I realized a few weeks ago that we could likely be doing more to optimize our 401k. Compared to investing with post tax money, it’s probably going to deliver us a significantly higher nest egg. But what about the taxes when it comes time to pulling the money out?
I estimate the long run impact to us of trying to max out our 401k vs just contributing toward the match should probably net us the equivalent of an extra $500k in our investment account. That’s assuming that we continue contributing for another 20 years or so.
My main priority in looking to max out our 401k’s is to shelter as much current income tax as possible, both federal and state. To put this in some perspective, any marginal tax dollar that can make it’s way into our 401k is saving us the equivalent of about $.40 on the dollar….. which is huge!
The ability to have an extra $0.40 on the dollar working for us, and growing and compounding will just make that 401k snowball that we are building larger and larger. Of course, the 401k isn’t an entirely free ride as far as taxes go. The idea is that you enjoy tax free compounding during your working life, but the tax man collects when it comes time to make distributions from the 401k.
My research suggests that when you eventually get around to making redemptions from your 401k, you are taxed on these distributions as if they are typical wage earnings. This means that you look at whatever your earnings happen to be at the time you collect your 401k distribution, you add your 401k distribution to those earnings and you pay taxes on those monies. If you collect early (ie before 59.5, you pay penalty taxation, apart from a few exceptions, but I’m ignoring this for now and assuming there’s no penalty tax payable).
For many of us, at the time we come to cash out the 401k, there likely won’t be any other source of income. As such, the 401k is likely it. Given this, whatever your 401k distribution happens to be is what you’d recognize as ordinary income.
Assume it’s you and another, and you need $50k in expenses to survive. In today’s dollars, that would put you into a 15% marginal tax bracket, or an average tax rate of something like 12.5% on the income you make.
Obviously tax brackets will change over time, so if you assume that they broadly go up with inflation, at retirement, you’ll be able to pull in an inflation adjusted $50k taxed at 12.5%. Maybe your expenses are slightly more, and you need $75k between the two of you. You’ll still be at an effective tax rate of about 15%. Not bad.
For me, in my case, that would mean more than halving of the effective tax rate that I would have been otherwise been paying on the same dollars today, had I not deferred tax in my 401k.
The effect of taxable account dividends ?
But does it get better than this?
I was pondering this further the other day, and something occurred to me in relation to my current taxable dividend account. All of my dividends are qualified dividends, and that means great tax efficiency. At the moment, given my income, I pay a tax rate of 15% on these dividends. However, when I’m done working, these dividends will still continue to come in. The only difference is that my income, and hence my tax rate will drop.
For those that pay a marginal tax rate on their income exceeding 15%, their effective tax rate on qualified dividend income is 15%. For those that have a marginal tax rate on their income of 15% or less, there is NO tax payable on qualified dividends.
Assume at the time that my wife and I decide to call it quits that we don’t have any other income. In our case (ie a married couple filing jointly), the 15% marginal tax rate cap is in place up to an income of $72,500.
So what does this mean, practically? It means that we can earn up to $72,500 annually in dividends and not pay an extra dollar in federal taxes. Not one. And this amount goes up broadly by the amount of inflation, so this will be an inflation adjusted $72,500 over time.
Assuming we can grow our taxable dividend stream to $70k/yr (a big if) and that we won’t need more than $90k annually to cover our expenses, then this almost guarantees that we won’t be paying greater than 10% on our 401k distributions when the time comes, assuming we withdraw up to the 10% tax rate income cap, or $17,850 annually. It probably also means our effective rate of tax will be close to 2-3% when we exit the workforce!.
You know what they say. If it sounds to good to be true then it probably is. I’m not sure that the current generous rates of taxation on qualified dividends will survive for the next 10 years in tact, let alone indefinitely. Think about it. If someone is able to bring in $72.5k in dividends, they’re probably not the ones in need of a generous tax concession which results in them paying no tax on this income!
I’m not sure if the AMT (alternate minimum tax) would be triggered in this situation, but this almost seems to good to be true. I suspect at some point, as the US deficit continues to rise, some government somewhere will look at dividend income as a soft tax target to go after.
Of course, if it is really true that large portions of retirees really do fund their retirements from dividend investments, than perhaps I am wrong and the generous dividend tax treatment really will be preserved. Clearly though, it’s the well off who can most afford to grow the dividend pot big enough to reap the rewards.
More than ever, I’m convinced that contributing the most I can to take advantage of my 401k is the right strategy. There are 3 components of this that come into play.
Time value of tax deferral
There’s a time value of money associated with my ability to pay the tax man the same tax obligation I owe him, but pay it 20 years later. If I’m able to earn a 10% return on those monies and have to repay him that exact same tax obligation 20 years, the effective “cost” of that same tax debt is now cents on the dollar.
For example, if I have a $200 tax debt that I need to pay today, but I can push that off 20 years and earn a 10% return on that money in the meantime, that same tax debt only costs me the equivalent $29 today. Provided I can earn more than the rate of inflation, and my tax obligation doesn’t go up much more than the rate of inflation, I come out ahead.
Permanent value of tax deferral
The example above assumes that the money that I have to pay the tax man in 20 years is the same amount. In fact, it’s not, because the tax man is so generous, that he allows me to pay him tax based on whatever income I am earning at the time. If my rate of tax are only 1/3 of what they are today based on what I happen to be earning in the future, then I’ve cut my $200 owed to the tax man today to $70 payable to him sometime in the future.
Assuming I can grow that money that I would have paid him at 10%, that now makes the effective cost of that $200 tax debt, $70 in 20 years and a cost of $10 today!
Taxation of investment earnings
It’s not all one way traffic though, because the tax man wants a share of my future investment earnings. Based on my thinking though, he’s only collecting this at 10%, or perhaps 15% on my investment earnings. That’s no different than what I’d be paying tax wise on my capital account for long term capital gains or annual dividends. Significantly, instead of collecting that 15% today, or the next day as he would in my taxable account, he’s collecting it years later.
Of course the beauty of a taxation scheme is that everything is subject to change. However to the extent I can keep the tax man at bay and continue to grow my investment balance in the mean time, I’ll worry about how to get at my much larger lump sum in the future, when the time comes.