Maxing Out 401(k) Contributions

General Discussion on the Permanent Portfolio Strategy

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technovelist
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Re: Maxing Out 401(k) Contributions

Post by technovelist » Mon Sep 29, 2014 3:31 pm

sophie wrote: It was mostly a debate about bird in the hand vs future tax rate increases.

I've been thinking some more about thus, thus the desire to resurrect this thread.  There are definitely downsides to deferring:

- Essentially no access to your money until age 59.5 (a few exceptions + the 10% early withdrawal tax)
- The tax savings may turn out to be minimal or nonexistent even if tax rates don't increase.  If your marginal federal tax rate is 28%, you may drop your marginal tax rate only to 25% on retirement.  In exchange for that 3% benefit, you have agreed to have all earnings taxed as ordinary income, not at the dividend or capital gains rates.
- If tax rates increase you may come out worse on the deal.

The main benefit is allowing the gains to compound tax free, which wins out over the higher tax obligation at the other end.  This however requires that the money be left in the account for many years - probably 15-20 years at least - before you come out ahead.  (Requires some spreadsheet fiddling...can't do that right now, so let's call this X years.)

The other clear win is if you can take advantage of the 0-15% tax bracket space to move the money out.  After you start receiving Social Security, you will have very little space in that bracket, if anything.  So your only opportunity is after retirement and before age 67 or whenever you plan on taking SS, and you are limited to $36,900 per year after deductions and minus all other income.

So I would say that if you are confident you can let the money sit in the account for at least X years (see above) then by all means contribute the maximum.  However, if you anticipate wanting to access the money in less time than that, then you will want to figure how much "space" you have in that 0-15% tax bracket and limit your tax-deferred retirement accounts to that amount.    You may find that given your number for X, your maximum tax-deferred # might be pretty low!

I realize I've signed myself up for another excel session but have limited time right now, so I am hoping someone (Tyler??) can jump on it.
If you want to increase your 0-15% bracket space, you could always get married.  :P
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Re: Maxing Out 401(k) Contributions

Post by Xan » Mon Sep 29, 2014 10:47 pm

Sophie, I think you're understating the advantages of tax-deferral.  The concept of "over-deferring" is a fascinating one, and I do believe that it's possible, but deferring isn't as bad as you're making it seem.

First, the list of exceptions to the early withdrawal penalty is fairly substantial, and covers many of the scenarios where you might need the money, like disability and medical expenses, and even first-time home buying (not sure why that one's there...)
http://www.irs.gov/publications/p590/ch ... 1000230905

More importantly, I don't think that having all earnings taxed as ordinary income instead of capital gains is a bad thing.  Let's say you're 50, in the 28% bracket, and you retire at 70, still in the 28% bracket.  Let's say the PP (or whatever you're investing in) doubles in that time.

If you don't defer the taxes, then you pay $280,000 in taxes up front.  You're investing $720K.  You have $1.44M when you retire, at which point you pay $108K (15% of the $720K gain) in taxes.  You're left with $1.332M.

If you defer the money, then you're investing the whole $1M, you have $2M at age 70, and you pay 28% on it at that time.  You have $1.44M after taxes.  That's $108K more than the non-deferral scenario.  The difference is the capital gains taxes which you NEVER had to pay.

Apart from the issue of the rules changing, tax deferral can only make you better off.  It's not a matter of losing the sweet capital gains rate in exchange for a hopefully lower tax bracket; it's never having to pay capital gains taxes at all.

Also, the non-deferred scenario was a best-case presentation of no buying or selling (rebalancing) during the 20-year period.  You might have to pay capital gains taxes multiple times.
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Re: Maxing Out 401(k) Contributions

Post by moda0306 » Mon Sep 29, 2014 10:51 pm

Xan wrote: Sophie, I think you're understating the advantages of tax-deferral.  The concept of "over-deferring" is a fascinating one, and I do believe that it's possible, but deferring isn't as bad as you're making it seem.

First, the list of exceptions to the early withdrawal penalty is fairly substantial, and covers many of the scenarios where you might need the money, like disability and medical expenses, and even first-time home buying (not sure why that one's there...)
http://www.irs.gov/publications/p590/ch ... 1000230905

More importantly, I don't think that having all earnings taxed as ordinary income instead of capital gains is a bad thing.  Let's say you're 50, in the 28% bracket, and you retire at 70, still in the 28% bracket.  Let's say the PP (or whatever you're investing in) doubles in that time.

