401K vs taxable savings

[sophie]

There have been several posts on the relative merits of taxable vs tax-deferred savings, and I thought this topic deserved its own thread.  

Time for some back of the envelope calculations.  Let's start with these assumptions:

Current age 40
Current tax bracket 28% Federal, 5% state
Current capital gains tax rate 15% federal, 5% state (let's assume no fiscal cliff, for now)
Post-retirement tax bracket 15% Federal, 5% state
Post-retirement capital gains tax rate 0% Federal, 5% state

Thus, money you sock into a 401K gets an immediate 33% return.  With taxable savings, you have to pay that 33% and also taxes on the interest and dividends (ignore rebalancing, commissions etc).  Let's assume the PP returns 2% per year in the form of interest and dividends.  The interest is exempt from state taxes, and let's assume that the rest is ordinary dividends.  Assuming the returns are 2/3 interest and 1/3 dividends, taxes decrease the annual return by 0.6%.

If you invest $10,000 now, and assume a 7.5% CAGR for 20 years:
401K: $44,865
Taxable savings: $26,659

Let's say you now want to withdraw the entire amount.  After taxes, you'll end up with:
401K: $35,892
Taxable: $25,326

So the 401K wins handily.  This proved to be the case even after reducing returns to account for the higher expenses in many 401K plans, and shortening the time horizon.  And it is still true even if you withdraw early and pay the 10% penalty.

I suggest running some numbers for your particular situation, but I suspect most of us will find that maxing out the 401K, even if planning an early retirement, is still the best option.  Pity, because it would have been very nice to justify keeping full control over that money.

[amp]

I think it's a pity that we've made our lives so complex and confusing by creating all sorts of different retirement, education, health savings plans/accounts.  Sure, I'm taking advantage of them, but regret all of the time I've killed figuring out what works for my particular situation.  In the end, the government hasn't adjusted it's spending to accommodate the lowered current taxes, so they have to make it up somewhere else (e.g. higher rates on taxable income, more variety of taxes, more borrowing... higher future taxes).

So, where did all of these different savings schemes come from?  Was it the financial services industry that introduced them?  Was it the social engineers on the Hill?

[Gosso]

And it is still true even if you withdraw early and pay the 10% penalty.

Don't you get this back when you file next years tax return?  So it's not really a "penalty" but is rather applied to potential future taxes.

The rest of your math looks correct.  Essentially by using the 401K we are borrowing money from the government (free of charge) by delaying our tax payments.  Plus the added bonus of falling to a lower tax bracket during retirement makes the 401K a great deal.

[WildAboutHarry]

I suggest running some numbers for your particular situation, but I suspect most of us will find that maxing out the 401K, even if planning an early retirement, is still the best option.  Pity, because it would have been very nice to justify keeping full control over that money.

I agree about maximizing the 401(k), although it is useful to balance that with some after-tax investing.

Did you consider the standard deduction/personal exemption in your after-tax calcs?  It doesn't appear so.  You get a tax-free chunk of change (the withdrawals offset by deductions/exemptions) before you have to start paying taxes on withdrawals from tax-deferred accounts.  And if the 10% bracket survives, that reduces the tax bite further, depending on your total annual retirement income.

Living in a state with state income taxes really boosts the advantages of tax-deferred savings, especially if you were to retire in a no-state-tax state.  But the Roth versions will not make as much sense if you are currently living in a state-tax state but plan on retiring in a non-state-tax state.

[Pointedstick]

Thanks for the math sophie. I came to the same conclusion when I ran these numbers. The 401k is an especially good deal if you're in a high tax bracket, live in a high-tax state, and plan to lower both of those in retirement. To me, the harder question is the utility of the Roth IRA.

