pretax saving, i dont get it

[endthefed]

can someone please explain to me the benefit of pretax saving? pretax 401k, ira, 403b, etc...

the negatives seem to outweigh the positives imo.

 

[ziggy29]

Based on everything you've written I'd say you already know what the benefits are. I think you're just using that topic as a way to introduce the topic of higher future income taxes into a thread.

 

[endthefed]

Based on everything you've written I'd say you already know what the benefits are. I think you're just using that topic as a way to introduce the topic of higher future income taxes into a thread.

nope, not it.

but since you brought it up....having the government as a partner inside the account is not ideal. especially when that partner can abitrarily decide what portion of the account is theirs.

back to the topic - what are the benefits?

 

[ziggy29]

back to the topic - what are the benefits?

Given your obvious distrust of the government and its willingness to uphold its end of the deal, very little.

People with less distrust may find there to be benefit if they believe they will have considerably lower incomes (and tax rates) when they start withdrawing in retirement. Of course, that assumes you don't think we are so doomed that tax rates at all income levels will skyrocket in the decades ahead. But that starts becoming a political discussion.

 

[FIREd]

2 reasons I like pretax savings:

1) I am currently in the 35% (soon to be 39.6%) tax bracket and I save a lot of money on taxes by contributing to a 401K (can't contribute to IRAs anymore). It is very unlikely that my tax rate will be anywhere near 40% in retirement, even if income tax rates go up dramatically form here, so I should see a net positive.

2) Asset protection. Most tax-deferred accounts enjoy some form of creditor protection at the federal or state level.

 

[endthefed]

Given your obvious distrust of the government and its willingness to uphold its end of the deal, very little.

People with less distrust may find there to be benefit if they believe they will have considerably lower incomes (and tax rates) when they start withdrawing in retirement. Of course, that assumes you don't think we are so doomed that tax rates at all income levels will skyrocket in the decades ahead. But that starts becoming a political discussion.

i'm not doing politics here - so no worries about that.

so, the benefit is the assumption that you are going to be in a lower tax bracket, right? aren't the last decade's tax rates historically low?

also, pretax accounts are a great way to convert qualified dividend income to regular income rates. no bueno.

 

[M Paquette]

Heh. All I know, is that if I were to start buying and hoarding gold, right after most of my net worth were in gold, someone would announce cheap nucleosynthesis in kilogram lots.

I'd rather diversify.

On the pretax stuff, I'm pretty sure I have a lower tax rate now than when I was stashing away cash in a 401K. I was in a high marginal bracket when saving (often the highest bracket), and now I'm in the zero percent federal 'bracket' after figuring in deductions and whatnot. I think it's unlikely that we'll see the lowest tax brackets rise to a rate higher than the highest brackets over the past 20 years.

Whacking someone with a 30K annual income with a 34% tax rate strikes me as a great way to induce armed insurrection. I don't see it happening.

 

[ziggy29]

also, pretax accounts are a great way to convert qualified dividend income to regular income rates. no bueno.

Not if it's a Roth IRA. (I think the Roth IRA deal may go away in the future but I don't expect it to include retroactively causing existing balances to be taxed on withdrawal.)

In a traditional IRA this may be true. This is why many people prefer to overweight their tax-deferred retirement portfolios (i.e. TIRAs, 401Ks, 403Bs) with fixed income and REITs, and do more stock investing in the taxable and Roth space -- so as not to convert long-term capital gains and dividend income into ordinary income.

As for the lowest rates last decade, that may well be true but if I have (say) $150K in income today but expect to have $50K (in today's dollars) of taxable income when I retire, even if taxes in general are higher you're still in a lower bracket (i.e. today's 15% versus today's 28%). Even if those brackets became 20% and 33% in the future you're still paying 20% later instead of 28% today.

Also keep in mind that many 401Ks receive "free money" in a company match. My employer matches dollar for dollar on the first 5% of salary, and that can overcome a lot of tax inefficiency.

 

[aaronc879]

pretax accounts are a great way to convert qualified dividend income to regular income rates. no bueno.

I can maybe see your point if you're near the end of your working life. If you're a younger worker then i'm quite sure that deferring the taxes for a couple of decades is far better than paying taxes every year. With a 401K and the company match that usually goes along with it, I think pretax is always a good choice.

 

[endthefed]

2 reasons I like pretax savings:

1) I am currently in the 35% (soon to be 39.6%) tax bracket and I save a lot of money on taxes by contributing to a 401K (can't contribute to IRAs anymore). It is very unlikely that my tax rate will be anywhere near 40% in retirement, even if income tax rates go up dramatically form here, so I should see a net positive.

