Who can explain to me 401K in simple terms? (55, pension plan, federal)
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Ok. Who can explain to me 401K in VERY simple terms.
Forget the employer match for now.
The benefit of a 401K is that you are contributing money into a fund tax free ... for NOW.
But when you take the money eventually (assuming you live that long), you will be taxed THEN.
So, can somebody simply explain the benefit and how significant the benefit is between being taxed now and being taxed then? Maybe with an example.
Seems to me like the benefits are really small.
I am Canadian but is of the impression 401K is like our RRSP ( whoops..maybe more like an IRA) ..which means when you put funds there..annually you can deduct that income in your tax return for that year..However, IF you retrieve it ..you have to declare it as an income since it was income that never got taxed...OR..IRA's which may be more like our RRSP..But IF 401K's strictly accessible thru workplace..it sounds more like our "Pension Plans" which workplace matches and takes over investment options..NOT the employee choice...Sorry..But the premise below applies....
Fast foreward..you took those funds and put it into an investment..income bearing type mutual funds or whatevers..and of course the fund values goes up and down..but it's on paper only..BUT if and when you remove a sum..you pay income tax on whatever you took out...But in the meantime..the 401K/IRA ( personal retirement account)..continues to compound over the years...
The whole premise is..you put this money away in HIGH INCOME years..and then tap into it when at lower income years thus lower tax rate...in the meantime investment compounds year over year until taped into...
Your marginal tax bracket is usually lower when you are older/retired. That is the advantage of a 401k. You will pay taxes when you withdraw the money, but it will be taxed at a low rate for most people.
But for many it's not, especially later in life. The only reason I contribute to my 401k now (at almost 58, and an income in the upper portion of the 25% bracket) is for the company match and the ability to save after tax dollars in a 401k that can annually be rolled over in to a Roth. When you are young (now, since Roths exist. They didn't when they would have helped me the most) you should save the max in a Roth first, when you are at your lowest income tax rate. Then fund your 401k which reduces the tax you pay now, for the unknown (but hoped for lower rate at retirement).
The dichotomy is if you really live below your means and save to the max in tax deferred, you WILL pay more in taxes than you saved, when in retirement. For us Boomers, where tax deferred IRAs and 401ks were the ONLY retirement savings means, we drank the "delay because it will be less later" koolaid, and are especially behind the 8 ball if we have a pension on top of savings. You can read about many people that have to carefully plan when to collect SS and have to convert their IRAs and 401ks to Roths before collecting SS to avoid paying more than they saved to the Fed, later. If we are lucky, we will break even.
Not that it is a bad position to be in, really at all. Better to have too much income to pay tax on, than much less income for less tax. I just wish I had saved more in regular after tax instead of most all in tax deferred.
Depends on what you consider a small benefit. It can easily be a few thousand a year.
But for many it's not, especially later in life. The only reason I contribute to my 401k now (at almost 58, and an income in the upper portion of the 25% bracket) is for the company match and the ability to save after tax dollars in a 401k that can annually be rolled over in to a Roth. When you are young (now, since Roths exist. They didn't when they would have helped me the most) you should save the max in a Roth first, when you are at your lowest income tax rate. Then fund your 401k which reduces the tax you pay now, for the unknown (but hoped for lower rate at retirement).
The dichotomy is if you really live below your means and save to the max in tax deferred, you WILL pay more in taxes than you saved, when in retirement. For us Boomers, where tax deferred IRAs and 401ks were the ONLY retirement savings means, we drank the "delay because it will be less later" koolaid, and are especially behind the 8 ball if we have a pension on top of savings. You can read about many people that have to carefully plan when to collect SS and have to convert their IRAs and 401ks to Roths before collecting SS to avoid paying more than they saved to the Fed, later. If we are lucky, we will break even.
Not that it is a bad position to be in, really at all. Better to have too much income to pay tax on, than much less income for less tax. I just wish I had saved more in regular after tax instead of most all in tax deferred.
Depends on what you consider a small benefit. It can easily be a few thousand a year.
That's not really explained simply.
If I put aside 15K in my 401K this calendar year, let's say untaxed. Right now, I'm taxed about a quarter of my income.
If I take that 15K out in 2040, 25 years from now, how much will I be taxed?
I don't want to get into investing and growth, because that complicates thing and there's too many external factors.
If I put aside 15K in my 401K this calendar year, let's say untaxed. Right now, I'm taxed about a quarter of my income.
If I take that 15K out in 2040, 25 years from now, how much will I be taxed?
I don't want to get into investing and growth, because that complicates thing and there's too many external factors.
I don't think there is an answer to your question which I bolded, because it depends on what your income is in 2040 as compared to your income in 2015.
The tax advantage of a 401K is premised on having a lower income in retirement - for some people that is the case and for some it is not.
I know you are striving for simplicity and for that reason didn't want to talk about the employer match, but I will just say that if there is an employer match where you work, go for it, otherwise you are leaving free money on the table.
I don't think there is an answer to your question which I bolded, because it depends on what your income is in 2040 as compared to your income in 2015.
The tax advantage of a 401K is premised on having a lower income in retirement - for some people that is the case and for some it is not.
I know you are striving for simplicity and for that reason didn't want to talk about the employer match, but I will just say that if there is an employer match where you work, go for it, otherwise you are leaving free money on the table.
To be honest with you, I really am not sure most people who pump $ into their 401k know any more than I do about the real tangible benefit.
If I have zero income in 2040, and withdraw 50K, then that becomes my income and keeps me in the 25% bracket, or ... the same bracket I am in now. Is that right or wrong?
So, my original 15K (which is part of that 50K) which I socked away is still being taxed at 25%.
Furthermore, from what I understand, if I ever need to withdraw it before age 60, my original 15K is penalized so that it becomes less than what it would have been had I just put it my savings account.
I don't want to get into investing and growth, because that complicates thing and there's too many external factors.
But you would be overlooking the main advantage of a 401k for someone your age--as it grows there is no tax taken out. So, for example, if you had $100K in it, and it grew 10% in one year, but the $ were not in the 401k, you would have to give up $2500 of your $10K in current income tax (you said you were in a 25% marginal tax rate category). Then, next year, there is less of a base on which to grow. This effect compounds over the years. So while you do pay tax when you draw $ out of a 401k, you have more to draw out than you would have if the money were not in a 401k.
The other key point is that not only will you likely earn less income after retirement (and thus would likely be in a lower % marginal tax rate category then), over the years, Congress typically adjusts ranges upward that are associated with higher rates. So for example, in 1980, you would have paid a 43% marginal rate of tax on $45K (because it was considered a very high salary then)
Here's an example. Say you're in the 25% tax bracket now. Option 1 puts $10,000 in a 401k. Option 2 puts only $7,500 in a regular investment account. After 30 years option 1 has grown to $100,600 and option 2 has grown to $75,500 at a 8% return. Say we now draw down over 10 years. Option 1 nets $8,550 after 15% tax rate and option 2 nets $7,550. So investing in a 401k netted an extra $1,000 each year. Also, option 2 likely would be less because dividends and gains would've been taxed over the years.
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