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Thread: 401k : pre-tax or after-tax contribution?

  1. #1
    L13 Sergeant O_loung1's Avatar
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    401k : pre-tax or after-tax contribution?

    401k : pre-tax or after-tax contribution?

    ive chosen pretax for years but been thinking about the tax burden during retirement.
    what are the benefits for me to "save" paying taxes now versus "not paying"
    taxes when i really need the money during retirement?

    i cant see the cost of living becoming cheaper and taxes falling in a few decades when i retire. discuss
    ___________________________________________

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    Spoofee.com! Spoofee's Avatar
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    It's definitely benefitial to put your income into 401k pre-taxed.

    There are different tax brackets.

    Let's just say, tax brackets go
    0~25k - 15% taxed
    25k~50k - 30% taxed

    and say you make $50k a year. If you throw $15k into 401k pre-taxed. That's $15k you don't have to pay tax with the higher tax bracket.

    So once you retire.. you can take a little bit out at a time and be taxed for the lower tax bracket (15% in this example).

    This is my understanding.

    If you know a way to make more money (hot real estate, brilliant business plan, etc.).. yes, forget 401k.. get your taxed dollars and invest.
    Thank you for using Spoofee.com

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    L9 Corporal StevenJ's Avatar
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    Yes, the general opinion is that pre-tax 401k contributions should be maximized before after-tax contributions be made to things like a Roth IRA. This assumes that you'll be in a lower tax bracket after you retire than you are now--which is generally the case.

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    L12 Sergeant pinkflutterbys's Avatar
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    When you put "pre-tax" money in a 401k, that means you will eventually pay taxes not only on the original principle, but also on the earnings.

    When you put "after-tax" money in a Roth IRA, you pay taxes on the principle (that comes out of your paycheck before you get your hands on it), but not on the earnings.

    I think it is better to maximize contributions into "after-tax" investments like Roth IRAs first because you only pay tax on the principle, not on the earnings.



    So, say you have $1,000. You put it into your investment vehicle of choice for 15 years and it earns 10% interest each year. (10% is a reasonable average rate of return for the stock market.) You will end up with $4,177.25. (You earned $3,177.25.)

    If you put your $1,000 into a pre-tax investment vehicle, you will have to pay taxes on the entire $4,177.25 when you decide to withdraw the money.

    If you put your $1,000 into an after-tax investment vehicle, you will have already paid taxes on the original $1000 when you earned it. You pay no taxes on the earnings-- $3,177.25-- when you decide to withdraw the money.

    I would rather pay taxes on $1,000 now than on $4,177.25 later.


    However, if your employer is matching your contributions on a pre-tax investment vehicle, I would be sure to take adavantage of that too-- it's free money!

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    CAT ATTACK! Meerowwer! ksocia's Avatar
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    Quote Originally Posted by pinkflutterbys
    So, say you have $1,000. ...

    If you put your $1,000 into a pre-tax investment vehicle, you will have to pay taxes on the entire $4,177.25 when you decide to withdraw the money.

    If you put your $1,000 into an after-tax investment vehicle, you will have already paid taxes on the original $1000 when you earned it. You pay no taxes on the earnings-- $3,177.25-- when you decide to withdraw the money.

    I would rather pay taxes on $1,000 now than on $4,177.25 later.
    Using the same dollar amount pre and post tax for the investment? You're comparing Apples to Oranges pinkflutterbys.

    If you have $1000 pre tax to use in that kind of 401k, you would only have $750 after paying taxes (assuming 25% bracket). The whole point of using pre-tax is that you can put MORE in now (bypassing higher taxes), to earn more over the years of compounded returns, to make up for paying taxes (at a lower rate) in the future on the whole balance.

    So the real math goes like this:

    $1000 pre tax 401k
    10% return for 15 years
    Total = $4177.25
    You are taxed on the whole amount (hopefully in lower bracket by now)
    $4177.25 - $626.59 (15% tax) = $3550.66 buy a new hip

    $1000 pre tax - $250 tax now (25% bracket) = $750 to put into the Roth IRA
    10% return after 15 years (on $750)
    Total = $3132.94 with no tax owed

    I'd rather have $3550.66 paying lower taxes later, than $3132.94 by paying taxes up front. Means more cat food when I'm 85


    ...Not to mention any matching employer amounts

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    L12 Sergeant pinkflutterbys's Avatar
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    Quote Originally Posted by ksocia
    Using the same dollar amount pre and post tax for the investment? You're comparing Apples to Oranges pinkflutterbys.

