REITS do not get any special capital-gains treatment, tax deferred growth on this income could be beneficial
- Option to rollover assets to a ROTH plan that will incur no future taxes if the rules are followed
- IF taxes remain the same, and you remain in the same/higher tax bracket, the impact to your lifestyle of paying more taxes relative to what you might have paid following some other strategy isn't a major consequence. IF you find yourself in a lower tax bracket every extra bit of income saved from tax deferral/growth may have a larger impact to your well being. If the outcome is uncertain, following the path with less severe consequence seems prudent.
Last edited by JoMoney on Fri Nov 21, 2014 10:05 pm, edited 1 time in total.
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Re: Does investing in a 401k actually save any money?

Post by LadyGeek »

BogleBoogie wrote:Why are comments being removed by ADMIN? Were they inappropriate? Didn't seem so based on the context of the text remaining? I'm curious...
To answer your question, see: Forum Policy
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PM me to discuss further (don't post here). I'm letting this post stand to remind members about our policy on moderation.
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Re: Does investing in a 401k actually save any money?

Post by telemark »

When you invest paycheck money in a taxable account you pay taxes twice: first as income tax when you earn the money, and again as dividend and capital gains taxes on the investment returns. In a tax-advantaged account you're only taxed once: as income when you withdraw from a traditional IRA or 401K, or as income when you earn the money in a Roth account.

If you somehow find yourself in possession of a lump sum without owing any taxes on it, a taxable account is probably the better way to go. Or if you can play the tax-loss harvesting game successfully.
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Re: Does investing in a 401k actually save any money?

Post by Greenman72 »

RenoJay wrote:Let's assume overall tax rates stay the same for 30 years since none of us has a crystal ball. Let's further assume that someone who is in the 33% marginal tax bracket during his working career will be in the 28% tax bracket when he retires. Let's further assume he's an index fund investor and over the course of 30 years he contributes $100k to an index fund within his 401k and, upon retirement, it's worth $400k due to appreciation and dividends.

If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.

So while getting some tax deferral along the way (which will feel good at the time), isn't he essentially giving up a 15% tax for the right to pay a much higher 28% tax in this scenario? What am I missing here that makes 401ks so wonderful??? (Assume no employer match for this situation.)
First, you have to understand that $100k in a taxable account does not equal $100k in an IRA. If you were to contribute $100k to an IRA, you would immediately receive a $33k tax deduction. And in order to make an apples-to-apples comparison, you have to assume that $33,000 went back into your IRA. This is the only way to make a fair comparison. So $100k in a taxable account equals $133k in an IRA.

So let's assume that we could get 10% on that $133k every year for 30 years. The account would be worth $2,321,000 before taxes and $1,671,000 after taxes (at 28%). This is the easy calculation.

Here's the hard calculation: We can ignore the 33% and 28% tax rates. The only taxes we owe are the 15% on capital gains and dividends. Let's further assume that we're in a stock fund that gets a 10% return. 2% of the return is from dividends and 8% is from capital appreciation. However, the fund turns over 50% of its portfolio every year. This means that the fund's after-tax rate of return is 9.1%. The 9.1% is comprised of:
- 4% unrealized gain, which results in a 4% return,
- 4% realized gain, which results in a (.04 x (1-.15)) = 3.4% return, and
- 2% dividends, which results in a (.02 x (1 - .15)) = 1.7% return.
If we take $100k, and compound it at 9.1% for 30 years, we come up with a before-tax gross amount of $1,364,000.

So there you have it. You have 23% more money, even after tax, in the IRA.
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Re: Does investing in a 401k actually save any money?

Post by Greenman72 »

It's also worthwhile to note that the above calculation uses certain assumptions, including the 2% dividend yield and the 50% turnover rate. The higher the yield and turnover, the more that the portfolio will suffer compared to the IRA.

If we use numbers that are more akin to the S&P 500, (EG - 1.5% yield, 5% turnover), we would get:
- 8.075% unrealized gain (.085 x .95)
- 0.36125% realized gain (.085 x .05 x (1 - .15))
- 1.275% dividend yield (.015 x (1 - .85))
And the total after-tax equivalent return would be close to 9.7%.

So if we take $100k, compound it at 9.7% for 30 years, we would get an after-tax value of $1,608,000. Still less than the IRA, but the portfolio hasn't been hit by nearly as many taxes along the way, which is why it is much closer to the IRA's value.
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Re: Does investing in a 401k actually save any money?

Post by Greenman72 »

Also note that this doesn't take into account the fact that you're going to die someday. And when you do, the IRA value will still be subject to estate taxes, then your beneficiaries will still have to liquidate the account and pay income taxes on the money. Assuming you owe 40% on the estate tax and the beneficiary owes 28% on his income tax, your $2,320,770 will turn into $1,003,000 overnight.

Alternatively, your S&P 500 index fund will go from $1,364,000 to $965,000, because it is only subject to estate tax. Your heirs will get a step-up in basis, and will owe zero taxes. Sure, the IRA still wins in the end, but I just wanted to bring up the fact that there's also an estate planning factor to deal with as well.
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Re: Does investing in a 401k actually save any money?

Post by grabiner »

RenoJay wrote:Let's assume overall tax rates stay the same for 30 years since none of us has a crystal ball. Let's further assume that someone who is in the 33% marginal tax bracket during his working career will be in the 28% tax bracket when he retires. Let's further assume he's an index fund investor and over the course of 30 years he contributes $100k to an index fund within his 401k and, upon retirement, it's worth $400k due to appreciation and dividends.

If my understanding is correct, he'll make withdrawls from the 401k during retirement and pay ordinary income tax (28% bracket) on all the withdrawls. But had he invested this money in a taxable account the whole time, he'd have paid mostly 15% capital gains and dividends taxes along the way, possibly subject to certain Obamacare taxes.

So while getting some tax deferral along the way (which will feel good at the time), isn't he essentially giving up a 15% tax for the right to pay a much higher 28% tax in this scenario? What am I missing here that makes 401ks so wonderful??? (Assume no employer match for this situation.)
You missed the tax deduction on contributions. When he contributed $100K to the index fund, he got $33K back in taxes; if he had made a taxable investment, he would have only been able to invest $67K, which would grow to $268K tax-free and even less after tax.

In this situation, he also had the opportunity to invest in a Roth IRA or 401(k) instead. Again, he could have invested $67K in the Roth, which would grow to $268K. That is clearly better than a taxable account, but inferior to the traditional 401(k), which gave him $288K to spend in retirement.
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Re: Does investing in a 401k actually save any money?

Post by Greenman72 »

^While your math is correct, remember that you have the benefit of knowing two things--that the tax rate in retirement is lower than the current tax rate, and the fact that the client can deduct his IRA contribution. If you don't know either or these with relative certainty, then the Roth becomes the vehicle of choice.
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