When I draw on my 401K (in 30+ years) will it be taxed just like income? IOW, if I pull out $80,000 in one year, will I pay income tax as if I got paid $80,000?
Not sure I understand the question.
Is it a regular 401k or a Roth 401k?
Are you asking if it is taxed as ordinary income or capital gains?
Assuming that it is not a Roth 401k then the entire $80,000 gets taxed as ordinary income.
But take that for what it’s worth as I do not work for the IRS.
I assume a regular 401K, not a Roth IRA…is there something different?
My understanding is that if I put away, say, $6K a year, I won’t get taxed on that $6K. It will grow as it earns a percentage based on how it is invested (mutual funds, real estate, bonds) and that won’t get taxed either. Then, when I retire, I will have this large sum of money that STILL doesn’t get taxed as long as it sits there. Only when I draw from it will it get taxed, at which point it will get taxed as regualr income.
So, IOW, if I have a billion dollars sitting in my 401K, but I only draw out $40,000 in 2040…then I pay the same taxes that someone who got paid $40,000 would in 2040. The rest still doesn’t get taxed. Then, if in 2041 I draw $100,000, I’ll get taxed as if I got paid $100,000.
Correct?
I assume a regular 401K, not a Roth IRA…is there something different?
You pay income taxes on a Roth prior to depositing the funds. Then you aren’t taxed on that amount when you withdraw it into income.
Yes, I understood that…but then don’t understand the advantage of a Roth versus just putting money into mutuals.
Yes, the problem comes in as you get older and your forced to take larger and larger amounts out of your 401k based on age. At this point you are paying ordinary income tax on your distributions at the current tax rate. If you think you will be in a higher tax bracket when you retire than you are now you may want to consider a Roth.
If you are young and just starting out and your income is rising you should use a Roth 401k rather than an old fashioned 401k. This means that you get no tax benefit on the money you put in now but because you have paid tax on it now you can withdraw it taxfree later in life. So if you are in a 18% tax bracket now and you think you will save enough for retirement or continue to work after you start pulling money from your Roth which may push your income into a higher tax bracket then you are wise to use a Roth.
There are complex rules that will allow you to contribute to both a Roth and a regular 401k in the same year but you really need to understand the implications.
I assume a regular 401K, not a Roth IRA…is there something different?
My understanding is that if I put away, say, $6K a year, I won’t get taxed on that $6K. It will grow as it earns a percentage based on how it is invested (mutual funds, real estate, bonds) and that won’t get taxed either. Then, when I retire, I will have this large sum of money that STILL doesn’t get taxed as long as it sits there. Only when I draw from it will it get taxed, at which point it will get taxed as regualr income.
So, IOW, if I have a billion dollars sitting in my 401K, but I only draw out $40,000 in 2040…then I pay the same taxes that someone who got paid $40,000 would in 2040. The rest still doesn’t get taxed. Then, if in 2041 I draw $100,000, I’ll get taxed as if I got paid $100,000.
Correct?
Barry,
This is correct. You are taxed at ordinary rates (not capital gains rates) on the amount you withdraw from your 401(k) in any given year. Assuming you are older than 59.5 there is no penalty (if you take it out at age 40 there is a 10% penalty on top of the income taxes). There are minimum required distributions beginning the year you turn 70.5, so if you have a billion dollars in your 401(k) and are 75, you won’t be able to just take $40,000 out…you’ll have to take something like $44 million out (the balance at the previous year end divided by 22.9 years). Good luck on getting to the $1 billion mark.
Mike
When you say “forced” do you mean because I’ll need the money and elect to take it out on my own, or is there some law where I have to take it out?
Regarding tax brackets, this is what I’m trying to work through. ALL of the money I put away right now will be avoiding a 25% federal tax since it lowers my taxable income. IOW, if I am in the 25% tax bracket, but defer 10% of my income and am still in the 25% tax bracket, then that’s 25% I would have otherwise been hit with.
