Reducing 401k contributions now for tax flexibility later?

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flyingpylon
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Reducing 401k contributions now for tax flexibility later?

Post by flyingpylon » Fri Mar 26, 2021 12:57 pm

I'm seven years (possibly less) from leaving my corporate job at age 62. I'm not sure yet whether it will be full retirement, semi-retirement, or whatever the cool kids will be calling it at that time. But there will likely be five or more years of greatly reduced income before taking Social Security at FRA of 67.

I've been on auto-pilot with my 401k contributions for quite a while, maxing out each year because that's what you're "supposed" to do and the tax deduction is nice. But now my liquid assets are 88% tax-deferred.

So I'm wondering if it makes sense to reduce the amount I'm putting into tax-deferred accounts in order to have more tax flexibility later. After running some numbers, it doesn't appear that these reductions would make much of an impact on the total amount I'd have available at retirement.

The biggest need for flexibility has to do with health insurance and potential ACA subsidies. Health insurance is a huge wildcard and it helps to be able to control your reportable income. In the past, there was a "subsidy cliff" that would eliminate subsidies if your MAGI was $1 over 400% of the Federal Poverty Limit. That has changed dramatically with the American Rescue Plan but right now the changes only apply to 2021 and 2022. Here's a good article: https://www.marketwatch.com/story/obama ... eid=yhoof2

I will be eligible for Medicare at 65 but my wife is 7 years younger (not currently working) and I'll have a dependent that may need continued coverage for a few years so health insurance will be a "thing" to contend with for a while. Of course there's no way to know if the ACA will still be around or what the options will be.

I already max out a Roth IRA each year but it's not huge. And of course I would still contribute enough to the 401k to get the full employer match. If I reduced the amount going to the tax-deferred 401k I could put it in my employer's Roth 401k or a taxable brokerage account, etc. Taxes would be higher in the short term but flexibility in the future could be worth quite a bit.

Has anyone else considered this or have any thoughts?
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Re: Reducing 401k contributions now for tax flexibility later?

Post by pp4me » Fri Mar 26, 2021 3:52 pm

Any possibility of contributing to an HSA?

I was never eligible for one, so never really looked into it until my wife's company started offering it this year. When I checked it out I thought what a great deal! You get the tax deferment of a 401k plus the tax exemption of a Roth as long as you spend the money on medical. So it's like a 3-fer for a retiree - tax deferred, tax exempt, and help towards medical expenses. Started maxing out my wife's contribution as soon as we joined the plan at the beginning of the year which also comes with some employer match. I'm retired but she's 55 and intends to work a little longer. I figure if she works another 2 years we'll have > 15k for medical expenses in the account. And you can invest it just like a 401k.

We also max out her 401k and Roth for both of us because my SS currently covers nearly our whole budget ( I delayed to 70 and get nearly the max amount).

Currently we're at about 66% tax-deferred, 17% tax exempt (Roth), and the rest (another 17%) is taxable.
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I Shrugged
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Re: Reducing 401k contributions now for tax flexibility later?

Post by I Shrugged » Fri Mar 26, 2021 5:45 pm

All I know is that I found a service to run my numbers through their black box, and in the long run it paid to defer as long as possible taking income from retirement accounts. I realize that is not what you are asking. I'm not sure I see why you wouldn't take the tax deferral while you can. It sounds like you want your income to be lower before you retire, due to the insurance pricing.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by WiseOne » Sat Mar 27, 2021 11:07 am

Flyingpylon, I hear you on the tax deferral situation. 88% is a lot. I'd be uncomfortable with that too.

You'll need to sit down with a spreadsheet and compare your tax burden now vs in future. If you figure on withdrawing almost the same amount from your 401K that you're earning now, then it's pretty unlikely that you'll benefit much from taking the full 401K deduction. But, you really have to model it to know your best strategy. It might involve, for example, taking large 401K withdrawals for a few years in order to withdraw less after that so you can stay under various income thresholds.

Be sure to consider state taxes as well as federal. Take into account the changes to ACA policy & tax treatment of medical expenses with the recent "COVID-19 relief" bill, any state taxes that might treat 401K withdrawals differently from earned income, and potential state/local tax benefits (like property tax rebates) if you stay below certain income thresholds.

