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401k - IRS tax-deferred retirement fund account - morfizm


Feb. 3rd, 2013 04:52 pm 401k - IRS tax-deferred retirement fund account

I wanted to explain to non-U.S. friends the specifics of the U.S. retirement accounts.
There are several forms of retirement protection available:

1. Social security. This form of pension, common in socialist countries, represents only a small fraction of what a typical capitalist retiree should get, because it's designed to be very small and cover only basic survival needs. People pay social security taxes during their active years, and may get social security benefits paid by younger generation who pays taxes when you're old. I am not sure if you're even eligible for social security benefits if you have other forms of savings (tried to Google this, but couldn't find). In any case, this might be something in the lines of $1-2K/mo, depending on the year when you retire.

2. 401k. This is tax-deferred pension plan, where you contribute your own money (pre-tax) during active years, and you can withdraw them after reaching retirement age, and pay all taxes at the time of withdrawal. It's generally difficult to withdraw these money before reaching retirement age.

Benefits of 401k:
2.1. Money grow (with all the compound interest) pre-tax.

While this is true, the impact of this is less significant than the common speculation.

The common speculation intended to promote 401K funds is to say you defer $1 pre-tax, and earn 7% on it, you get $1.07 in your savings account by the end of the year. If you invest in IRA (after-tax retirement fund), you already get, say, 70% of that $1 (if it's your current tax rate is 30%), therefore you invest $0.7 and only get $0.77 by the end of the year. 401k is better than IRA: $1.07 vs $0.77.

The common speculation intended to promote IRA funds is to say that you defer $1 pre-tax, earn 7% on it, get $1.07, but when you need to withdraw, you pay, say, 30% in taxes, off the entire amount, so you get $0.75 (70% of $1.07). While if you invest $1 in IRA, you get $1.07, but only pay taxes for the profit, so you end up with $1.05 ($1.00 + 70% of $0.07). IRA is better than 401k: $1.05 vs $0.75.

In the first variant we forget to account taxes you pay at withdrawal. In the second variant we forget about taxes upon contribution (investment of $1 in IRA requires to earn $1.43, $1.00/(1-30%), so it's a 43% bigger investment).

The correct calculation is more like this: if we assume effective tax rate is the same 30% at both contribution and withdrawal, and effective interest rate is 7%, then in case of 401K we invest $1.00, get $1.07 and pay 30% taxes upon withdrawal, getting $0.75, and in case of IRA we invest $0.70, get $0.77, and pay 30% taxes upon withdrawal, but only on interest: $0.77 - $0.07*70% = $0.75.
So in case of one year investment followed by a withdrawal, we end up with the same $0.75, no difference.
The difference show up *only* dealing with compound interest. For the sake of simplicity, imagine we only invest during 1 year, then we wait 30 years, accruing compound interest, and then we do a withdrawal on the entire amount, at the same effective tax rate of 30% and the same interest of 7%.

In case of 401k, you'll get $1 * (1.07^30) * 0.7 = $1 * 7.61 * 0.7 = $5.33.
In case of IRA, you'll get ($1 * 0.7) * (1.07^30) = $5.33, but because the difference $5.33-$1.00 = $4.33 is made from interest, you pay another 30% on $4.33, which is an extra $1.30 in taxes. End result is $5.33 - $1.30 = $4.03.

Basically, in case of 401k you multiply the entire amount, with compound interest, by tax rate, and in the IRA variant, you pay taxes once on base amount and twice on the interest part.

7% is a reasonably high/aggressive interest rate. Most people save more conservatively, and get, say, 4%. In this case, over 30 years, IRA may give them 15-20% of advantage. If you invest aggressively and get, say, 15% of annual interest, then you can get an extra 40%.

2.2. It's a common practice that employer "matches" your contributions up to a certain percentage. For example, for every 1% of your annual salary contributions, employer adds 50%, up to 4%. You invest 4% and get 6%. Employer's part is a "free money", taken away from people who don't use 401k, and given to you. In my opinion, it is stupid, and I would prefer equality, where everyone is just getting a higher salary, regardless of their 401k contribution choices, but this is the way it is today, and since it is the way it is, it's beneficial to be in the half that gets the money, rather than in the half that doesn't get. If you think about these 50%, it makes it worthwhile to contribute to 401k up to employer matching limits, even if you're planning to make an early withdrawal with paying taxes and paying 10% early withdrawal penalty, you still win because of free money.

Another good part of employer match is that it's not counted for the IRS limits for the maximum 401k contribution. You can contribute max, and have employer add something on top of it.

2.3. 401k savings are protected from creditors, and you save 100% it in case of bankruptcy.
2.4. You can borrow from 401k, assuming you timely pay it off back into your 401k. No taxes are involved, and the funny part is that you have to pay yourself back along with interest. You can look at it as a legal opportunity to contribute more, above IRS limits for maximum 401k contributions.

2.5. When you retire, you typically have your house paid off, and you also don't have to live in expensive area near your job, your kids have grown up, so your life expenses are generally lower. Which means there is a possibility you'll be in a lower tax bracket, and pay smaller effective tax rate. 401k allows you to take advantage of contributing pre-tax when your tax rate is higher, but then paying taxes at, hopefully, lower rate.

Given our current socialistic trends and Obamageddon, I wouldn't bet on it very much. In fact, the opposite might be the case: what if taxes at retirement age are much higher than today?

3. IRA. IRA is similar to common investment account, where you invest your after-tax money, with a few extras:
3.1. There are additional choices of certain tax-free funds, that theoretically help you earn more with the same level of risk.
3.2. This money are protected in case of bankruptcy, but not the entire amount (last thing I've heard is that only the first $1,000,000 is protected).
3.3. You have limits on how much you can contribute to IRA.
3.4. There are early withdrawal penalties, which are different from the ones you have on 401k, but still harsh. There is also a waiting period in case of early withdrawal - you won't be able to make new contributions for several years after this event.

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