USA Are traditional 401k's of any value from a tax perspective?


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I'll preface my questions with stating:

This question is strictly from a tax perspective. I recognize that some employer 401k's offer a match to a certain percent (so that is free money) and that there is some protection around guarding your assets if they are in a 401k (versus a savings account).

When thinking about a traditional 401k from a tax perspective is there a real benefit?

No matter what, Uncle Sam is going to get your money (assuming you play by the rules), it's just a matter of how much and when. When I think about a traditional 401k from a tax perspective, the first thought that comes to mind is that you're deferring the tax on these contributions, in hopes that you'll be in a lower tax bracket in retirement and hopefully lowering which bracket you're in over your lifetime. The downfall though is when you do begin to withdraw funds, you're paying ordinary income taxes on both the money you put into the fund, as well as the gains that have been acquired in the fund.

If I were to invest money into a brokerage account versus contributing the money to a traditional 401k, I would pay ordinary income tax on the money I am putting into the account. This money may be taxed at a higher income tax rate (versus at a lower rate during retirement if invested in a traditional 401k), however, the long term capital gains I acquire on this investment would be taxed at a much lower rate (ex. 15%) than my ordinary income rate. As such, when comparing investing independently in a brokerage account versus placing funds in a traditional 401k account, isn't the real comparison in the difference between my ordinary income tax rate with the long term capital gain tax rate, compared to how much deferring the taxes on my income may prevent me from going to the next higher tax bracket?

Take the following for example:
- Married
- Filing Jointly
- $350,000 AGI

If I were to invest the maximum amount allowed by the IRS in 2019 ($19,000) into a traditional 401k, that would lower my AGI to $331,000, which would keep me in the same 32% tax bracket for monies $315,001 to $331,000. Fast forward 20 years, I now retire and begin taking distributions from the 401k and I am paying ordinary income tax on those distributions (say 22% now that I am retired). On the contrary, if I were to place my income into a brokerage account and invest on my own and make a return over a year out (long term gain), then I am only paying 15% on that gain. That's a savings of 7% on the capital gains in this example.

So when comparing a traditional 401k to that of individually investing in a brokerage account, why would I put more than an employer match into a traditional 401k (strictly from a tax perspective)?

With a Roth 401k, while you do pay your current ordinary income tax rate (which I believe will be higher now than in retirement, I know there's a big debate) any capital gains you receive in this Roth 401k account are not going to be taxed at time of distribution (during retirement). As such, wouldn't I be better off investing in a Roth 401k than individually investing in a brokerage account as with the latter, any capital gain I receive, I'll be taxed, where as with a Roth 401K capital gains are not taxed.

Most articles you find online compare traditional and Roth 401k's and continuously reiterate if you think you're going to be in a higher tax bracket in retirement go Roth, or lower, go traditional, but I think there's a lot more to consider (which is what I presented above).

Thank you in advance for any replies in assisting my understanding of taxes as it pertains to investing.

Sincerely,

A baby boomer born in a millennials world
 

kirby

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In your second paragraph you exclude the employer match from the comparison. You need to include it for a fair comparison.
 
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bklynboy

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If you choose to save through a brokerage account likely that is a mutual fund or ETF and a lot of those gains are short term meaning not taxed at lower rate. Even where its long term you will need to pay taxes in that year and may need to liquidate other savings to get the funds. The time value of the lost money you pay today to fund the tax needs to be baked into your calculation. For instance if I put 100 into a 401K and leave for 30 years (rate of return is 10%) this grows to 16,500. However, if I put in a mutual fund and need to pay taxes on distributions each year (same return) I will end up with much less than 16,500.

So unless you are experienced at investing and directly purchase stocks, you will not do as well as a 401K. The whole point of these is to maximize payments into a fund(s) without paying taxes during the build up of value. Using brokerage you dont get that benefit.
 

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