2) Asset protection. Most tax-deferred accounts enjoy some form of creditor protection at the federal or state level.

the creditor protection is valuable. thanks for the tip.

 

[kyounge1956]

can someone please explain to me the benefit of pretax saving? pretax 401k, ira, 403b, etc...

the negatives seem to outweigh the positives imo.

IMO, one of the big positives is the early withdrawal penalties. I think a lot of people find it an irresistible temptation to have a large sum of money sitting there whispering "spend me, spend me" in their ear all the time. Knowing they will have to pay full taxes plus a ten percent penalty if they listen to the voices is an incentive to leave the money alone so it will be there when needed later in life. From what I've read, even with the incentive, all too many people succumb to temptation and spend the money in their 401k when switching jobs, instead of rolling it over to the new employer's plan or a personal IRA. It's easy to say "they should have enough self-discipline to save as needed without hand-holding", and maybe they should—but a lot of people don't.

Math is not my strongest point but I think in addition to the psychological aspect, tax deferral provides a sort of front end boost to the savings. Right now I am maxing out my tax deferred plan at work. To put $22K into my retirement account, I only have to earn $22K, but to put $22K into a taxable acccount, I'd have to earn $27,500. I can make it on my salary less $22K, but it's a near thing sometimes. I don't think salary-less-$27,500 would cover all expenses. I'd have to reduce my savings level if it was all going into a taxable account. That would delay my retirement date, as would the reduction in portfolio growth resulting from paying taxes on each year's earnings rather than later. I think I gain in terms of time (reducing the number of years it takes to save the required amount), even if my tax rate in retirement is the same as while working.

Will you explain the negatives of tax-deferred savings for retirement and education? What's not to like?

I notice while I was writing this you added a comment about tax deferred accounts turning dividends into ordinary income. To me this (and the potential for tax-loss harvesting which is also lacking in a tax-deferred account) seems an argument in favor of having both types of accounts, not a reason to omit the tax-deferred in favor of taxable.

 

[MichaelB]

Pretax saving and investing are also a way to get the federal gov’t to share some of the pain. Investments losses are shared at ordinary income rates, while after tax losses are treated at capital gains rates.

Tax deferred income is much easier to invest – no need to worry about taxable events and taxable income.

When your marginal tax rate is close to investment tax rates it doesn’t make so much sense to defer – better Roth type. When your marginal income rate is twice or more the capital gains rate, the math is compelling. Take the tax money, defer it, then invest it. Watch it grow. Then pay the tax and keep the rest. And if it doesn’t grow (and it wouldn’t have in a taxable account either) the gov’t is the big loser – it collects tax at lower future value.

 

[endthefed]

thanks for the many great replies.

a pretax account with a roth account seems ideal. that way you can manage your withdrawals with respect to tax bracket issues - hopefully only withdrawing enough pretax to be in the zero or lowest bracket.

the fact that i have a partner inside the account bothers me. and that partner has the power to change their take.

if i put $1 pretax into a pretax account - and then grow it to $1 million, my partner's share has grown from 30 cents to $300,000 - on the blood sweat and tears of my investment efforts. it just doesnt feel right. i guess it would be much the same if i had it in a taxable account.

seems the positives are #1 assumption of lower tax bracket and #2 creditor protection.

the negatives - penalty for withdrawals, the low 72t calculations, and the potential for the partner to increase his take

 

[growing_older]

While I am working (now) I am making a lot more money than I actually need to live on. I save as much as I can and as much of that in tax deferred (even pretax) savings as possible. I do expect tax rates to rise in the future, but they would have to go up a great deal for the future tax on my future income to be anywhere near the tax I can avoid paying now if I took the current income. If I do succeed in ER, then I will have some years when my work income will be zero, I will not yet be taking Social Security and I will be living off my portfolio. If I can keep as much of that tax advantaged as I can, then I can control how much income I allow to be subject to tax and can arrange my affairs to take as much advantage of the (future) tax brackets as possible. Maybe I can manage to join the 47% who pay no income tax, or if not that then at least pay at the lowest brackets. My actual expenses and needs are very modest, so I think there is a good opportunity to arbitrage current (high bracket, albeit historically low rates) tax costs against future tax obligations (expected to be lower bracket, even if rates in general rise considerably).

