Too much in retirement accounts

[rollergrrl]

Is the 401k millionaire goal the best route for young investors?

 

[pb4uski]

Tax-deferred savings is premised on the idea that your marginal tax rate in retirement will be lower than your current marginal tax rate while eferring income, so you will save on taxes in the long run.

That's all there is to it. Some people will say that the money grows tax-deferred, but if the tax rate is the same then there are no savings... it can be proven mathematically.

Now many on this forum saved tax-deferred thinking that their marginal tax rate in retirement would be lower than their marginal tax rate when they deferred that money but as it turns out they either were wrong in that thinking or ended up being more successful that they thought they would be financially and it ends up that their marginal tax rate in retirement is actually higher than their tax rate when they were working. Either was a nice problem to have.

 

[rollergrrl]

Now many on this forum saved tax-deferred thinking that their marginal tax rate in retirement would be lower than their marginal tax rate when they deferred that money but as it turns out they either were wrong in that thinking or ended up being more successful that they thought they would be financially and it ends up that their marginal tax rate in retirement is actually higher than their tax rate when they were working. Either was a nice problem to have.

If you know by maxing out your 401k that you have a great chance of being in a higher tax bracket at retirement and you are maxing out Roth too. Are you better off slowing down the 401k and focus on a Brokerage account?

 

[Souschef]

That's all there is to it. Some people will say that the money grows tax-deferred, but if the tax rate is the same then there are no savings... it can be proven mathematically.
.

I am sorry,but i disagree. When your savings grow tax deferred, there is the power of compounding, as you do not pay tax every year. That can be proved mathematically.

 

[pb4uski]

Yes. Tax deferred savings make no sense if your expect to be in a higher tax bracket when you withdraw.

 

[Gumby]

One thing I have learned here is the value of having your savings spread among a variety of pre- and post-tax vehicles. Let's assume you are talking about a person in their early twenties starting a corporate job. Assume further that they are single and starting a $50k per year. Finally, assume that the employer will 401k match dollar for dollar up to 6% of their salary.

1. First, the person should contribute the full 6% of salary to the 401k to get the company match. It is an immediate 100% return on your money. That takes care of $3000 of taxable income.

2. If the person takes the standard deduction of $12,400, their taxable income is now down to $34,600 and they are in the 12% tax bracket. It is likely that they will never again be in a lower bracket than this.

3. Accordingly, they should make the rest of their savings after tax. I would suggest that they max out their Roth IRA at $6000. The contributions (but not the earnings on them) can be taken back out at any time and can serve an emergency fund.

4. This young person will pay a total of 7.62% in social security and medicare taxes ($3810), $3000 in 401k deduction, and health care premiums for their employers's plan, say $1200 (see https://www.kff.org/report-section/ehbs-2019-summary-of-findings/). On $34,500 taxable income, they will pay $3942 in federal income tax and, say, $800 in state tax. This results in a net paycheck of $ 37,248 per year ($3104/mo.) If they can live on that, they're golden.

5. As they get pay raises, they should direct them to increase the Roth as the limits increase and then to a straight after tax account. As their AGI creeps up to $40,000, they may want to increase contributions to the 401k as necessary to preserve 0% tax treatment for Long Term Capital gains in their taxable account. But don't bother if they don't expect to realize gains that year.

6. They shouldn't worry about going into the 22% bracket for ordinary income, because if they do this right, that rate will be higher when then take the money back out of the 401k some day, so they might as well pay the taxes now.


IMHO

 

[COcheesehead]

Make so much money that you can max out your deferred accounts and still fund a taxable account with 10+ years of income.
















Then retire early.

 

[rollergrrl]

Yes. Tax deferred savings make no sense if your expect to be in a higher tax bracket when you withdraw.

One thing I have learned here is the value of having your savings spread among a variety of pre- and post-tax vehicles.



