::  Posts  ::  RSS  ::  ◂◂RSS  ::  Contact

How is a 401k tax advantaged?

June 11th, 2013
money, retirement  [html]
People often describe 401(k) accounts as "tax advantaged", but how do they help? How much? Let's look at a single person earning $50k, saving 20% for retirement over 40 years, and then spending down their money over 25 years. How does a 401k change how much they have in retirement?

First off, imagine they don't use a retirement plan and just invest the money on their own. The 20% ($10k/year) they're saving becomes about $8k after taxes [1], and after 40 years they've saved $320k. They average a 3.5% real return, bringing the total up to $700k. The spend the money over 25 years, selling $28k of investments each year. About 73% of those investments would count as "gains" [2], and paying tax on the gains brings the $28k down to $25k. Their total savings were $400k before taxes and after tax they received $625k.

Now imagine they had instead invested in a Roth 401(k). This means that you pay taxes on the money you contribute, but you don't pay taxes on growth. They end up with the same $28k, but they don't have to pay taxes on their gains. Their total savings were $400k before taxes and after tax they received $700k.

Finally, imagine they invest with a traditional 401(k). They don't pay taxes on the money they contribute, but they do pay taxes on the money they withdraw. They put in $10k/year pre-tax, for a total of $400k over 40 years. With investment gains this is aroun d$875k. Over 25 years they withdraw $35k/year, and their income tax would be around 15%, bringing the $35k down to $30k. Their total savings pre-tax are $400k, and the total amount the receive after tax is $744k.

(The key difference between the two 401k examples is that the marginal tax rate in the Roth case was 20% but that the tax rate when withdrawing from the traditional 401k was 15%. If both tax rates were 20% then both investments would end up at $700k after tax. There's no advantage to paying the tax sooner or later except how it affects what your tax rate is.)

This gives us:

Method ROI
Standard investment 56% ($400k becomes $625k)
Roth 401k 75% ($400k becomes $700k)
Traditional 401k 86% ($400k becomes $744k)


[1] If they earn $50k they deduct $10k for the standard deduction and one exemption, have $40k of taxable income, and pay $6k in federal tax. If they had instead only earned $40k, then after their $10k of deductions they would have had a taxable income of $30k for $4k in taxes. In earning an additional $10k they paid an additional $2k in taxes.

[2] I've been using just real returns and 2013 dollars everywhere, but to figure out how the money is taxed we need to know what happens with inflation because the 15% long term capital gains tax is on nominal growth, not real growth. If inflation were 0%, then a 3.5% real return over 40 years means that of your final balance 46% would be the initial after-tax contribution and 54% would be gains. Add an estimated 3% annual inflation, however, and 73% would be gains. (In this case after 40 years of inflation-adjusted $8k contributions they would have put in $600k (nominal) and ended up with $2.2M (nominal).)

Comment via: google plus, facebook

Recent posts on blogs I like:

What Does Private Affluence, Public Squalor Mean?

I’d like to compare three cities: Paris, New York, Boston. They’re about equally wealthy, and I’ve lived years in two and spent a lot of time in the third. Americans dismiss New York and Boston too often as Not Real America, but they’re both excellent exa…

via Pedestrian Observations November 19, 2019

Pieces of time

My friend used to have two ‘days’ each day, with a nap between—in the afternoon, he would get up and plan his day with optimism, whatever happened a few hours before washed away. Another friend recently suggested to me thinking … Continue reading →

via Meteuphoric November 11, 2019

Wild animal welfare in Hans Christian Andersen

Continuing the theme of wild animal suffering in children’s lit… Hans Christian Andersen’s stories involve a lot of suffering of both human and animal varieties. “The Ugly Duckling” takes a brief detour from describing the duckling’s repeated social humil…

via The whole sky November 7, 2019

more     (via openring)

More Posts:


  ::  Posts  ::  RSS  ::  ◂◂RSS  ::  Contact