With any "future" tax planning, I am taking a risk that future rules will wipe out any advantage I think I am planning to get, but that is always true. It seems to me, that for my situation, using pretax savings now is the best available option to try to reduce the lifetime tax bite and maximize the value I retain to use as I want. There is a large margin of error that allows this to still be true, even if rates rise. In the unlikely event that rates rise much more than I expect or current tax policies are replaced with a completely new system, then I will have made a sub-optimal choice, but I think those scenarios are very very unlikely. I have to take my chances on something. This seems my best option available.

 

[MichaelB]

thanks for the many great replies.

a pretax account with a roth account seems ideal. that way you can manage your withdrawals with respect to tax bracket issues - hopefully only withdrawing enough pretax to be in the zero or lowest bracket.

the fact that i have a partner inside the account bothers me. and that partner has the power to change their take.

if i put $1 pretax into a pretax account - and then grow it to $1 million, my partner's share has grown from 30 cents to $300,000 - on the blood sweat and tears of my investment efforts. it just doesnt feel right. i guess it would be much the same if i had it in a taxable account.

seems the positives are #1 assumption of lower tax bracket and #2 creditor protection.

the negatives - penalty for withdrawals, the low 72t calculations, and the potential for the partner to increase his take

But if you invested after tax you only had $0.70 to invest, because you had to pay tax first, and the $0.7 grows to $700K. So it's pay now or pay later.

Edit - the difference is - you pay tax now regardless or you pay tax later only if you were successful.
You choose.

 

[Hamlet]

Bingo. Most people in the asset accumulation phase have pretty high realized incomes that get taxed at a high rate.

In retirement, those incomes are likely to be a lot lower.

In my case, my wife and I would be paying 28% marginal rates currently (plus a pretty high rate for Minnesota income taxes).

In retirement, I would expect us to be able to stay in the 15% bracket most of the time. Granted, this is assuming no massive changes to the tax code. A raise in rates down the road could hurt this plan, but I would be surprised if the rates on the lower incomes doubled from where they are today. Given the political realities, I would expect higher rates in the future for everyone, but I also expect that the higher incomes will face the steepest increases.

Add in the fact that we get a sizable match from our employers, and that lowering our gross incomes assures us of being able to use Roth IRAs, and it becomes a pretty good deal.

2 reasons I like pretax savings:

1) I am currently in the 35% (soon to be 39.6%) tax bracket and I save a lot of money on taxes by contributing to a 401K (can't contribute to IRAs anymore). It is very unlikely that my tax rate will be anywhere near 40% in retirement, even if income tax rates go up dramatically form here, so I should see a net positive.

2) Asset protection. Most tax-deferred accounts enjoy some form of creditor protection at the federal or state level.

 

[LARS]

can someone please explain to me the benefit of pretax saving? pretax 401k, ira, 403b, etc...

the negatives seem to outweigh the positives imo.

I think it is actually pretty simple... the beauty of COMPOUNDING.

 

[Bestwifeever]

I agree with Lars--all of our money was in pretax 401K and it all grew to a much larger sum in compounding and reinvesting; and our tax rate now is so much lower than it was while working.

It's really very simple, I'm surprised anyone doesn't understand it.

 

[kyounge1956]

thanks for the many great replies.

a pretax account with a roth account seems ideal. that way you can manage your withdrawals with respect to tax bracket issues - hopefully only withdrawing enough pretax to be in the zero or lowest bracket.

the fact that i have a partner inside the account bothers me. and that partner has the power to change their take.

if i put $1 pretax into a pretax account - and then grow it to $1 million, my partner's share has grown from 30 cents to $300,000 - on the blood sweat and tears of my investment efforts. it just doesnt feel right. i guess it would be much the same if i had it in a taxable account.

seems the positives are #1 assumption of lower tax bracket and #2 creditor protection.

the negatives - penalty for withdrawals, the low 72t calculations, and the potential for the partner to increase his take

It would be just as easy, if not easier, for Uncle Sam to change the take on your taxable account as on the tax deferred. In your eyes, the growth is blood sweat and tears regardless of which account it's in, isn't it? But possibly in the eyes of the electorate, it is "unearned income of some rich guy" in your taxable account, but "hard-earned retirement savings of someone just like me" in your IRA. Which one do you think is the more attractive tax target for legislators? Which account could they raise the taxes on with less damage to their chances of getting re-elected?

I agree pre-tax plus Roth is a good combination. I doubt that anyone likes to pay taxes, but having both kinds of accounts at least lets you choose when to pay the taxes, to your best advantage. Pay beforehand, pay afterwards or pay now to convert from one to the other. Add in a taxable account and you have even more flexibility.