It really heavily depends on your situation! If you're planning to retire to a state with no income tax with a low enough income that you're in the 10 or 15% bracket, then the only advantage to using a Roth is that while you're above the 15% bracket and live in a state with income taxes, rebalancing and other inter-account selling is less of a hassle and interest and dividends are tax free. But you give up a lot of the flexibility of a taxable account, and selling early outside of the few narrowly-defined exemptions imposes a real whopper of a tax hit. If today you're in or under the 15% bracket and live in a no income tax state, then there's currently no benefit to a Roth.

Personally, as someone who plans early retirement, has a high current tax bracket, and lives in a high tax state (CA, ugh), it was a no-brainer to max out my 401k, especially since the SEPP method for getting out early without penalties actually looks reasonable feasible.

But I'm more torn about my wife and my Roth IRAs. We still contribute, but I'll admit we're not maxing them out anymore, and I can't get rid of that nagging feeling that we should sink the money into the more flexible taxable PP instead.

[WildAboutHarry]

But I'm more torn about my wife and my Roth IRAs. We still contribute, but I'll admit we're not maxing them out anymore, and I can't get rid of that nagging feeling that we should sink the money into the more flexible taxable PP instead.

I also live in CA but will retire to a no-state-tax state.  We funded Roth 401(k)s for a short while, but only for tax diversification purposes, and do the regular Roths occasionally for the same purpose.  As you mentioned, it really makes less sense in CA to fund a Roth.  And don't get me started on HSAs

I-Bonds offer a pretty good taxable investment masquerading as a tax-deferred investment.

Of course there is always the ticking time bomb of RMDs.  If you are fortunate enough to have a large 401(k)/Regular IRA balance at 70 1/2, RMDs can really generate killer taxes.  A nice problem to have, but it also suggests considering withdrawing from 401(k)/Regular IRA accounts first, doing Roth conversions along the way (filling out the bracket), and minimizing RMDs later.

[notsheigetz]

Post-retirement tax bracket 15% Federal, 5% state
Post-retirement capital gains tax rate 0% Federal, 5% state

For the average person I think you are probably 100 percent correct about 401k's but for diligent savers with above average incomes there may be some caveats.

I recently read an interesting book called "The Retirement Savings Time Bomb" that gave some interesting anecdotes about people who made the assumption that they would be in a in a lower tax bracket upon retirement and turned out to be very wrong. In fact, some things people do to make their retirement more secure, like paying off the mortgage, actually work against them when it comes to taxes. And obviously the more you sock away in the 401k and the better the investments contained therein perform, the more you run the risk of putting yourself in a higher bracket when MRD time comes around. Delay SS payments until age 70 1/2 to get the maximum benefit (85% taxable), at the same time that MRDs begin and you might even be closer to discovering that the government giveth and the government taketh away.

Throw into all the above a younger wife still working and entering her peak earnings years as a medical professional at the same time as I am retiring and you have my fast approaching situation. And why I'm putting some money into Roth accounts.

[moda0306]

Careful with what you assume tax brackets are in retirement.  When social security starts phasing into taxable income, there's a relatively broad swath of income where you aren't really in the 15% bracket but more like the 28%.  It's especially difficult to avoid once you have to start taking RMDs.

[Tortoise]

When my company first started allowing Roth contributions in our 401(k) plan a couple of years ago, I switched over from 100% tax-deferred contributions to 100% Roth contributions.

I had always read (and reasoned) that Roth is a better deal since it's more like a "sure thing." You pay a known, fixed amount of tax on the contribution up front and then never again have to pay tax on that money or its earnings. By contrast, with tax-deferred contributions there's a big question mark hanging over the situation. You get the tax break up front, but nobody knows for sure what their tax bracket will be in retirement--mostly because it depends heavily on the actions of politicians. If anything, you'll probably pay higher taxes in retirement than you anticipated decades earlier. The reality just seems to be that taxes steadily go up, not down, over time.

