401K Cruel Joke On Workers. Taxed As Regular Income On Distribution. Not Part Of Capital Gains Rate

[TheMastersNemesis]

As Senator Rubio's and GOP's tax bill includes ZERO taxes on investments your 401K does not fall under the "capital gains' tax rate. Upon distribution the 401k is taxed like earned income just like your job pay. You are treated like you are still working even though your 401k actually is grown on investing in the stock market. Capital gains rates are based on the argument of investors taking risk. Workers with 401K's are NOT considered in that class. So if you lose you lose.

And their is another anomaly in the 401k system. If your 401K loses big in the stock market during your career you are not able to take tax reduction for all those losses over the years. If you make big gains you are taxed. If your 401k sinks you are sunk I guess.

[Wella]

1. You're lucky they're actually letting you keep your 401K, taxed and all

At least for now.

[Larry66]

2. dual rules

Another example of the double standard for the wealthy and the rest of us.

[cbdo2007]

3. Are your comments geared at 401Ks in general or Senator Rubio's tax bill??

[TheMastersNemesis]

7. In A Sense Both.

Taxes paid on capital gains are less than on 401k's upon distribution. The tax bill came up on Chicago progressive radio this morning. Rubio's and the GOP tax bill could be passed by reconciliation. They want to eliminate ALL taxes on capital gains which would cost the government trillions. The tax burden would be passed on to workers under such a plan.

Ultimately a huge hole in the budget would be the result. The GOP plan is to ultimately bankrupt the US altogether so they could shut down the bulk of the US government they hate. In their view the only cabinet level agencies that should exist is Homeland Security and Department of Defense. Everything else resides in individual sovereign? states.

They will never give up on the idea of virtually no federal government. Natural disasters in their view should be handled at the state level. Any domestic programs should be handled by charities and churches like pre 1900.

[alcibiades_mystery]

4. My 403(b) statement shows my contribution and my institution's contribution

At the very least, the sum of the 401k/403b above the contribution should be taxed at the capital gains rate, since it is, in fact, made up of capital gains. I can see how the contribution would be taxed as compensation since it is technically compensation. Why the gain (or loss) should be taxed as compensation at distribution is not clear to me at all (apart from the obvious reason that workers get soaked).

[Nye Bevan]

10. The reason is that your 401k contributions come from pre-tax dollars,

which is equivalent to them being fully deductible.

As an alternative, you can open a Roth IRA and your entire investment will grow fully tax-free; no income tax, no capital gains tax, nothing, ever. The difference is that in this case your contributions will come from after-tax dollars and are nondeductible.

[dixiegrrrrl]

32. AND there is a way to turn your 401-k into a Roth at some point.

I think it is after you are not working any more????
I remember I did that with one of my retirement funds.
and it might include paying taxes on the 401-k before turning it into a Roth.

All I know is I did something like that, in 2000, and invested in Vanguard's REIT funds, which turned out to be highly lucrative at the time.

I am sure there is someone here with a better memory or better grasp of the process...

[B Calm]

5. We should demand that Congressional pensions be replaced with a 401k retirement plan!

[madville]

23. They already have a similar style fund

It's called TSP, I'm in it, it's a major part of the overall FERS retirement package on top of the pension.

Basically the Feds match your contribution into the fund, up to 5% of one's annual income. The employee then selects if they want bonds, various funds, etc.

[B Calm]

24. Sure they got that too, but they also get a very nice pension after only 5 years in office! Like

a lot of companies all over the country who did away with our pensions and replaced it with 401k, the same should be done to congress!

[Nye Bevan]

6. 401Ks effectively provide a fully tax-free return, thanks to the deductibility of the contributions,

assuming that your income tax rate at retirement is less than or equal to your income tax rate when working, which will generally be the case.

To see this, assume for simplicity that your income tax rate both when working and when retired is 30%. Say you invest $100 in a 401k when working, get a 5% annual rate of return on your investment, and withdraw the value of this investment (principal and interest) 10 years later, when you are retired.

The $100 contribution is fully deductible, so the after-tax cost to you of the investment is $70. Over the 10 years the $100 grows to:

$100 * (1.05^10) = $162.89

So in 10 years you withdraw $162.89 and pay 30% tax on this whole amount, leaving you with $114.02.

Looking at the after-tax numbers, you invested $70 and received back $114.02 10 years later. Note that $114.02 is equal to $70 compounded up at the full 5% for 10 years. You have effectively earned a tax-free return on your investment of 5%.

Moreover, if your tax rate after you retire is lower than your tax rate while working, you will have done even better. And all of this is before even considering any matching contributions.

None of this is intended to constitute financial advice. Always consult a professional before making any investment decisions.

[A HERETIC I AM]

8. Saying that 401(k) contributions are "deductible" is a bit of a misnomer

Money contributed to such plans are done so pre-tax and lower the individuals adjusted gross income and therefore his taxes.

If one does not have such a plan and uses a traditional IRA, money contributed to that is indeed deductible.

It is in effect the same at the end, but terminlogy is important.

[Nye Bevan]

9. The key point is that the after-tax cost to you of contributing $100 to a 401k is $70,

assuming that your marginal income tax rate is 30%.

Thank you for the clarification on the semantics.

[A HERETIC I AM]

11. I was just going to edit my post when I saw you responded!

First, I like to state that I don't mean to tell you things you are probably aware of, and I was going to edit to mention that!

Your larger points are accurate and well taken.