Also, you might want to check if there are any Obamacare policies available to you at all. The major insurers have largely pulled out, leaving ones that have very limited networks that your current physicians and local hospitals may not be in. In my state (New York), the only Obamacare policies are Medicaid HMOs. Yuck.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by flyingpylon » Sat Mar 27, 2021 12:48 pm

Thanks for the replies. Health insurance is a big factor that I mentioned, but there can be lots of other reasons to keep reportable income low. Or at least have the option to do that. Maybe options are what I really want given that there is no way to predict the future with 100% certainty. Right now it seems that I'm on a path to just one option (withdrawing from tax-deferred) unless I make modifications.

I'm not eligible for a HSA. My employer's plan has a deductible that qualifies but we get some benefits before hitting the full deductible which makes it a non-qualifying plan.

I have a lot to learn about the health insurance options out there (or lack thereof). I just know that many of the FIRE stories I read really emphasize keeping income low to qualify for ACA subsidies, etc.

Still a lot of numbers to crunch. There's a lot more to retirement planning than accumulating a pile of assets. Who knew? :)
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Re: Reducing 401k contributions now for tax flexibility later?

Post by LittleDinghy » Sat Mar 27, 2021 8:11 pm

FlyingPylon, I'm 68 and retiring at 70 in 2022, when I'll be taking Social Security. In 2018 I woke up and realized I had a lot of money in my corporate 401k. Fortunately my company allows in-service partial distributions, so in each of 2018, 2019 and 2020 I've been doing two things: first, trustee-to-trustee transfer of after-tax amounts from my 401k to my Roth IRA, and second, trustee-to-trustee transfer of pre-tax amounts from my 401k to my Roth IRA. On the first after-tax transfers, I don't have to pay tax but do have to also transfer the earnings on the after-tax money, on which I haven't paid taxes of course) to a rollover IRA (a traditional IRA). On the second pre-tax transfers, I do have to pay tax, and so determine the amount to transfer that will get my income up near, but not over, my marginal tax bracket. This approach has enabled me to rapidly move a significant amount of money to Roth, though I do pay a lot of tax.

To do this your 401k needs to allow partial in-service distributions, and needs to separately track your after-tax contributions and returns on same. I understand that some, perhaps many, 401ks don't allow and do this. But you could check.

If your 401k doesn't allow in service distributions, then perhaps when you're 62, you could then at least transfer all the after tax contributions in your 401k to a Roth IRA with no tax penalty, as long as you also transfer the gains on that money to a rollover IRA. This would possibly help a lot.

Also, you'll have 10 years from age 62 to age 72 with relatively low income, and then should be able do transfer money to a Roth each year to the top of your tax bracket. I don't have this opportunity but for one year, when I'm 71. So, I think this should help a lot for you as well.

Also, can you wait till 70 to claim SS? I think you'll get an 8% growth per year from FRA to age 70 if you do.

Anyway, these are my thoughts. Would appreciate any others comments...
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Re: Reducing 401k contributions now for tax flexibility later?

Post by WiseOne » Sun Mar 28, 2021 12:20 pm

With the elimination of the Obamacare fiscal cliff, you have a bit more leeway with your retirement income tax management. And of course, it's very important to find out if you even have a viable Obamacare option. For example, the Obamacare options available to me are insurances that almost no one takes, rendering them almost completely worthless.

I don't quite follow the rollover plan that Little Dinghy outlined. If you Roth convert 401K money (which flyingpylon will do, regardless), you have to pay income tax on the entire amount. And there is no penalty for conversion. If you convert to a rollover IRA that has zero effect from a tax perspective.

What I think you're saying though, is that instead of refraining from making 401K contributions, FP would be better off making the contributions and then immediately getting in-service rollovers to convert to a Roth IRA - as much as possible and maybe even to the top of his current tax bracket. That amounts to a large back-door Roth contribution that can chisel away at that 88% tax-deferred figure. Am I right?? If so, a very valuable maneuver indeed!
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Re: Reducing 401k contributions now for tax flexibility later?

Post by Cortopassi » Sun Mar 28, 2021 1:54 pm

What I am noticing is all you guys seem to have younger wives... ;)
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Re: Reducing 401k contributions now for tax flexibility later?