However, after reading this thread I'm starting to reconsider the wisdom of my 100% Roth approach. It's very difficult to predict what the future holds, so maybe the best approach for someone like me who has no desire to try is simply to split my 401(k) contributions 50/50 between Roth and tax-deferred. That way at least I'd be hedging my bets, kind of like the simple and agnostic 4x25% allocation of the HBPP.

What do some of you think? Would a 50/50 split between Roth and tax-deferred 401(k) contributions be a reasonable, agnostic compromise instead of doing 100% of one or the other type of contribution? (I live in CA.)

God, I hate the labyrinthine U.S. income tax code...

[sophie]

Interestingly, even if you retire to a no-tax state, the 401K math doesn't change much.  And you may actually be worse off because of higher sales and property taxes.  If course, here in NY (similar to CA), you get the pleasure of all of the above.

If today you're in or under the 15% bracket and live in a no income tax state, then there's currently no benefit to a Roth.

But I'm more torn about my wife and my Roth IRAs. We still contribute, but I'll admit we're not maxing them out anymore, and I can't get rid of that nagging feeling that we should sink the money into the more flexible taxable PP instead.

I am as well, for precisely the same reasons.  >90% of the advantage of the 401K is that immediate boost to the investment balance from the tax deferral, and you lose that with the Roth.  So you're tying up your money with very little to show for it (0.6% cagr plus a bit of savings on capital gains tax).  I still plan to contribute to the Roth but no more than 1/4 of after-tax savings.

The real solution is to get the Fair Tax passed.  What a magic bullet that would be!  All retirement accounts and the associated paperwork and complications would just go away.  Well, maybe not entirely because there is still state tax to deal with.

[WildAboutHarry]

What do some of you think? Would a 50/50 split between Roth and tax-deferred 401(k) contributions be a reasonable, agnostic compromise instead of doing 100% of one or the other type of contribution? (I live in CA.)

That is kind of sort of what we did.  A few years regular 401(k), a couple of years Roth 401(k), then repeat.  Of course 401(k) matching, etc. always goes in as tax-deferred.  Our Roth to Regular ratio is currently about 1:3

Interestingly, even if you retire to a no-tax state, the 401K math doesn't change much.  And you may actually be worse off because of higher sales and property taxes.  If course, here in NY (similar to CA), you get the pleasure of all of the above.

Probably true for most states, but CA has a 9.3% maximum state income tax rate and, as you mention, high sales taxes, etc.  So each 401(k) dollar "earns" a 9.3% rate of return going in, and would lose 0% state tax going out.  It would take a ferocious differential between the 9.3% CA rates and higher sales/property tax to negate that benefit.

[Pointedstick]

The real solution is to get the Fair Tax passed.  What a magic bullet that would be!  All retirement accounts and the associated paperwork and complications would just go away.  Well, maybe not entirely because there is still state tax to deal with.

I have to say, I agree. I'm no fan of slapping a massive federal sales tax on top of state sales taxes, but at least it would be simple. And with something simple, broad, and virtually impossible to evade, you wouldn't need to waste time and money trying to game the system like we're all sitting around doing here. Not to mention the huge mess of deductions just flits away! There goes a ton of tax evasion right there.

The FairTax has an implementation of stone's highly-desired citizen's dividend, too. 

What do some of you think? Would a 50/50 split between Roth and tax-deferred 401(k) contributions be a reasonable, agnostic compromise instead of doing 100% of one or the other type of contribution? (I live in CA.)

That seems sensible, although a 50/50 split is a bit too much Roth for me. I still contribute to the Roth IRAs, but I'm starting to consider it a form of hypertaxation insurance more than an actual investment. In case future Congresscritters raise taxes a bunch, at least I have my tax-free Roth. Then again they could easily strip that benefit too but I guess in theory they could probably do anything they wanted. At some point, you just have to accept a level of worry you're comfortable with I suppose.

[MachineGhost]

I suggest running some numbers for your particular situation, but I suspect most of us will find that maxing out the 401K, even if planning an early retirement, is still the best option.  Pity, because it would have been very nice to justify keeping full control over that money.