I was going to ask the OP if he realizes that the money going into such a plan has yet to be taxed.

So...again, not directed at you specifically, but for the discussion I'll add;

Anyone can open a regular, run of the mill, taxable investment account and pay capital gains tax rates when they do indeed have capital gains.

Those rates don't apply to 401(k)'s because they aren't taxed on an annual basis, only upon withdrawal. No one has to add a line to their 1040 showing how much their 401(k) gained or lost every year. That's why it's called "deferred taxation".

[Nye Bevan]

12. I would just add that all but the rich can open a Roth IRA,

contribute to it out of after-tax dollars, and pay zero income tax, zero capital gains tax, no taxes at all, provided they hold onto it until retirement.

[A HERETIC I AM]

14. Deleted above cause I can be too quick!

(I restated what you said!)

Everyone who has the ability should open a Roth.

They have some distinct advantages over 401(k)'s and Traditional IRA's

[dixiegrrrrl]

33. Not just the rich.

I had a Roth, with Vanguard, self directed, and at the time their minimal amount to open an account was maybe..200.00?
It has gone up, but still affordable to those who make more than min. wage.

the only caveat at the time was that you has to max out your annual 401-k contribution, the Roth was with "leftover" money.
And of course this was when jobs paid a decent salary.

[lumberjack_jeff]

18. Buying one share of XYZ corporation for $70

Which appreciates in value to $185.75 after 20 years (5% compounded) is the same net amount after subtracting withdrawal taxes of 30% on an initial 401k investment of $100.

In other words, investing in an IRA or 401k has no advantage over investing in individual stocks (or any investment which only yields a capital gain when sold).

The difference is that the taxable investment isn't locked up in the interim.

[Nye Bevan]

19. I'm not sure I follow.

Compare the following 2 strategies:

1. Invest $100 (after-tax cost=$70) in a 401k which buys XYZ stock. Stock appreciates 5% per year for 20 years, account value ends up at $265.33. Withdraw this from your 401k, pay taxes of $79.60, end up with $185.73 after tax.
Summary: after-tax cost=$70, after-tax return 20 years later = $185.73.

2. Invest $70 in XYZ stock using after-tax dollars. Stock appreciates 5% per year, value of stock in 20 years is $185.73. Sell stock and pay capital gains tax of 15%*(185.73-70) = $17.36, leaving you with $168.37.
Summary: after-tax cost=$70, after-tax return 20 years later = $168.37.

So you are better off with the 401k. Only exception might be if your tax rate after retirement was significantly higher than your tax rate at the time of making the contribution, which will not be the case for most people.

A third strategy is to invest $70 in a Roth IRA which buys the stock, and you will then again end up with the $185.73 at retirement.

[lumberjack_jeff]

21. You understand - despite my poorly worded post.

Your math is sound, but all things being equal, the flexibility to use/invest the money how you see fit is a powerful upside.

[rogerashton]

27. Moreover,

Depending on how it is invested, not all of the growth of a pension fund is capital gains. Reinvested (taxable) interest and dividends will also be included. Some of the growth may be reinvested rental income -- many 401k's and 409b's include options to invest in REITS. Still another complication.

About financial advice: what he said.

[bullwinkle428]

15. Leona Helmsley was right - it's the little people that pay the big taxes.

[Still Sensible]

16. Absolutely true and terribly unfair! n/t

[jtuck004]

17. Just another way for thieves and liars to get their hands on money they don't work for. n/t

[onenote]

20. Another thread in which some DUers pass up the opportunity to learn something

from those with actual knowledge of the subject.

[magical thyme]

22. that is because a 401K is funded with PRE-tax income, same as an IRA

It's income that you never paid income taxes on. Therefore it is taxed as ordinary income.

Non-retirement investments are made with POST-tax income. You already paid income tax on it. Only the earnings on your post-tax income fall under capital gains, and only investments that you held for longer than 1 year qualify for capital gains rates. Investments held 1 year or less are also taxed as ordinary income.

[Vinca]

25. Thanks for the information.

My first thought after reading the initial post was "thieving bastards." Reality is, you can't escape the tax man.

[Demonaut]

26. and if taken early you are charged a fee, even if you are unemployed, and the 401k is audited

if the company you worked for goes bankrupt..again YOU are charged for the audit
while the 401k is held hostage by the auditors

[cascadiance]

31. And more of us who are losing our savings when unemployed are forced to cash them in now too..

I'm going to have to cash in one of my 401k's soon to not have cash flow problems soon. Have already cashed in most of my IRAs now.

Unless employer contributes to the 401k, I don't think it really pays off, and even then, in today's job climate, jobs don't last as long as they used to either, making it so many don't ever get to that point of employer's matching their contributions either.

[RobinA]

28. 401Ks

are like any other financial product, you need to know what you are buying. I was working when they rolled out 401ks and at the time they did a pretty good job of explaining what the deal was. I wonder if this is still the case.

The cruel joke, which should be obvious to anyone thinking, is the use of 401ks to replace defined benefit pensions. This is not the fault of the 401k.

[BeyondGeography]

29. There needs to be more flexibility for 401s

After the meltdown in 08 the idea of letting people withdraw up to $10K tax free as a stimulus was floated. Most rational people (or many) would have used that to pay down debt and get financially healthier (which is certainly why it was killed). Another great thought that went nowhere.

[Yo_Mama]

30. But the initial investment wasn't taxed.

Tax-free contributions going in. And capital gains taxes, esp. on stocks, are paid every year.