Tax planning to make the 401k into your own retirement pension

The 401k is a retirement plan which is employer sponsored.  In 2013, an employee may contribute up to their qualifying income or $17,500 (whichever is greater) to this account.  Many employers will match your contributions up to to several percent of your salary, but not all will.  The benefit of this plan is that your contributions are deferred from present taxes and gains within the account are sheltered from taxes.  This means that if you earn $75,000 per year and are $3,000 into the 25% marginal tax bracket, then contributing $3,000 to your 401k over the year will reduce your taxable income by $3,000 and knock you back down to the %15 marginal tax bracket.  This equals a tax savings of $750 in that year!  That’s $750 that you get to keep and don’t have to give to the government.

There’s other options for retirement accounts.  The term Roth comes up often, and points to the one downside of a 401k.  That is, for a 401k, the amount withdrawn at age 59 1/2 is subject to taxes.  Any amount withdrawn before age 59 1/2 is subject to taxes and a 10% penalty.  In the case of a Roth 401K, the principle can be withdrawn from the account, and withdrawals after age 59 1/2 are tax free.  The same penalty rules apply.

The fact that taxes aren’t paid on Roth 401k withdrawals sounds like a good deal, and it is.  However, contributions are made with “after tax” dollars.  This means no $750 savings in 2013.  The conventional financial wisdom suggests a bias towards Roth contributions for all except those in the higher tax brackets, usually 28% and higher.  The reasoning is that if you’re below this bracket, your present tax rates are low and will likely be higher in retirement since you will have multiple sources of income.  If your tax rate is 28% or above, the standard advice to to contribute to a traditional 401k.

Does the conventional wisdom work?  Is the bias towards Roth contributions valid?  Not so much.  Here’s why:

  • The above advice for Roth contributions make the fatal mistake that anyone has an idea what U.S. income taxes will look like in a decade or more.
  • The advice also ignores all elements of tax planning; where proper planning has multiple options for deferring taxes.
  • Roth contributions serve the government better as it brings in more tax revenues in the present.  Wouldn’t you rather have that money in hand?
  • The 10% bracket for Married Filing Jointly is about the same size of the maximum contribution limit of $17,500.  Even if all of your 401K contribution is in this bracket, you will get back $1750 if you max out your contribution.
  • 401k contributions lower your AGI.  They’re an “Above the line” deduction, one of the sweetest tax deals available.  This can open the door to the retirement tax contribution credit (or even a higher credit multiplier) and the earned income credit; which if you have kids you should at this point expect the additional child tax credit.

Based on this, the best strategy at any time is to defer taxes the most that you can in the current year.  The only exception to this rule exists for those who are in or near the 1% category.  Even in the case of a 0% tax rate, your best bet may not be the Roth contribution because of working your way out of the “phase out” of the earned income credit which is 16% with 1 child and 21% with 2 children.  Also worth considering is that the additional child tax credit is refundable.

>>>Taxes are complicated.  They are built to be that way.  It is not reasonable to expect mastery based on one read.  Financial Place Online will continue to provide only the best in tax guidance to make sure that you can maximize your own wealth development.

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