Have you ever read an enrollment book for your 401k? A lot of them show examples of how much ‘tax savings’ you can get by investing in your 401k. They say that if you are in a 25% tax bracket that for every $100 you contribute you’ll pay $25 dollars less in taxes, right? Ever hear your account tell you that a strategy for paying less taxes is to max out IRA or 401k contributions? Do you believe these statements? Let’s look at it…
You’ve got an extra $10,000 you want to put away for retirement and you are trying to figure out whether to do all in your Traditional 401k or all in your Roth 401k and you are in a 25% tax bracket. You hear about this great ‘tax savings’ so you say…
Traditional 401k
You have $10,000 the full $10,000 goes into your Traditional 401k. So you’ve probably been told that you don’t pay taxes on the $10,000 so you’re saving $2,500 in taxes, right? To keep that math simple we’re going to use a 7% rate of return and the Rule of 72 let’s us estimate that it will double every 10 years. So in 10 years it doubles to $20,000; another 10 years and it’s $40,000; and the final 10 years and you have $80,000. Now your in a Traditional 401k so the growth is tax-deferred which means you don’t owe any taxes on the growth.
Now when you want to access the money in your Traditional 401k it’s fully taxable because you haven’t paid any taxes on it right? Right. So all things kept equal, you are still in the same 25% tax bracket because who wants to retire on less money. That means you owe $20,000 in taxes on your $80,000. So you only really have $60,000.
We forgot something, your ‘tax savings’. You’ve been a good boy and saved the $2,500 you were told you saved. So you put it into an investment and it got a 7% rate of return, so you’re doing awesome. It doubles, $5,000; doubles again, $10,000; then the final double, $20,000. Great so your laughing all the way to where ever you want as you go to cash in this investment. You are about to offset the taxes they say you owe and guess what? Your hit with capital gains (best case scenario) on your investment that you just sold off. Now today that’s 15%. So where do you come up with the money to pay the $3,000 capital gains tax bill? You now have $17,000 to pay a $20,000 tax bill.
Where’s your ‘tax savings’?
To Be Continued…
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{ 2 comments… read them below or add one }
Um, no.
The 2500 you put aside to save for taxes would typically get taxed ANNUALLY. So, the 7% on the money outside of your 401k is generally going to be lower than the money in the 401k.
For example, let’s say you buy a bond, with a 7% yield… some of that yield is going to come to you as interest payments, and interest payments are TAXABLE ANNUALLY on your 1040.
Oh, it’s a stock… with no dividends?
Mutual fund? both div’s and cap-gains.
So, where do you pay the 20,ooo tax due on your 401k? Well, to start with, you do have 80,000 and/or you could take the money over time to get to a smaller tax bracket then the 25% you assumed — you can start taking the money after age 59.5 (in most cases) and aren’t FORCED (min required distributions) to take anything until the year you turn 70.
Why are you so opposed to 401k’s?
Paul:
I was trying to create a best case scenario for the money put aside so I figured it would be invested and held for duration then sold off at the capital gains tax rate of 15%. That’s best case. As you point out it can get a lot more complicated than that and face a lot higher tax rates.
You are also correct that you can take money out over time to control taxes. The point is to compare a Roth vs Traditional 401k. I ‘m not opposed to 401ks at all everyone should have one and make sure they are taking advantage of them. The point of this post is to show that a Traditional 401k doesn’t give you some hidden tax savings versus other types of investing, including a Roth 401k.
@EvolutionWealth
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