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Lev
Lev, Tax Advisor
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401K + Deferred Income question

Resolved Question:

If I have a $100k+ in cash right now and make about $165k/year, while only needing about $70k/year to live on, what's the best conservative strategy to minimize taxes today and provide for a decent return on my money? Also, I'm only at a 3% contribution on my 401k today. Additionally, I'm 27 years old. Does it make sense to maximize my 401k contribution and then take a deferred income? Thank you.

Submitted: 1 year ago.
Category: Tax
Expert:  Lev replied 1 year ago.

LEV :

Hi and welcome to Just Answer!
Most likely - you have 3% contribution into 401k plan - because only 3% are matched by your employer. So your strategy is to maximize your employer's contribution - and that is perfect.
If you want to increase your own contributions should be based on several issues.
First - if you are willing to put these money aside for long period - generally till the time you will stop working (while there are some options to access funds - still that might be not practical)
Second - how your 401k plan performs? If it produces a good return - I would say - yes - you need to make larger contributions.
If however your 401k doesn't produce any earnings - you might be very careful.
Larger contributions will provide you with some benefits:
- your tax liability will be less (federal and state!) and you might avoid larger tax brackets.
- your adjusted gross income (AGI) will be less - and that might affect other deductions and credits many of which are based on AGI.
Please be aware that your total 401k contributions are limited - $17,500 in 2013 (plus $5500 catch-up contribution limit for employees aged 50 and over)

LEV :

Please be sure you review the answer.
Let me know if you need any help.

LEV :

My goal is to provide EXCELLENT service.
I will address all your concern and tax related issues.

Customer:

my employer does not match contributions, so the 3% is something i selected myself

Customer:

i understand that there is a 10% penalty on withdrawing funds prematurely + your income tax

LEV :

Unfortunately - some employers do not match. The law doesn't require employees to match contributions - that is optional.

Customer:

so if my 401k grows 10% or more and i take out the money then, i basically come out even

Customer:

right?

LEV :

Yes - that is correct - early distribution is generally subject of 10% penalty. However if distributions are taken after 59 1/2 - there is no penalty.

Customer:

what if i want to take out money from my 401K to purchase my first home. still a penalty?

LEV :

That is not exactly right.
First of all - it is anticipated that you will start distribution after you retire - and your income will be much less - so your tax rate will be less as well.
Second - you defer tax liability (not avoid!) - so whatever taxable income you defer now by making contributions into 401k plan - will be taxed when eventually you will stat taking distributions.
However - even if your tax rates will be same - by deferring taxes - you king - using these money to earn additional income.

LEV :

There are some exemptions from penalty - including to purchase the first home. However this exemption doesn't valid fro distributions from 401k - only for distributions from IRA. To use it - you need to rollover the money to IRA first - and after that take a distribution. Also that exemption is limited by $10,000.
In case of 401k - you might have better option - to take up to $50,000 loan out of your 401k and use it to purchase the house - you will pay back the loan out of your paychecks and the loan will not be taxable.

Customer:

ok i see. right now, my income is roughly $168k, but by the time i retire, i anticipate it to be higher due to investments and passive incomes (i.e. rent income on property, stock dividens, etc.) in this case, does it still make sense to have a retirement plan?

LEV :

In many situations - having retirement money would be a good option.
If you have large income - it might have sense to defer part of your income.
In additional - you might be able to convert funds from your 401k plan into Roth IRA - yes - the amount you convert will be taxable - but all earnings in Roth IRA potentially will never be taxable.
In additional - funds in 401k are protected from garnishment (I hope you do not need this option now - but we never know the future).
On another hand - you are correct - there should be right balance between retirement saving and regular accounts.

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 23259
Experience: Taxes, Immigration, Labor Relations
Lev and 5 other Tax Specialists are ready to help you
Customer: replied 1 year ago.

Hi Lev,


 


I'm still trying to wrap my mind around the benefit of a 401K and whether it makes sense for me to forego my earnings today for a potential future payoff. It basically boils down to this: I'm a very ambitious young man and I fully intend to be earning more at retirement than I am currently. Right now, I'm in the 28% federal income tax bracket, but I expect that in about 10 years or so I'll be in the 35% or 39.6% income tax bracket. I don't expect my income to decline over time, as I intend to have passive investments and rental properties. Effectively, I have two questions:


 


How is retirement defined for the purposes of the IRS? Can you retire from work, but still run your own business(es)?


 


If the scenario I described above holds true, why would it make sense for me to have a 401k right now?


 


Thanks very much.


 

Expert:  Lev replied 1 year ago.

How is retirement defined for the purposes of the IRS?
There is no special definition for "retirement."
You may consider yourself as retired as you wish and at any age.
There are some definition of retirement based on specific purposes. Most are based either on age or on years in service or on both.
For instance for social security purposes -
early retirement age is generally started at 62
normal retirement age is between 65 and 67 (based on the year of birth)
For the IRS - for distribution purposes from retirement funds to avoid early distribution penalty - the age is 59 1/2.

Can you retire from work, but still run your own business(es)?
You definitely could - there is no age discrimination from running the business.

 

If the scenario I described above holds true, why would it make sense for me to have a 401k right now?

I would say - yes - because contributions into qualified retirement plans are limited - I would suggest to make contributions whenever it is possible.

The advantage is that tax liability on earnings inside qualified tax deferred account is also deferred. That is true - you will pay taxes later - but by delaying tax liability - you are kind-of interest free loans from government to use for your investment.

In additional - funds from 401k plan could be converted to Roth IRA. Yes - such conversion is taxable - however earnings inside Roth IRA are potentially NEVER be taxable,

So - there are some opportunities arise from having funds in the 401k plan.

Customer: replied 1 year ago.

Thanks Lev - this is helpful.


 


Under what scenario would it make sense to convert a 401K into a Roth IRA and are there costs associated with that?


 

Expert:  Lev replied 1 year ago.
Under what scenario would it make sense to convert a 401K into a Roth IRA and are there costs associated with that?
There might be several circumstances when such conversion could be beneficial.
Mainly because when converting deferred funds to Roth IRA - you will recognize income and will pay income taxes on the amount converted.
For instance if any particular year - your taxable income is dropped to lower tax brackets - you might think to "boost" your income and pay additional taxes.
Also - if you expect that earnings in your Roth IRS will be substantially higher - you will benefit from possible tax free income.

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