However, if the money truly remains as a lump that is untaxed until I draw on it, and is taxed as regular income, assuming I am within a realistic range of my current income, it will be taxed at a lower rate BECAUSE only income above $50K gets hit at 25%. The income between $30K and $50K is charged 15%, $7K-$30K is charged 10%, and $0-$7K gets charged 10%…not to mention the standard $6K deduction that gets charged nothing.
I calculated out, assuming that this is correct, that putting away $60K over several years will defer $15K in taxes, but will only cost $10K in taxes if I draw it out in one year of retirement.
Okay I have to preface ALL of this by saying I am not a financial planner I am a CFO. Big difference.
There are a lot of big IF’s in your assumptions.
First one that jumps out at me is that you are assuming the only income you will have is from your 401k? Highly unlikely. You will accumulate non tax deferred stocks and bonds and such through your lifetime, you will probably work in some capacity, or you will have income from other sources (spouse etc). All of this will combine to push your income up to a higher bracket even at retirement.
Second - you are assuming the tax brackets will stay the same. Not the best assumption for 30 years from now.
And yes, you will be “forced” to take money out. I do not know the calculations but beginning at age 70 1/2 you are REQUIRED to withdraw money from your 401ks.
My suggestion as I say to all employees of clients I advise. Pay a few hundred dollars to a NON-ALIGNED Certified Financial Planner. (someone who doesn’t earn fees for steering you to investments) for some advice. It will be the best money you ever spent if you do not feel comfortable in this area.
With mutuals you pay tax on the gain when you sell. You don’t pay tax on anything you pull out of a Roth. Say you put $40k into a Roth. You’ve already paid tax on the money. If you invest wisely and your $40k turns into a million bucks, you take that money out tax free. If you put $40k into a plain old mutual fund and it turns into a million bucks you’ve got to pay tax on your $960k gain.
The “forced” withdrawals are calculated based on actuarial tables.
An example:
Let’s say you have $1 million in your 401k at age 70.5. Just guessing here as I am not an actuarian, but let’s say the tables say you are going to live to 86 years of age (on average I would suppose) as you are a non-smoker, married (probably), and whatever factors go into the equation. Then, you have 16 years to withdraw all that money (plus interest), or a minimum withdrawal of $62,500 per year (plus interest). I do believe you are allowed to withdraw more per year than the minimum. I am not yet familiar with what kind of withdrawal schedule options exist (e.g. monthly, quarterly, annually).
The trick is, that by the time you start withdrawing (pre-tax contribution) money from your 401k, you should be in a lower income tax bracket than when you contributed to the 401k. For example, if while you are working you are in the 28-31% marginal tax rate bracket, but then retire to where your retirement income (pensions, S.S. and 401k fund withdrawals) leaves you in the 15-20% marginal tax bracket, then you come out ahead by 1) essentially deferring taxes until you are in a cheaper tax bracket, and 2) allowing for tax free interest accumulation on both the interest and your contributions for many years. Win-win.
One little know caveat, there are potential penalties involved for the super motivated. If you accumulate too much money in your 401k, you can be subject to a 15% (as best as memory serves me) excise tax on withdrawal. This was projected to be around $2.5 mil in about 9 years according to the last time I looked at it. Under this scenario, it would happen if you turned 70.5, had $2.5 mil+ in your account, and the actuary table required complete withdrawal in 12-13 years. Then the annual amounts would exceed a specific number and would be subject to the tax. Slight good news is that the target amount for the tax was subject to annual cost of living type increases, so that threshhold for the tax limit rises. Having not contributed to a 401k the last 10 years, this is no longer an issue for me and I have not followed it closely since then. Some details might have changed.
But, it use to really piss me off that, on one hand the government tells you not to count on S.S. and that you are responsible for your retirement years, and don’t count on us. But, on the other hand, if you do take appropriate action and take advantage of everything out there, they come back and pick on you for being reasonable intelligent and self-sufficient. Don’t even get me started about self-directed S.S. 
