Comments on: You’re Not Contributing As Much As You Think to Your 401k

By: Chris

Chris — Fri, 22 Feb 2008 08:57:19 +0000

I think the rate of inflation, and the requirement that your nominal income needs to grow to keep up with it, almost ensures that your tax bracket will not be lower in retirement than it is right now. The skeptic in me thinks this on purpose, since it’s tightly controlled by a few powerful people, but I digress. Of course, I say that it will be tough to go to a lower tax bracket in retirement as a 20-something, but certainly, if you’re 60 now, you could probably knock it down a notch when you retire and maintain the same lifestyle.

But Yes, I was going to throw in my recommendation of the Roth 401(k), but the comment was already long enough.

By: Randall

Randall — Thu, 21 Feb 2008 22:38:06 +0000

@Chris,
Whew!! Great comment. Only one thing to add. The whole idea of the 401k is to defer taxes on it until your taxation rate is lower, as in retirement. The theory goes that you won’t be in the 33% tax bracket by the time you start withdrawing the money (age 62 1/2+ or so), so that skews the numbers to the good again.

33% savings now + accrued interest – lower taxation rate (25%?)at retirement = still better than a sharp pointy stick in the eye.

Otherwise, I’d switch to the Roth 401k (which I actually would rather do to begin with, since I’m none too sure that taxation rates won’t be HIGHER in the future regardless).

By: Chris

Chris — Thu, 21 Feb 2008 22:20:11 +0000

A little misleading, considering that you will eventually be taxed on the money when you finally do take it out of the 401(k) account. So this “33% profit” is temporary and forever intangible. The 401(k) account is a tax DEFERRED account, not a tax AVOIDANCE account, meaning that the participant will never see a dime of that so-called “profit”.

The real profit is the excess earnings that you collect on the “additional” 33% (minus the taxes on those earnings of course), because that is the real extra money that will eventually end up in the hands of the investor.

Using the numbers in the post, let’s say you’re putting away $300 of gross pay into your 401(k). If you weren’t putting that into the 401(k) account, you would pay 33% taxes before coming away with $200 in take home pay. If you wait for 20 years and take that same $300 out of your 401(k), you still only come away with $200 in your hands (assuming your tax bracket hasn’t changed one way or the other). Where did that supposed “profit” go? To the same place it would have gone if you hadn’t put it into your 401(k), the government. The real profit is the increased earnings you get from having those dollars in the account that would normally be used to pay taxes.

Assuming a 10% annual return, if you had put your after tax $200 into an investment account, after a year you would have $220, and that extra $20 would be taxed as income at the same rate, leaving you with about $213.40 when all is said and done. If you get that same return from your 401(k) where you were able to put in that extra $100 that normally would have gone to taxes, then you would have $330 at the end of the year. If you withdrew the $330 you would be taxed on the entire amount, leaving you with $221.10. So your actual tangible profit is $7.70 (221.10 – 213.40). So, by sacrificing $200 of take home pay to put into a pre-tax account, you gain $7.70 in real profit. That’s a 3.85% profit, which is roughly enough to keep up with inflation.

I’m not saying you shouldn’t invest in or max out your 401(k), because the alternative is worse, but to say that doing so “gives you a guaranteed 33% increase as soon as you buy it” is extremely misleading.

Though the premise of the post is true, the statements about profit and returns within the post are not.

By: January Roundup

January Roundup — Sat, 02 Feb 2008 18:27:46 +0000

[...] Withdrawal – You’re Not Contributing As Much As You Think to Your 401k. There are tax considerations involved with your 401(k) contributions, and by contributing to your [...]

By: Successful Friday Roundup 2-1-08 | Mrs. Micah: Finance for a Freelance Life

Successful Friday Roundup 2-1-08 | Mrs. Micah: Finance for a Freelance Life — Fri, 01 Feb 2008 17:47:41 +0000

[...] it. I’m not sure how I missed it the first time around. He does a little math to prove that you’re not contributing as much to your 401(k) as you think. You’re contributing more! And it’s good. So if you elect for a $500 deduction, [...]