    If you have $1000 pre tax to use in that kind of 401k, you would only have $750 after paying taxes (assuming 25% bracket).

    You can invest as much as you want. Why only invest $750?
    The guy is trying to decide between a pre tax and post tax investment. I think the only way to make a fair decision is to compare the two using the same amount of money. If its an automatic kind of plan--like a certain amount would come straight from his check each time--most people would have the same dollar amount taken out no matter the tax status. Practically speaking, it's more useful to compare the plans using the same amount of invested money.

    Of course, I may not be factoring in being in different tax brackets at different stages of life. I am a school teacher, so I will probably be in the 15% tax bracket my entire life.

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    CAT ATTACK! Meerowwer! ksocia's Avatar
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    I don't think you're understanding the situation correctly...
    Using $1000 that you earn in your paycheck IS a set amount of money, but if you are going to talk about paying tax on the full balance 15 years later (and not paying tax now) vs. doing a post-tax investment (and paying tax NOW), you HAVE to factor in paying tax NOW and having less to invest with. Without doing this you are ignoring the entire point of pre-tax investment, which is to have more to invest now because you don't pay tax on it, and therefore more to earn interest with.

    Can someone else explain this concept differently?

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    L12 Sergeant pinkflutterbys's Avatar
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    But you don't have to have less to invest with. You decide how much you want to invest.

    I don't have the option of paycheck withdrawls, but I assume your employer will want you to answer these basic questions when you set it up:

    1. How much do you want taken from your check?

    2. Do you want it to be put in a pre or post tax investment?

    The average person is going to request the same amount taken from their check (answer to question 1) regardless of the tax status (answer to question 2). For instance, my husband and I can afford to invest about $800 per month for each of the 10 months that I get a paycheck. This amount wouldn't change if we suddenly decided to change from a post tax to pre tax investment. Therefore, I think you are mathematically correct, but practically speaking, it makes more sense to compare the investments using the same amount of money invested.

    Taxes on a post tax investment for a person remaining in a 15% tax bracket would be 15% of $1000 or $150 as soon as the money is earned. Then the earnings are tax free. (Or, for me, 15% of 800 is $120)

    Taxes on the pre tax investment for a person remaining in a 15% tax bracket would be 15% of $4177 or $626.55 in 15 years if the investment earns 10%. (Or, on my $800, 15% of $3342 is $501.)

    I'd rather pay $150 in taxes now than $626.55 later. Likewise, I'd rather pay $120 in taxes now than $501 later on the $800 per month I can afford to invest, which, again, does not change if I decide to switch to a pre tax investment.

    We already make sure we have the correct amount deducted from our paychecks for taxes, so we either get a very small refund or have to pay taxes when it comes time for that. We played around with the tax filing software and figured out it would take 3 or 4 thousand dollars going into my husband's pre tax Simple IRA at work to save just a few hundred dollars in taxes now. We're already investing as much as we can afford, and I know we're saving in taxes later. Maybe for people that make a lot more money than we do, pre tax investing is good. That makes me think the point of pre tax investing it to lessen the amount of taxes wealthy people have to pay, not to have more to invest now and earn interest with, as you mentioned.

    Additionally, the guy says in his original post:
    "i cant see the cost of living becoming cheaper and taxes falling in a few decades when i retire"

    He's not planning to be in a lower tax bracket later, so he doesn't benefit from squirreling away pre tax money in hopes of paying less in taxes later.
    Last edited by pinkflutterbys; 05-22-2006 at 05:38 AM.

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    CAT ATTACK! Meerowwer! ksocia's Avatar
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    You win

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    L12 Sergeant pinkflutterbys's Avatar
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    You just gave up 'cause you're tired of arguing, didn't you?

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    Bargain Shopper alshah's Avatar
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    Quote Originally Posted by pinkflutterbys
    You just gave up 'cause you're tired of arguing, didn't you?
    Ding Ding Ding!

    We have a winner!! :D

    I have learned to put as much away pre-tax as you can now. My dad taught me that, and my financial advisor agrees. I have a 401k with company match at work that is a pre-tax deduction, and I put the maximum into an IRA every tax year to get that deductible on my return.

    You can debate both sides to no end. The bottom line is do you want more money now or later? If you want it now, do the tax deductible one, if you want it later, do a Roth. That is how I look at it.

