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Is a 401k Plan Really a Great Deal?

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A disclosure before I start... I have maxed out my 401k plan whenever given the opportunity to do so.  Recently, I put 75% of my paycheck towards it because I knew I was going to a new job that might not have a 401k plan.

The other day I realized that if I continued this for the next 35 years, I might have a huge nest egg in there.  What would happen if I had so much that withdrawing it would put me in a higher tax bracket that I'm in now?  I know it sounds like an extraordinary good "problem" to have - and I won't be complaining.  Getting the tax-deferred gains would definitely be a benefit as well.  However, that's just a small amount of leverage, I'd still have to pay tax on the growth when it comes out.

I think it gets confusing because now it feels like I'm escaping taxes forever.  However, down the line there will be a piper to pay.  I wish there were a way to know if that piper would be charging more or less then.

(As a post script, I max out my Roth IRA as well.  Since I "pay that piper" now, I'm hedging my bets, that if he wants more in the future, I'm still doing okay.)

Posted on November 3, 2006.

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21 Responses to “Is a 401k Plan Really a Great Deal?”

  1. Single Ma says:

    You put 75% of your salary in a 401k? Isn’t the ’06 limit something like $15,000?

  2. Jeremy says:

    I help maintain a retirement plan for a company, and while it is a 403(b) the question is the same. I have people ask me about this issue quite often. They are concerned about possibly saving so much that they are hit hard in retirement.

    While it is possible, it isn’t as big of a problem as people first think. Thanks to the IRS we are required to take distributions when we turn 70.5, which is when people begin to fear the tax-man.

    But a quick example using an RMD calculator, let’s say you have a a combined qualified retirement savings of $2 million and it earns 8% a year. Even if you waited until you were 70.5 before taking your first distribution, your first year distribution would only be about 73k. It would increase a bit each year though, and if you only ever take out the minimum if you survive to be in your 90’s you could be forced to take upwards of 200k out per year.

    This is where a new stage of financial planning comes in handy. Building wealth is only one stage of planning, and learning how to structure your distributions through retirement can be even more important. It is possible to structure your distributions so that you can minimize taxes over the years and even begin to shift some of your distributions to tax-exempt investments early so you can pay taxes once, and then let them continue to produce income throughout your retirement tax free.

    So it is a valid concern, but we don’t even know what taxes will be 20, 30, or 40 years from now so it is hard to put too much worry into it at this point. As long as you have a plan in place when you retire for structuring your income you should end up benefiting by putting as much into these tax qualified accounts as you can.

  3. Sun says:

    I never thought about withdrawing because it seems too far, far away, but does the tax rate when withdrawing depend on how much you withdraw, rather than on the total amount you have? I think the former makes more sense and if that’s indeed the case, I won’t worry to much about withdraw. Besides, the tax-deferred growth accumulated over dozens of years definitely overweights the tax burden when it comes to withdraw, if it’s a burden at all.

  4. Jeremy says:

    Money you withdraw from a retirement account is taxed just as ordinary income. So if you were pulling 50k out of your 401k a year, that would be essentially the same as working somewhere and making 50k.

    It is only taxed as it is withdrawn, otherwise it continues to grow tax-deferred inside the account.

  5. Single Ma, well I’m counting May as “recent.” It was just for about three pay periods, which was all the notice I really had that my fiancee had a great job opportunity that would require relocation. I should have explained that better, but I had a post about it a couple of months ago, so I took the short-cut :-). I wanted to get as close to the $15,000 limit as possible.

  6. Jeremy, very good points. I realize it will be taxed as ordinary income, but as you say “we don’t even know what taxes will be 20, 30, or 40 years from now.” Maybe 73K will be a really high tax bracket.

    I agree with you about the tax planning though. I definitely need to look into it more in the future. To be honest, I used to be a software developer for a 401k company, so whenever the 401k advisors come to a company I work for, I give them a nice grilling ;-).

  7. I love my 401K. I consistently use it as a working capital fund. Where else can you get a loan where the interest expense is given back to you (deposited in your account).

    I also have used it twice to come up w/ 20% down payments on real estate. If you use the real estate option (401k) loan, you not only pay yourself in the interest, that interest is tax deductible too as a mortgage expense.

    Disclaimer: Always check w/ your accountant or IRS.gov before taking action on blog advice.

  8. Steve says:

    I think you’re playing your cards right. People often ask if they should be contributing to a tax-deferred account or post-tax contribution account. The answer is: both!

  9. Sun said, “Besides, the tax-deferred growth accumulated over dozens of years definitely overweights the tax burden when it comes to withdraw, if it’s a burden at all.”

    I guess that’s my question. If you look at the historical top tax rates at Truth and Politics, historically 35% looks like a low top tax rate. There have been times that it’s 70, 80, or even 91%. I know these are just top tax brackets, but I don’t have better data to me right now (I’ll have to research it some more), but if I were in the top tax bracket, I’d much rather pay the 35% now, than risk it being say 60% when I withdraw it. And yes, I might not be in the top tax bracket at that time.

    There are a lot of “ifs” here, but I want to point out that if tax rates were to rise, it might be an issue. There are numerous people crying foul at the disappearing pensions (which is a whole different can of worms). Thirty years from now will be crying foul about increased taxes then making the 401k a bad deal? Maybe there be some guarentee that the tax brackets for the money that you withdrawl would be the same as when you deposited it. On the other hand, maybe, I’m playing a bit too much of a Chicken Little here.