Post by vnatale » Sun Mar 28, 2021 2:33 pm

Cortopassi wrote:
Sun Mar 28, 2021 1:54 pm

What I am noticing is all you guys seem to have younger wives... ;)


Seems to be a way of emulating Harry Browne in ALL ways!

His birth date: 6/17/33

His wife's birth date: 10/28/48
Above provided by: Vinny, who always says: "I only regret that I have but one lap to give to my cats." AND "I'm a more-is-more person."
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Re: Reducing 401k contributions now for tax flexibility later?

Post by flyingpylon » Sun Mar 28, 2021 4:24 pm

LittleDinghy wrote:
Sat Mar 27, 2021 8:11 pm
FlyingPylon, I'm 68 and retiring at 70 in 2022, when I'll be taking Social Security. In 2018 I woke up and realized I had a lot of money in my corporate 401k. Fortunately my company allows in-service partial distributions, so in each of 2018, 2019 and 2020 I've been doing two things: first, trustee-to-trustee transfer of after-tax amounts from my 401k to my Roth IRA, and second, trustee-to-trustee transfer of pre-tax amounts from my 401k to my Roth IRA. On the first after-tax transfers, I don't have to pay tax but do have to also transfer the earnings on the after-tax money, on which I haven't paid taxes of course) to a rollover IRA (a traditional IRA). On the second pre-tax transfers, I do have to pay tax, and so determine the amount to transfer that will get my income up near, but not over, my marginal tax bracket. This approach has enabled me to rapidly move a significant amount of money to Roth, though I do pay a lot of tax.

To do this your 401k needs to allow partial in-service distributions, and needs to separately track your after-tax contributions and returns on same. I understand that some, perhaps many, 401ks don't allow and do this. But you could check.

If your 401k doesn't allow in service distributions, then perhaps when you're 62, you could then at least transfer all the after tax contributions in your 401k to a Roth IRA with no tax penalty, as long as you also transfer the gains on that money to a rollover IRA. This would possibly help a lot.

Also, you'll have 10 years from age 62 to age 72 with relatively low income, and then should be able do transfer money to a Roth each year to the top of your tax bracket. I don't have this opportunity but for one year, when I'm 71. So, I think this should help a lot for you as well.

Also, can you wait till 70 to claim SS? I think you'll get an 8% growth per year from FRA to age 70 if you do.

Anyway, these are my thoughts. Would appreciate any others comments...
Thanks. My 401k plan does allow partial in-service distributions, but not until age 59.5 (unless there is a hardship situation). But I suppose it's an option each year I stay past that age.

I'm a little confused by this: "On the first after-tax transfers, I don't have to pay tax but do have to also transfer the earnings on the after-tax money, on which I haven't paid taxes of course) to a rollover IRA (a traditional IRA)."

I don't currently have any after-tax contributions but we do have a Roth 401k option. My understanding was that with the Roth 401k, both after-tax contributions as well as the earnings would not be taxed. Are your after-tax 401k contributions done a different way that requires the earnings to be taxed?
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Re: Reducing 401k contributions now for tax flexibility later?

Post by flyingpylon » Sun Mar 28, 2021 4:32 pm

WiseOne wrote:
Sun Mar 28, 2021 12:20 pm
With the elimination of the Obamacare fiscal cliff, you have a bit more leeway with your retirement income tax management. And of course, it's very important to find out if you even have a viable Obamacare option. For example, the Obamacare options available to me are insurances that almost no one takes, rendering them almost completely worthless.
I do have a lot to learn about the insurance options available. Looks like there are just two in my current state but several in a potential retirement state including BC/BS.

The COVID relief bill only eliminates the subsidy cliff for 2021 and 2022. Given the general trend of things perhaps it will be retained in the future but who knows.