If you don't defer the taxes, then you pay $280,000 in taxes up front.  You're investing $720K.  You have $1.44M when you retire, at which point you pay $108K (15% of the $720K gain) in taxes.  You're left with $1.332M.

If you defer the money, then you're investing the whole $1M, you have $2M at age 70, and you pay 28% on it at that time.  You have $1.44M after taxes.  That's $108K more than the non-deferral scenario.  The difference is the capital gains taxes which you NEVER had to pay.

Apart from the issue of the rules changing, tax deferral can only make you better off.  It's not a matter of losing the sweet capital gains rate in exchange for a hopefully lower tax bracket; it's never having to pay capital gains taxes at all.

Also, the non-deferred scenario was a best-case presentation of no buying or selling (rebalancing) during the 20-year period.  You might have to pay capital gains taxes multiple times.
This.

Definitely build in some after-tax options such as Roth, but the combo of roth and traditional tax accounts are better than taxable accounts.
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Re: Maxing Out 401(k) Contributions

Post by WildAboutHarry » Tue Sep 30, 2014 9:12 am

Tax deferral is a wonderful gift.  I think it is a given that funding tax-deferred accounts to the maximum of your ability is the way to go, especially since you lose "deferral dollars" each year that you do not use them (i.e. there is no carry over).

One caveat is with a Roth or Roth 401(k).  If you live in a high state-tax state (like I do) and you intend to retire in a no-state-tax state (like I will) Roths do not make as much sense.
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Re: Maxing Out 401(k) Contributions

Post by dualstow » Tue Sep 30, 2014 9:34 am

williswine wrote: DualStow, Sophie: which thread was it that discussed overdeferrence? Thank you!
Very sorry for the late reply, W. I just saw your question, as I haven't visited this thread for a while.
There have been threads in this forum or bogleheads or both called "Possible to have too much in tax deferred?" or something like that.
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Re: Maxing Out 401(k) Contributions

Post by williswine » Tue Sep 30, 2014 10:00 am

Thank you dualstow, I will use your quote as a search keyword.
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technovelist
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Re: Maxing Out 401(k) Contributions

Post by technovelist » Tue Sep 30, 2014 10:08 am

Xan wrote: Sophie, I think you're understating the advantages of tax-deferral.  The concept of "over-deferring" is a fascinating one, and I do believe that it's possible, but deferring isn't as bad as you're making it seem.

First, the list of exceptions to the early withdrawal penalty is fairly substantial, and covers many of the scenarios where you might need the money, like disability and medical expenses, and even first-time home buying (not sure why that one's there...)
http://www.irs.gov/publications/p590/ch ... 1000230905

More importantly, I don't think that having all earnings taxed as ordinary income instead of capital gains is a bad thing.  Let's say you're 50, in the 28% bracket, and you retire at 70, still in the 28% bracket.  Let's say the PP (or whatever you're investing in) doubles in that time.

If you don't defer the taxes, then you pay $280,000 in taxes up front.  You're investing $720K.  You have $1.44M when you retire, at which point you pay $108K (15% of the $720K gain) in taxes.  You're left with $1.332M.

If you defer the money, then you're investing the whole $1M, you have $2M at age 70, and you pay 28% on it at that time.  You have $1.44M after taxes.  That's $108K more than the non-deferral scenario.  The difference is the capital gains taxes which you NEVER had to pay.

Apart from the issue of the rules changing, tax deferral can only make you better off.  It's not a matter of losing the sweet capital gains rate in exchange for a hopefully lower tax bracket; it's never having to pay capital gains taxes at all.

Also, the non-deferred scenario was a best-case presentation of no buying or selling (rebalancing) during the 20-year period.  You might have to pay capital gains taxes multiple times.
It's not that simple, as higher regular income has more than one drawback. You will pay taxes on 85% of your Social Security, you may have to pay higher Medicare premiums, there may be AMT issues at certain income levels, and that's just the beginning. I haven't even mentioned the possibility of leaving appreciated securities to your heirs, who also won't have to pay capital gains taxes due to the step-up in basis at death.

Also, as far as paying capital gains taxes, what if you can realize most or all of those in the 0% bracket, as can be done with up to $77K taxable income for a married couple?

These things are VERY complicated and need significant advance planning to optimize them.
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