  10. Foobarista says:

    My take: avoid taxes now, and let the future bring what it will. Trying to manage around tax schedules in several decades requires a rather massive ability to predict the future. Many things can happen in the meantime: we could go to an all-consumption-tax strategy (ie, the “fair tax”), a flat tax, etc.

    If you’re really worried about this, you could plan to do a Roth rollover at some point in the future, unless you’re planning to be a “lifer” in your current company. I always roll over old 401Ks to traditional IRAs so I can manage them, and so I can do Roth rollovers when I get the chance.

  11. Foobarista, that’s solid advice and what I plan to do. I do have some old 401k’s that I need to move to IRAs, but I’m anxious to do it with Zecco, so that I can diversify into ETFs without a lot of trading commissions. I don’t really have a good reason for why I didn’t do it in the past.

    Yes, I could do a Roth rollover in the future and I actually probably will. This way I’ll be betting a little bit on the taxes of today vs. the taxes of tomorrow. I’d feel better if there was some kind of perfect solution though. It’s really does feel like “bet” and it’s not a small one either.

  12. Ralph Morgan says:

    I’d take any tax planning regarding what will apply in 20-30 years time with a pinch of salt anyhow – you never know what political changes will have happened in the meantime.

    Here is Oz they just changed the tax applying to personal retirement accounts (“superannuation”) – it used to be 15% tax on contributions, 15% on earnings, and 15% on withdrawals (above a $100K or so, threshold) during retirement. They’ve just SCRAPPED tax for retirees on superannuation withdrawals – so the tax rate on withdrawals is now 0%.

    Who knows, with the US looking at how to “reform” the unfunded social security system, similar changes could happen there in the next 10 years or so.


  13. Pete says:

    I am wondering if you are comparing how much you will be withdrawing to the current tax brackets. Note, as others said, we do not know what will happen, yet typically the income limits to the tax brackets will increase by inflation over time. Thus if the $74,200 upper limit for 25% single tax bracket will increase over time (e.g. to $300,000 in 40 years at 3.5% inflation).

    Plus, other than a Roth IRA, there is not much other options to defer income. Using regular post-tax investment vehicles can be worse because you are tax twice (now and then on income) rather than taxed once. See http://www.myfinancialawareness.com/Topics%20Financial/Power%20of%20401(k)%20and%20IRAs.htm
    for how the tax works.

  14. The US Government hasn’t always been quick to adjust things for inflation. I’m not sure about tax brackets, but it took awhile for them to increase the amount you can put in your 401k. I’m not seeing the amount you can put into a Roth IRA keep pace with inflation either.

    So yes while it will go up over time, that’s not really my concern. My concern is that relative dollars (those dollars in 25 years) will be taxed at a higher percentage than they are today. What if the today’s 25% tax bracket becomes tomorrow’s 50% tax bracket? If that happens I think I would prefer to pay the double tax with one being a small one than a huge one in the future.

    I realize the only other choice is the Roth IRA and I’m maxing that out as well. I figure by doing everything, I play the odds that things will work out.

  15. […] Lazy Man wonders if a 401K is a really good deal? […]

  16. Foobarista says:

    The main wrinkle in 401K planning taxwise is the difference between cap-gains and dividend tax rates and ordinary income rates. Since 401K withdrawals are taxed at ordinary income rates, you could get into a situation where you’re actually getting taxed higher on your stock and dividend profits by taking them out of a 401K versus taking them out of a simple taxable account.

    But, as I and others have said, the chances that all this moving tax machinery is relevant to you is pretty trivial: the chance that dividend and cap gain tax will survive at 15% until we retire is pretty darn remote. I expect it to either go to zero or to be ordinary income. (My preference is for capital gains tax to go away, for the corporate tax to go away, and for dividends to be taxed as ordinary income, assuming we don’t convert to a consumption tax.)

  17. Foobarista, the point about dividends is an excellent point that I didn’t think about.

    I think you also summarized what I suspected is really the case. It’s probably best to diversify your money in various different vehicles, 401k, Roth IRA, and even some taxable accounts, because it’s impossible to predict tax law. I haven’t heard that articulated in the past. Maybe it’s just an advanced concept and advisers are more focused on things like getting people to save and asset allocation. Not that those aren’t important – they are.

  18. Foobarista says:

    I think the problem with many advisers is many of them don’t know much about tax law, and those who do are more the “wealth manager” types and not typical “entry level” financial planners. It’s pretty hard to find financial planners that also give useful tax planning advice; in fact, they often run like heck away from the subject, probably because they don’t want to get sued for saying something wrong.

    Annoyingly, on the other side of the fence, accountants often know little about financial planning vehicles beyond what they need to know for tax preparation purposes. I had to teach my accountant about self-employed 401Ks since he had never head of them, and he’s otherwise a very experienced and skilled accountant with 35 years in the business.

  19. Tax Carnival #6: Decision 1040…

    E Day is almost here. E for election and E for electronic voting. I know I’ve been focusing on Nov. 7 recently (here and here, just in case you missed them), but voting is more than a right or a privilege. It’s a duty. It’s your country, your state,…

  20. […] Is a 401k Plan Really a Great Deal? […]

  21. Scott Brooks says:

    Having a blend between 401k & IRA (tax-deferred) money with Roth (tax-free) money makes sense. With the current state of fiscal affairs for the US…i dont see how tax rates go much lower from here.
    I read the average boom has less than $50k saved for retirement….when social security and medicare is underfunded more than 50 trillion.

    A big win for the Roth.

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