You can keep full control by rolling it into a Solo Roth 401(k).

[MachineGhost]

That seems sensible, although a 50/50 split is a bit too much Roth for me. I still contribute to the Roth IRAs, but I'm starting to consider it a form of hypertaxation insurance more than an actual investment. In case future Congresscritters raise taxes a bunch, at least I have my tax-free Roth. Then again they could easily strip that benefit too but I guess in theory they could probably do anything they wanted. At some point, you just have to accept a level of worry you're comfortable with I suppose.

I think it is reasonably safe to assume that in the future sales tax-free states will implement a sales tax (Oregon is already trying) and federal income taxes will go up, not necessarily marginal rates, but extraneous, surtaxes like the 2% or so Medicare tax under Obamacare.

There's also the consideration of actually living outside the country in low-tax Central or South America, where it costs a lot less to live and quality of life can be higher.  A lot of baby boomers are just not going to be able to afford to retire in the USA (or want to continue to live in suburban hell).  When inflation hits double digits by the end of the decade, it may become an exodus.

[Gosso]

And it is still true even if you withdraw early and pay the 10% penalty.

Don't you get this back when you file next years tax return?  So it's not really a "penalty" but is rather applied to potential future taxes.

No. If you are under 59.5 years old, unless you take withdrawals as 'substantially equal payments' over your actuarial life span [5 year minimum, I believe], there is a non-refundable 10% penalty tax.

Shitty.  I figured it was the same in both Canada and the US, since in Canada many people assume that the withholding tax is an additional penalty, but is rather a pre-payment of taxes (in case they decide to leave the country or something).

[AgAuMoney]

Current tax bracket 28% Federal, 5% state
Current capital gains tax rate 15% federal, 5% state (let's assume no fiscal cliff, for now)
Post-retirement tax bracket 15% Federal, 5% state
Post-retirement capital gains tax rate 0% Federal, 5% state
...
So the 401K wins handily.

Of course it does.  The only factor that matters is the tax rates and you rigged those.  If you assume a lower tax rate when it comes out of the 401(k), the 401(k) will win.  If you assume a higher tax rate it will lose.  The same tax rate will tie.  (The comparison gets really complicated if you try the model the real world with constantly changing rates.)

Now think about it...  Current tax rates are historical lows.

I personally will not stake my entire retirement on tax rates being even lower in 25 years.  (not to mention other factors which currently reduce my effective rate.)

[AgAuMoney]

What do some of you think? Would a 50/50 split between Roth and tax-deferred 401(k) contributions be a reasonable, agnostic compromise instead of doing 100% of one or the other type of contribution? (I live in CA.)

God, I hate the labyrinthine U.S. income tax code...

Me too.  My wife started doing our taxes a few years ago because she didn't like how steamed I get dealing them.

I recommend you diversify your assets in all three tax classifications:  taxable, tax deferred and tax-free (Roth).  Currently I have 40% tax deferred and only 26% Roth and 34% taxable but no additional tax deferred is in the forecast.

[AgAuMoney]

The real solution is to get the Fair Tax passed.  What a magic bullet that would be!  All retirement accounts and the associated paperwork and complications would just go away.  Well, maybe not entirely because there is still state tax to deal with.

YES!!!

(And I expect states would mostly follow because it would be a complete rework for most of them if the federal income tax paperwork was no longer available for them to base upon.)

[notsheigetz]

No. If you are under 59.5 years old, unless you take withdrawals as 'substantially equal payments' over your actuarial life span [5 year minimum, I believe], there is a non-refundable 10% penalty tax.

I can confirm this to be true because I had to pay it once. When my first wife died and I needed to take some time off I withdrew enough money to live on for a year. As things turned out I think the only federal tax I paid that year was the 10 percent penalty.

