Tax wise 401ks aren't that good of investment for the future?
I mean it get's taxed as regular income when you hit retirement, what are some alternatives ways to plan for retirement that don't get taxed as income.
- AmyLv 72 months ago
Let me explain why 401(k)s are actually great tax-wise. (That is, beyond the fact that most employers will add extra money to your account for free).
Let's say you're earning $60,000 per year. The way US tax brackets work:
You pay 0% tax on the first $12,400 (a.k.a the standard deduction)
You pay 10% tax on the next $9,875
You pay 12% tax on the next $30,250
You pay 22% tax on the remaining $7,475
total tax bill: $6262.
But suppose that you put that last $7,475 into a 401(k). You don't pay tax on it this year, so your tax bill drops to $4,617.50.
You do this every year from age 30 to 60, and then you withdraw $7,475 every year from age 60 to 90.
In retirement, tax is calculated the same way: you pay 0% tax on the first $12,400. Because $7,475 is less than $12,400, you don't owe any tax.
What about investment gains?
Let's say you invest $10,000 in a product that pays 5% every year.
In the first year you earn $500. Capital gains are taxed at 15%, so you pay $75 tax and end up with $10,425 in your account.
In the second year you earn $521.25. You pay $78.19 tax and end up with $10,868 in your account.
And so on. Every year the tax on your earnings cuts reduces the 5% return to 4.25%.
After 30 years your investment is worth $34,856.
If you put that money in a 401(k) instead, it will be taxed as regular income when withdrawn. But ONLY when withdrawn. The tax isn't compounded over every year of investment.
$10,000 invested at 5% for 30 years grows to $43,219. Look again at the tax brackets above. You'll pay 0%, 10%, and 12% on the dollars you withdraw - that's less than the 15% you paid every single year with a taxable account.
There is one situation where you want an alternative to a 401(k). That's if your income is pretty low this year (maybe you lost your job) but you expect a higher income in retirement (maybe from a big inheritance). In that case you want to get your taxes over with in this year, but you'd like to still avoid paying tax every year on investment gains.
That's when you want a Roth account. Some employers offer a Roth 401(k), or you can open a Roth IRA.
- StephenWeinsteinLv 72 months ago