After tax 401k?

[superguy]

I want to use my 401k after tax as an easy way to invest, then take the money out in just a few years.

It's just easier since it's taken out of my check, than investing it myself.

But what are the tax drwabacks? I cant see any, except that normal investments would be taxed at the capitol gain rate, which would be lower than the 401k investnent earnings which would be taxed at regular income rates.

Is that right? Is that the only drawback, and how big a deal is it?

 

[RussSchultz]

There are penalties from withdrawing from your 401k, even after tax money, from my understanding.

 

[London Geezer]

Oh god, for a minute there i thought you meant something like "after tax on 401k" as in "how much have i got left after tax on a $401k gross?"....

Guess 401k is some sort of US tax type or something...?

 

[Joe DeFuria]

There are penalties from withdrawing from your 401k, even after tax money, from my understanding.

No, that's not correct AFAIK.

You can withdraw your after tax dollars (but not the earnings on them.) I'll have to check the specifics though. I personally withdrew my after tax 401(k) dollars about 5 years ago due to changing employers. I rolled over the pre-tax dollars and all earnings into my new employer 401(k), withdrew my after-tax dollars. (And since then, smartened up and stopped putting after-tax dollars into a 401(k).

 

[Joe DeFuria]

I did some quick googling and it appears I am correct:

1) You can withdraw your tax-paid dollars from your account at any time.
2) You can NOT withdraw any earnings on your tax-paid dollars. If you do, you will owe income taxes on them, plust the 10% early penalty.

That being said, it doesn't make much sense to use a post-tax 401(k) for a "few years" investment. You will only be able to withdraw the dollars you put in...not any earnings on them.

If you're looking at about a 5 year time horizon, perhaps a balanced (stock/bond) mutual fund, or bonds in general. You will get hit with some income tax annually as the dividends / yields are paid, but if you go after growth stocks, you may be too at risk for losing capital over that relatively short time period.

I don't have any specific recommendations for you myself...as the "mid term" maturity is one type of investment that I do not personally have. (Everything I'm investing in at the moment is either basically cash / savings, or long-term, about 20 years).

Depending on exactly how short a time period you're looking at, you may even consider a simply high interest savings account like hsbcdirect.com. It's the worst from a tax persepctive, but the safest.

BTW, you can make investing in mutual funds, bonds, or even regular savings as "painless" as investing in your 401(k). Most places will allow you to set up regular automatic withdrawls from your checking account.

 

[superguy]

2) You can NOT withdraw any earnings on your tax-paid dollars. If you do, you will owe income taxes on them, plust the 10% early penalty.

That's what I gathered, except I'm not entirely sure about the 10% penalty.


The thing is I have no checking account. Just a savings. I buy money orders to pay my bills and thats it.

So it's easier for me to just have a paycheck deduction.

And right now, I just put money in a savings account that probably earns basically zero interest. I mean it might be 2%. I know when the economy was down it was literally zero.

So to me even the ten percent penalty is probably worth it, better than doing nothing. I will pay the income taxes either way. I would rather make some investment earnings, than nothing at all.

How much is the regular interest at the hsbdirect? The 4.8 appears to be short term..

 

[superguy]

Here's the way I figure it:

My normal income is taxed at lets say, 20%.

Right now I do nothing or dump it in a low interest savings.

So if I was investing it, I would be able to withdraw it whenever I want tax free. But the earnings would be taxed, + possible 10% tax. But I'd still come out way ahead than if it sat in my savings account. See?

But are normal investment earnings taxed at the low capitol gains rate of 15%? Because from what I understand, I mean I already make X per year, whatever earnings I take out, if it's a lot, would that also then kick my annual income into a higher tax bracket? Like say, 33 instead of 20% (or whatever the case, example numbers only).

 

[3dcgi]

There is a fundamental flaw in your thinking. You're assuming that your 401k investment will yield more than a 12% return. Assuming that is like gambling in Vegas, your chances aren't good.

Most companies can split your paycheck and direct deposit into two accounts so you'd be better off opening an investment account and depositing some money directly in there. Or maybe you can deposit directly to your savings account. Granted I don't know your reason for not having a checking account, but in the US you can get a free checking account at most banks. Some banks require you maintain a modest checking/savings account balance, but it sounds like that's not a problem for you since you're willing to invest some money for a few years.

Also, look into online bill pay options as you can usually do that free with a checking account and you'll avoid paying for money orders.

 

[Joe DeFuria]

Dude!