[moda0306]

I don't see how the fair tax would be any simpler.  I've seen complexities with sales tax and they can be mind boggling in ways that income tax isn't really all that complicated.  I haven't read the book, though... though I am a tax accountant and see little value in it.

[sophie]

Current tax bracket 28% Federal, 5% state
Current capital gains tax rate 15% federal, 5% state (let's assume no fiscal cliff, for now)
Post-retirement tax bracket 15% Federal, 5% state
Post-retirement capital gains tax rate 0% Federal, 5% state
...
So the 401K wins handily.

Of course it does.  The only factor that matters is the tax rates and you rigged those.  If you assume a lower tax rate when it comes out of the 401(k), the 401(k) will win.  If you assume a higher tax rate it will lose.  The same tax rate will tie.  (The comparison gets really complicated if you try the model the real world with constantly changing rates.)

Now think about it...  Current tax rates are historical lows.

I personally will not stake my entire retirement on tax rates being even lower in 25 years.  (not to mention other factors which currently reduce my effective rate.)

Actually, if you go back and do the numbers assuming a higher tax bracket post-retirement, up to 40% even, the 401K still wins.  In reality, the rates would be graduated and you wouldn't pay that on the entire amount.

I also expect taxes to go up, but I'm not sure what form they'll take.  The worst that could happen is the government's equivalent of a hot potato game:  federal tax stays low, shifting more cost to the states.  Those guys have to get elected, and nobody likes a congressperson who votes to raise taxes. State tax stays low for the same reasons, shifting more cost to the municipalities.  End result: local taxes (income, sales, property, tolls etc) go through the roof.  That's what's been happening, in fact.  Since this is hardest on retirees, if I were you I'd want federal tax rates to increase.

[sophie]

I don't see how the fair tax would be any simpler.  I've seen complexities with sales tax and they can be mind boggling in ways that income tax isn't really all that complicated.  I haven't read the book, though... though I am a tax accountant and see little value in it.

There's a website (fairtax.org).  They've thought of a few potential complications, but there are clearly going to be more, like people ordering stuff from Canada, whether U.S. citizens who are nonresidents should get the prebate, how expensive it will be to send out all those prebate checks, and what the effect of the tax will be on consumption.  My favorite part about it is that it will capture a lot of the underground economy, painlessly.  What complications do you foresee, as a tax accountant?

[moda0306]

sophie,

Simply, what does the tax apply to?  Consumption of goods?  What about services?  What about goods used to produce other goods?  What about long-lived assets?  Why should a bike be subject to tax when I can buy a house without paying the tax (directly)?  What is the philisophical/functional basis of having some things and not others subject to the tax?

I hate sales tax... mostly because I don't understand it as well... maybe that's why I'm so against the fair tax .

[Pointedstick]

As I understand it:

Simply, what does the tax apply to?  Consumption of goods?

Yep.

What about services?

As I understand it, yes.

What about goods used to produce other goods?

Intermediate goods sold B2B are exempt. Only new goods sold at retail.

What about long-lived assets?  Why should a bike be subject to tax when I can buy a house without paying the tax (directly)?

Houses are subject to the tax. But only new houses. Used houses, like all used goods, are not subject to it. Not sure how the new-vs-used thing affects land. Can you really call a plot of land "new" or "used"?

What is the philisophical/functional basis of having some things and not others subject to the tax?

Meh, IMHO all taxes are based on the philosophy of "I want it, gimmie!"

[moda0306]

They'd move to Fair Tax Compliance instead of Income Tax Compliance.  Accountants are spending a HUGE amount of time on state-by-state sales tax analysese.  It's not all that simple.  Heck, a flat income tax would still have questions as to "what constitutes income," just as sales tax would have the question "what constitutes a taxable sale."

I guarantee you it's really not "simple," and probably not all that "fair."

I tend to think that a lot of what complicates the tax code is simply the fact that our lives & contracts are complicated, and the tax code has to decide what constitutes "income" or a taxable event.