 

[endthefed]

I think it is actually pretty simple... the beauty of COMPOUNDING.

the tax bill is compounding too. this leads a lot of people to think they have more money than they do. and they head back to work after this slaps them in the face. i've seen quite a few boomerang retirements at my workplace.

 

[Nords]

Not if it's a Roth IRA. (I think the Roth IRA deal may go away in the future but I don't expect it to include retroactively causing existing balances to be taxed on withdrawal.)
In a traditional IRA this may be true. This is why many people prefer to overweight their tax-deferred retirement portfolios (i.e. TIRAs, 401Ks, 403Bs) with fixed income and REITs, and do more stock investing in the taxable and Roth space -- so as not to convert long-term capital gains and dividend income into ordinary income.
As for the lowest rates last decade, that may well be true but if I have (say) $150K in income today but expect to have $50K (in today's dollars) of taxable income when I retire, even if taxes in general are higher you're still in a lower bracket (i.e. today's 15% versus today's 28%). Even if those brackets became 20% and 33% in the future you're still paying 20% later instead of 28% today.
Also keep in mind that many 401Ks receive "free money" in a company match. My employer matches dollar for dollar on the first 5% of salary, and that can overcome a lot of tax inefficiency.

IMO, one of the big positives is the early withdrawal penalties. I think a lot of people find it an irresistible temptation to have a large sum of money sitting there whispering "spend me, spend me" in their ear all the time. Knowing they will have to pay full taxes plus a ten percent penalty if they listen to the voices is an incentive to leave the money alone so it will be there when needed later in life.

Not only is tax-deferred compounding a good deal, but with the right conversion planning a tax-deferred account can be cheaply converted to a tax-free account.

The only way to avoid (not evade) taxes in a taxable account is to be highly tax efficient. Some mutual funds can achieve that (at a price) but the only other real tax-efficient alternative would be holding stock shares for decades. Even that's not as assured as a tax-deferred account.

I really appreciate the ability to make the assets inconvenient (but not impossible) to access before 59.5. Can't do that with an annuity or a pension.

I'm willing to trade some political risk for lower expenses. Did I mention that the govt-sponsored TSP has the nation's lowest expense ratios?

 

[easysurfer]

can someone please explain to me the benefit of pretax saving? pretax 401k, ira, 403b, etc...

the negatives seem to outweigh the positives imo.

I have trouble seeing the negatives.

What I see is avoid (defer) paying early on, pay (maybe) later on. What's so bad about that?

I guess the negative for those who believe money in the bank is money wasted, is early on that money is invested in a 401K, etc. instead of burning a hole in the pocket and being spent

 

[endthefed]

a huge negative for me is the 55 or 59.5 age requirement on pretax accounts. the 72t is of little value as long as the fed maintains the ridiculously low interest rates.

at least in a roth you can withdraw contributions without being a member of aarp.

we have a roth 401k at my work - so far that looks pretty good - my contribution money is roth, the company match is pretax.

 

[endthefed]

Not only is tax-deferred compounding a good deal, but with the right conversion planning a tax-deferred account can be cheaply converted to a tax-free account.

The only way to avoid (not evade) taxes in a taxable account is to be highly tax efficient. Some mutual funds can achieve that (at a price) but the only other real tax-efficient alternative would be holding stock shares for decades. Even that's not as assured as a tax-deferred account.

I really appreciate the ability to make the assets inconvenient (but not impossible) to access before 59.5. Can't do that with an annuity or a pension.

I'm willing to trade some political risk for lower expenses. Did I mention that the govt-sponsored TSP has the nation's lowest expense ratios?

i think my plan's expense ratios might give you a run for your money. i'm assuming you have index funds? ours makes vanguard's look expensive.

 

[kaneohe]

the tax bill is compounding too. this leads a lot of people to think they have more money than they do. and they head back to work after this slaps them in the face. i've seen quite a few boomerang retirements at my workplace.

Seems like you are focusing on the amount of tax you pay when what really matters is what you have left after taxes. If you start with $1 in tax deferred account and grow it to $1M and pay 30% in taxes, you end up with 700K.
If you pay the 30% upfront, and start w/ 0.70, in an ideal situation (no taxes) you would grow the 0.70 to 700K. However you would owe taxes on the 700K growth (either at the end or along the way), so although you would pay less in taxes, you would also end up with less than in the tax deferred case.
Looks like a win-win (you, Uncle) or a lose-lose......but you're in the same boat.