I assume a regular 401K, not a Roth IRA…is there something different?
This may help:
My suggestion as I say to all employees of clients I advise. Pay a few hundred dollars to a NON-ALIGNED Certified Financial Planner. (someone who doesn’t earn fees for steering you to investments) for some advice. It will be the best money you ever spent if you do not feel comfortable in this area.
This is why I’m trying to feel comfortable in this area. One of my training partners is a very sucessful financial planner and gives me advice, but I find it a little frustratin that he can’t give good answers to some of my questions (to the best of my knowledge, he completely misunderstood how mortgage interest works…either that or I do, but all the info I find backs up my position). I get the feeling that sometimes these financial planners are just really good salesman who also happen to be on the ground floor when it comes to future market predictions.
Granted, this doesn’t mean that they won’t do the right thing with my money…I just like to understand what it is that I am doing. WHY a 401K and not mutuals? WHY more bonds? WHY a Roth IRA? etc.
Anyway, thanks CLD and everyone else.
Ernst & Young (a top CPA firm) have a series of books on this subject geared to people with a three figure I.Q. I just checked and they are available on Amazon.
They would answer a lot of your questions and are not that expensive.
WHY a 401K and not mutuals? WHY more bonds?
But a good 401k program should offer you the chance of many mutuals. It all depends on who runs the 401k and to some extent the size of the company employing you.
Bonds are something, when you are young, for diversity. Otherwise, I think they are of more value to much older folk who need tax shielding investments (gets back into the high marginal tax rate situation again). Personally, if you’re young and into bonds, you’re a wuss.
I also agree that a lot of financial planners are pretty much salesmen. The idea of going with the big investment brokers and buying the house brand mutuals, or letting them invest your assets in stocks as they see fit is really ludicrous in mind mind. There is no risk for them to play with your money.
Ernst & Young (a top CPA firm) have a series of books on this subject geared to people with a three figure I.Q. I just checked and they are available on Amazon.
Well…I’m pretty sure I’m in the three figure range ; ^ )
Thansk a lot. I’ll check them out.
But a good 401k program should offer you the chance of many mutuals.
Yes, but only as a tax deferred investment that you can’t touch until you are ~60. I meant to differentiate that from ivesting into mutuals psot tax.
Yes, I know WHAT the difference is, but want to truly understand the why.
A couple quick things:
Let’s say you have $1 million in your 401k at age 70.5. Just guessing here as I am not an actuarian, but let’s say the tables say you are going to live to 86 years of age (on average I would suppose) as you are a non-smoker, married (probably), and whatever factors go into the equation. Then, you have 16 years to withdraw all that money (plus interest), or a minimum withdrawal of $62,500 per year (plus interest). I do believe you are allowed to withdraw more per year than the minimum. I am not yet familiar with what kind of withdrawal schedule options exist (e.g. monthly, quarterly, annually).
The IRS sets the tables giving life expectancies. There are two tables you can use: Uniform Life Expectancy Table, or Joint and Last Survivor Table. There isn’t a separate table for smoker/non-smoker or anything like that. You have to use one of those two tables. If the table says 20 years, and you have $1MM in your 401(k) and IRAs, then you have to take out at least $50K. You can take out more than that if you desire. Generally, the withdrawal schedule can be whatever you want (this probably depends more upon who is holding the money and their terms).
One little know caveat, there are potential penalties involved for the super motivated. If you accumulate too much money in your 401k, you can be subject to a 15% (as best as memory serves me) excise tax on withdrawal. This was projected to be around $2.5 mil in about 9 years according to the last time I looked at it.
I have never heard of this rule. I know folks with well over $3MM in their IRAs and have never heard this mentioned. My tax research (done very quickly) did not bring anything up on this either. The only excess contribution rules I know of are on the front end (there are limits to the amount of contributions).