IMHO

Would your advice change with a Government 457 account vs a 401k when it comes to FIRE regarding maxing it out? The 457 would give access to the funds before 591/2 so in theory you would have more years to take out the money, keeping your taxes lower.

 

[pb4uski]

I am sorry,but i disagree. When your savings grow tax deferred, there is the power of compounding, as you do not pay tax every year. That can be proved mathematically.

I concede the point... but there are situations where what I wrote is true. If there is tax on the income that the after tax money is invested in then you are correct. But if there is no tax on the income of the taxable account then it would be a push... for example, if the subject invested the money in equities either way and the dividends and LTCG were not taxed (0% preferenced rate) then there would be no difference.

 

[RobbieB]

I always encourage a 401K contribution that maxes the employer match as a minimum. Pick up the free dough first. Do whatever next.

 

[rollergrrl]

I always encourage a 401K contribution that maxes the employer match as a minimum. Pick up the free dough first. Do whatever next.

When I say max I mean $19500.

 

[NW-Bound]

I concede the point... but there are situations where what I wrote is true. If there is tax on the income that the after tax money is invested in then you are correct. But if there is no tax on the income of the taxable account then it would be a push... for example, if the subject invested the money in equities either way and the dividends and LTCG were not taxed (0% preferenced rate) then there would be no difference.

+1

 

[Gumby]

Would your advice change with a Government 457 account vs a 401k when it comes to FIRE regarding maxing it out? The 457 would give access to the funds before 591/2 so in theory you would have more years to take out the money, keeping your taxes lower.

If it is a government 457, it is quite unlikely that there is an employer match, so I wouldn't bother at the very low tax brackets I posited. I would just max the Roth and save the rest after tax. However, if our hypothetical young person is successful, they will soon move up to the 24% bracket. At that point I would contribute to the 457 as necessary to stay in the 22% bracket, but not more.

I also don't believe there is any difference between the 457 and the 401k categorically that would preclude the Rule of 55 withdrawal. It is up to the individual plan. Actually, I think early retirement is best served by having a wad of after tax money on hand when you retire.

 

[jollystomper]

You might be in a situation where, for retirement, a tax deferred account is your only option. When Roth IRAs became available I was never eligible for them, and by the time Megacorp made Roth 401Ks available I was too close to retirement.

I agree with above that you should try to use as many retirement savings vehicles as possible. But there are a lot worse things than having "too much" in your 401K account. There are worse "mistakes" one can make.

 

[rollergrrl]

If it is a government 457, it is quite unlikely that there is an employer match, so I wouldn't bother at the very low tax brackets I posited. I would just max the Roth and save the rest after tax. However, if our hypothetical young person is successful, they will soon move up to the 24% bracket. At that point I would contribute to the 457 as necessary to stay in the 22% bracket, but not more.

By having my Spouse and I max out tax Deferred accounts we can lower are taxes from 22% to 12%. Is that worth putting that much in a tax deferred account special with not having a match? Is lowering to 12% bracket worth it? The fees in the accounts are not that bad.

 

[NW-Bound]

... Actually, I think early retirement is best served by having a wad of after tax money on hand when you retire.

+1

If I did not have my wad of after-tax money, I would have to spend a lot of time juggling different options on 72(t) withdrawals.

 

[pb4uski]

By having my Spouse and I max out tax Deferred accounts we can lower are taxes from 22% to 12%. Is that worth putting that much in a tax deferred account special with not having a match? Is lowering to 12% bracket worth it? The fees in the accounts are not that bad.

If you think that you'll be in the 22% tax bracket in retirement then it is only somewhat attractive... I would be indifferent.

OTOH, if you think that you'll be in the 12% tax bracket in retirement... less than $105k of income in 2020... then you are avoiding 22% now to pay 12% later so you would want to defer... at least until you pull your income down into the 12% tax bracket.

 

[Gumby]

By having my Spouse and I max out tax Deferred accounts we can lower are taxes from 22% to 12%. Is that worth putting that much in a tax deferred account special with not having a match? Is lowering to 12% bracket worth it? The fees in the accounts are not that bad.