Keep working or figure out the health insurance puzzle... honestly not sure which is worse at this point.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by pp4me » Sun Mar 28, 2021 5:54 pm

Cortopassi wrote:
Sun Mar 28, 2021 1:54 pm
What I am noticing is all you guys seem to have younger wives... ;)
Has many benefits, including reduced RMD's.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by LittleDinghy » Tue Mar 30, 2021 12:06 pm

WiseOne wrote:
Sun Mar 28, 2021 12:20 pm
What I think you're saying though, is that instead of refraining from making 401K contributions, FP would be better off making the contributions and then immediately getting in-service rollovers to convert to a Roth IRA - as much as possible and maybe even to the top of his current tax bracket. That amounts to a large back-door Roth contribution that can chisel away at that 88% tax-deferred figure. Am I right?? If so, a very valuable maneuver indeed!
Yes, WiseOne, that is what I was trying to say.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by LittleDinghy » Tue Mar 30, 2021 12:18 pm

flyingpylon wrote:
Sun Mar 28, 2021 4:24 pm

Thanks. My 401k plan does allow partial in-service distributions, but not until age 59.5 (unless there is a hardship situation). But I suppose it's an option each year I stay past that age.

I'm a little confused by this: "On the first after-tax transfers, I don't have to pay tax but do have to also transfer the earnings on the after-tax money, on which I haven't paid taxes of course) to a rollover IRA (a traditional IRA)."

I don't currently have any after-tax contributions but we do have a Roth 401k option. My understanding was that with the Roth 401k, both after-tax contributions as well as the earnings would not be taxed. Are your after-tax 401k contributions done a different way that requires the earnings to be taxed?
My employer's 401k allows me to keep contributing after have contributed the max pre-tax amount ($19,500 + catch-up), up to a max of the max the IRS allows which is around $60k. Those additional contributions are after-tax. These after-tax amounts can be trustee to trustee transferred to a Roth IRA, and there is no tax on this because I paid the tax before it went into the 401k. However, any earnings on those after tax amounts while they were in the 401k have not yet been taxed and I think the IRS requires that those earnings be moved out of the 401k when you move the after-tax amounts out. So, I have these earnings (usually small) transferred to a rollover (traditional) IRA; I'll end up paying tax on them sometime in the future whenever I withdraw them from the rollover IRA, probably as RMDs.

FYI, my employer's 401k also has a Roth option, but I don't use it.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by Kbg » Wed Mar 31, 2021 1:19 pm

Mathematically, it is almost always the case that you want to defer taxes because you can compound a higher amount longer all things being equal.

Roth not Roth always comes down mathematically to projected tax rates.

One option that sometimes can yield some really outstanding advice is chuck your situation into the personal finance section of the bogleheads board.

However, the best most accurate answer for your case is it depends and you either need to figure it out yourself or hire someone to figure it out for you. Between tax law, debt and debt type, insurance specifics, location, account and amount specifics and age, to do a good job you really do need to use your situation vs. generalized advice.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by glennds » Wed Mar 31, 2021 2:49 pm

Kbg wrote:
Wed Mar 31, 2021 1:19 pm
Mathematically, it is almost always the case that you want to defer taxes because you can compound a higher amount longer all things being equal.

Roth not Roth always comes down mathematically to projected tax rates.

One option that sometimes can yield some really outstanding advice is chuck your situation into the personal finance section of the bogleheads board.

However, the best most accurate answer for your case is it depends and you either need to figure it out yourself or hire someone to figure it out for you. Between tax law, debt and debt type, insurance specifics, location, account and amount specifics and age, to do a good job you really do need to use your situation vs. generalized advice.
Not to mention that if you're anything like me, there seems to be some type of cosmic reason that when I time a transaction with taxes in mind, I end up worse off.....
It's like I'm the fisherman in the Old Man and the Sea just trying to get his LT capital gains to shore.
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Re: Reducing 401k contributions now for tax flexibility later?

Post by flyingpylon » Wed Mar 31, 2021 3:37 pm

I appreciate everyone's replies. There is a lot to consider and of course it comes down to each individual's unique situation. I was just curious to see if others had already thought through some of the issues and had any tips or tricks to share.

For example I liked LittleDinghy's setup, but additional after-tax 401k contributions are probably not in the budget even if my plan allows them. Good info though.

Right now there are too many unknowns to come up with anything resembling a solid plan. The best I can probably do is to make a list of things to keep an eye on and see if Roth conversions make sense in the future. I've already learned a lot and I'm glad I've started the research sooner rather than later.
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