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I have maxed out my 401K for the past 6 years or so, always hearing how it is advantaged. I have done researched and convinced myself it was true, but I was always under the impression that earnings in the plan were never taxed, which I now believe to not be true. Aside from the employer match, which is an obvious direct benefit, what is the 401K really getting me? "Tax Deferred" doesn't seem to matter, because I am paying the tax man now or later, so I don't perceive that as a great benefit as I don't need the extra money now. Is this benefit that I could use extra money now if I really needed to?

Secondly, if there were no employer match, why wouldn't I just go with a Traditional IRA? Both are tax deferred, and the biggest difference that I understand is the employer match obviously doesn't exist in the non employer plan.

Thanks for clearing this up for me!

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The tax deferred status of a 401k plan helps you in theory because your tax rate will be lower once you retire and start drawing the money. This theory could prove incorrect.

Also the money you add to a 401k lowers your taxable income today so you end up paying less taxes to the government right now. Depending on where you are in the tax bracket scale that could have the affect of lowering your tax bracket which will save you money in other areas.

Each person's situation is different by my general theory is to contribute towards retirement in the following order:

  1. 401k - contribute enough to get any free money.
  2. Roth IRA - contribute the maximum allowed under the law.
  3. 401k - contribute the additional up to the maximum allowed under the law.
  4. Non-retirement account - any additional you want to save just save it in a non-tax deferred account.

Hope this helps.

  • Thanks for your input. I have seen this ordering elsewhere as well. I guess you believe that your tax bracket will be HIGHER upon retirement since you are electing to do the Roth IRA before the 401K, right? – skaz Mar 30 '11 at 18:10
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    @skaz - Not necessarily that my tax bracket will be higher in retirement as much as a Roth IRA gives you more flexibility as far as getting the money out. For example you can always withdraw your contributions tax and penalty free since you already paid taxes on that money. Also the investment choices in a 401k are typically very limited but a Roth IRA account can be opened that will give almost limitless investment options. – mpenrow Mar 30 '11 at 18:14
  • @skaz I think 401(k) free money comes first because the employer match essentially doubles your return. For example, if your employer matches up to 3% and you defer 3%, then your retirement contribution gets a 100% return the moment it is taken out of your paycheck. That is hard to beat, even when you have to take out taxes on the back end. – rajah9 Mar 30 '11 at 19:51
  • I don't think tax brackets enter into the equation. Say that your taxable income with no 401k contribution is $92,400. Dollars 0-$8,375 are taxed at 10%, $8,375-$34k at 15%, $34k-$82,400 at 25%, and $82,400-$92,400 at 28%. If you contribute $10k to a 401k, you don't pay 28% on that 10k, but it doesn't affect the rate that you pay on the rest of your income. – KeithB Mar 30 '11 at 20:57
  • @KeithB - Your tax bracket will matter in some circumstances. The most notable being short term capital gains. They are taxed at your tax bracket rate. There are other examples as well. So keeping your tax bracket a low as possible is beneficial in general maybe not in this specific situation. – mpenrow Mar 30 '11 at 21:14
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The benefit is that your earnings in the 401k are not subject to income tax until you make withdrawals. This allows you to grow your money faster than if you made equivalent investments in a taxable account and had to pay taxes on dividends and capital gains along the way. Also, the theory is that you will be in a lower tax bracket in retirement and thus you will pay lower taxes overall. If this is not true (especially if you will be in a higher tax bracket in retirement), then there may not be any advantage for you to contribute to a 401k.

One advantage over the Traditional IRA is the higher contribution limit. Some 401k plans also allow you to take loans from the plan, I don't think this is possible with a Traditional IRA.

An alternative to both the 401k and Traditional IRA is the Roth version of either plan. With a Roth, you pay taxes up front, but your withdrawals during retirement are tax free.

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    You might want to do an IRA instead of a 401(k) if your employer's 401(k) plan was terrible (bad fund selection, high fees) and you weren't going to exceed the maximum contribution anyway. My employer's plan charges me 1% for an S&P500 index fund :( – fennec Mar 31 '11 at 23:07
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With a 401k you will be taxed when you withdraw the money upon retirement (just like an IRA), but conventional wisdom had it that you're likely to be in a lower tax bracket at that time. That may not necessarily be the case though, in which case a Roth IRA would be a better option because you're paying for it with after tax dollars and distributions are untaxed. If you wanted to hedge your bets you could have both an IRA/401k and a Roth IRA.

An IRA has income limits above which the contributions are no longer tax deductible, I don't believe a 401k has the same limitations (for completion's sake: a Roth IRA has income limits above which you can't contribute to one).

And like you said, the employer match is free money.

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