Well, now you're talking about MFJ, not single. Not a big deal, but in general it doubles the numbers for the brackets.

On to your question. I will assume that you are currently in the 22% marginal bracket and that you can drive your taxable income down to the very top of 12% bracket by contributing to 457 plans. So your gross is $144,050, you contribute $39,000 to two 457 plans ($19,500 each), and you take a standard deduction of $24,800, resulting in taxable income of $80,250.

By putting the money into the 457 you are avoiding taxes on $39k at 22%. The big question is: what will your rate be when you take it back out in 30 or more years? I think probably at least as much and likely higher. Maybe a lot higher. If that is the case, you would have been wiser to have paid the taxes now and funneled the money into your Roth. You also would be locking away that $39,000 until you could get some out after you are 59.5 (or 55 if your plan permits and you have retired directly from that employer), or in smaller amounts via a Rule 72(t) withdrawal. Note also that all the gains in a 457 are taxed as ordinary income when they are taken out. With an after tax account (non-Roth) you can engineer your investments to result in your gains being mostly from long-term capital gains, which will be taxed at a much lower rate.

Personally, I have only ever made 401k contributions to avoid taxes at 24% or higher.

 

[rollergrrl]

Thank you everyone amazing information. Lots to think about.

 

[rollergrrl]

OTOH, if you think that you'll be in the 12% tax bracket in retirement... less than $105k of income in 2020... then you are avoiding 22% now to pay 12% later so you would want to defer... at least until you pull your income down into the 12% tax bracket.

Retirement isn’t for another 15 years but this is what I am hoping. To withdrawal on the high end of 12% bracket + standard deduction.

 

[rollergrrl]

Note also that all the gains in a 457 are taxed as ordinary income when they are taken out.

Do you know if this ordinary income from retirement accounts will affect social Security being taxed?

 

[Gumby]

Yes, it counts toward taxation of up to 85% social security (that's not the tax rate, just the amount that is subject to taxation) See https://www.irs.gov/pub/irs-pdf/p915.pdf The provisional income for determining how much SS is taxed includes 1/2 of social security plus "all other income"

 

[Another Reader]

If it is a government 457, it is quite unlikely that there is an employer match, so I wouldn't bother at the very low tax brackets I posited. I would just max the Roth and save the rest after tax. However, if our hypothetical young person is successful, they will soon move up to the 24% bracket. At that point I would contribute to the 457 as necessary to stay in the 22% bracket, but not more.

I also don't believe there is any difference between the 457 and the 401k categorically that would preclude the Rule of 55 withdrawal. It is up to the individual plan. Actually, I think early retirement is best served by having a wad of after tax money on hand when you retire.

My recollection of governmental 457 plans is that because it is deferred compensation, you can take money out before age 59.5 without penalty. I left my money in the plan when I retired at age 53, but did not take distributions. At some point I moved everything into the stable value fund, which paid around 3 percent consistently through the downturn. I moved it into IRA's in stages after turning 59.5 when the 10 percent penalty became moot.

 

[Jerry1]

I always encourage a 401K contribution that maxes the employer match as a minimum. Pick up the free dough first. Do whatever next.

This ^

You don't leave free money on the table. After that, good arguments can be made to go further. Others on this thread have already pointed them out, but I can't think of any reason not to get your maximum employer match.

 

[Gumby]

My recollection of governmental 457 plans is that because it is deferred compensation, you can take money out before age 59.5 without penalty. I left my money in the plan when I retired at age 53, but did not take distributions. At some point I moved everything into the stable value fund, which paid around 3 percent consistently through the downturn. I moved it into IRA's in stages after turning 59.5 when the 10 percent penalty became moot.

You are correct. I was confusing it with a 403b plan.

https://www.investopedia.com/ask/answers/021616/are-457-plan-withdrawals-taxable.asp