    This is a decent article on the comparisons of each.

    http://www.fairmark.com/rothira/taxfeat.htm

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    CAT ATTACK! Meerowwer! ksocia's Avatar
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    Quote Originally Posted by pinkflutterbys
    You just gave up 'cause you're tired of arguing, didn't you?
    ;)
















    You will rue the day you crossed me when I am finally ready to unleash my army of no-thank-you robots like a PLAGUE upon the land! No Roth IRA will be safe! Viva la pre-tax 401k!

  13. #13
    L12 Sergeant pinkflutterbys's Avatar
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    http://www.tcalc.com/tvwww.dll?User

    Try this calculator. I've tried all kinds of numbers. The Roth IRA always comes out better.

    My situation is:
    Current IRA amount: $8,000
    Current tax bracket: 15%
    Retirement tax bracket: 15%
    Estimated investment rate of return: 10%
    How much do you plan to save each year: $4000
    Amount saved is: After Taxes
    Maximum IRA sheltered contribution:* $4000
    How many years until you retire: 30

    And my result is according to the calculator is:
    ------------------------Regular IRA------Roth IRA
    Sheltered---------------863,368.93 -----863,368.93
    Non Sheltered------------94,733.54------0.00
    Total Before Taxes-------958,102.47-----863,368.93
    Total After Taxes--------828,597.13------863,368.93

    The Roth IRA is better. Even if I change my current tax bracket to 25% the Roth is still a little bit better.

    Now, if I had more money to invest (which I don't), I would put it into a regular IRA (or 403b if my school system would ever get with the program) rather than investing in just plain old mutual funds or stocks because of the tax sheltering advantage. Maybe this is what you're thinking about-- I could invest in a mutual fund straight up and pay taxes on my income before I invest it and then also pay taxes on the earnings later OR I could invest in a mutual fund within an IRA and then only pay taxes on the earnings.

    Ok so here are my options:
    Best option: Roth IRA: Pay taxes only on my meager income, not on future massive investment earnings
    Next best option: Regular IRA: Pay taxes on massive investment earnings, but not on my meager income
    Worst option: Straight up mutual fund/stocks: Pay taxes on both my meager income and massive investment earnings

  14. #14
    CAT ATTACK! Meerowwer! ksocia's Avatar
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    Use the "Before Tax" money option to get an idea of what I was talking about:

    Other than "Before Tax", I'm using all the same numbers as you EXCEPT I put 25% tax bracket now, and 15% bracket when I retire:

    ---------------------Regular IRA---------Roth IRA
    Sheltered------------863,368.93---------682,425.53
    Non Sheltered---------17,509.91----------0.00
    Total Before Taxes---880,878.84---------682,425.53
    Total After Taxes----751,373.50---------682,425.53

    This is assuming you put $4000 pre tax into your IRA, or whatever is left after subtracting the tax into the Roth IRA. The whole point of the regular 401k is to defer taxes until you retire and (hopefully) are in a lower bracket because you won't be earning as much. Almost every expert I've seen on TV or read about recommends maxing your pre-tax 401k contribution to get any matching funds, and then the spill over goes to Roth IRA once you can't contribute any more.
    Last edited by ksocia; 05-23-2006 at 03:07 PM.

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    L12 Sergeant pinkflutterbys's Avatar
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    Ok, here's the result for 25% tax bracket now, 15% retirement tax bracket, with all my same numbers using the "After Tax" option:

    ----------------------Regular IRA Roth IRA
    Sheltered-------------863,368.93 863,368.93
    Non Sheltered---------128,664.23 0.00
    Total Before Taxes----992,033.16 863,368.93
    Total After Taxes---862,527.82 863,368.93

    And your final results, using the "Before Tax" option:
    Total After Taxes----751,373.50-----682,425.53

    Using a Roth IRA to invest $4000 a year before taxes yields the greatest return.
    To get similar results using the "Before Tax" option, you have to invest about $5350 per year. Then you end up with:

    ----------------------Regular IRA Roth IRA
    Total After Taxes-----959,006.16 865,630.81

    I know the Regular IRA is higher in this case, but now we can look at it this way:

    I could invest $4000 per year and end up with about $860,000.
    OR
    I could invest $5350 per year and end up with about $860,000.

    It seems better to invest only $4000, to me. (That's probably all I can afford anyway.)

    But, anyway, all that is using the 25/15 tax bracket situation when my situation is actually 15/15. I think it depends on the individual situation. I don't think there's one right answer for everybody. It seems like we've all researched what is best for our personal situation. Maybe O_loung1 could tell us more about his or her situation since he or she asked in the first place. O_loung1 does seem to plan on staying in the same tax bracket in retirment, in which case I believe the Roth IRA would be the best bet.

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