1) Get yourself a no-fee checking account, become an adult. You should be able to get one just about anywhere if you direct deposit your paychecks. Stop paying and wasting money buying money orders to pay bills. Find a bank that lets you pay 'em on-line even.

2) Even if you don't get a checking acount, most if not all investment firms also allow you to automatically withdraw from a savings account anyway, so you have no excuse.

So if I was investing it, I would be able to withdraw it whenever I want tax free.

If you put it in a high interest savings account, you can also "withdraw" your prinicpal tax free.

But the earnings would be taxed, + possible 10% tax. But I'd still come out way ahead than if it sat in my savings account. See?

Not at all. It's very unlikely that your return in your 401k is going to be 10% higher than the interest rate in your savings account. And again, you seem to be ignoring your time horizon. If you invest in a high risk / high reward vehicle in your 401k, you have a very real fluctuation risk, where at any given time you may actually have a loss. Again, if your idea is to be able to take money out over the next few years, it really makes zero sense to put it in a 401(k).

But are normal investment earnings taxed at the low capitol gains rate of 15%? Because from what I understand, I mean I already make X per year, whatever earnings I take out, if it's a lot, would that also then kick my annual income into a higher tax bracket? Like say, 33 instead of 20% (or whatever the case, example numbers only).

Whether you get dividends or capital gains earnings depends on te type of investment you make, and how long you hold onto them before you sell. If you sell an investment within one year of when you bought it, any earnings based on growth (price differential) is taxed at your normal income rate.

Bottom line is that tax treatment should not be THE deciding factor on how you invest your money. It's a secondary consideration. First decide how long you expect to leave your money parked before you might need it, then determine how much risk you're willing to take....

 

[superguy]

You're assuming that your 401k investment will yield more than a 12% return.

Where did I assume that?

Okay, example, now. my money, earns no dividend. I looked up my savings acount and it is currently earning .9%

If I put it in after tax 401k, with the ease of automatic deduction, it's just like my savings account. EXCEPT that it will be easy to invest it and being earning.

When I take the EARNINGS out I will get hit, income tax plus apparantly 10%. But it'll still be better than NO earnings, correct? I mean I'll still get some 60 or 70% of my earnings after the tax, right?

Which again, is much better than nothing?

The only thing I'm worried about, is the earnings kicking me into a overall higher tax bracket for the year if I take them out. Is that possible?

 

[superguy]

I guess I could deduct from my saving, but I think you're only allowed a certain number of withdrawls per month or whatever before being penalized. I suppose I could deduct from it once monthly. Then I would have to deposit once monthly to.

I really like patroll deduction because you dont miss the money. All my bills are due at the first of the month, I'm not going to feel like depositing into my savings account at that time too. It's just mentally harder to deposit a big sum once a month. Payroll deduction (I am already in before tax 401k) is wonderful.

Money orders are like..50 cents. Who really cares? But you'tre right I need to "grow up" however, it will change the way I live my daily life a lot.

Basically I want to save a lot for five or ten years, and then probably use it for a house down payment. That is my goal..

 

[superguy]

Sorry for three post but:

If I make a 100 earnings, and my income tax rate is twenty percent, +the ten percent penalty, and I withdraw, I still get $70 right? Which is much better than the 0% I'm currently getting right? Is this thinking incorrect?

The only thing I'm worried about, is If I'm sitting on the line of a higher tax bracket and take out my 401k after tax earnings, will they count as income and kick ALL my income into a higher bracket? That could be bad news seems to me.

Also, are all "normal" stock dividends/sales taxed at 15%? (After being held one year of course). So if I go invest in the market, I will be taxed only 15% instead of my income rate on money?

 

[3dcgi]

The 12% number came from this. I was thinking all of your after tax contributions would be taken out rather than just the earnings so I anticipated more of a penalty hit. The other 2% came from your saving account number.

Regardless I think it's crazy to accept a 10% hit just for the convenience of not setting up another account. Although since you plan to use the money for a home you might not have a 10% hit. I can't remember for sure, but there might be special withdrawal circumstances for buying a home.

 

[Ty]

If you're "counting" on the money in 5 years (and can't deal with it being illiquid during this time period), good luck with the stock market.

Better you put it ING.com which earns 4.75% or Emigrant Bank which is probably a tad higher.

 

[Joe DeFuria]

Regardless I think it's crazy to accept a 10% hit just for the convenience of not setting up another account. Although since you plan to use the money for a home you might not have a 10% hit. I can't remember for sure, but there might be special withdrawal circumstances for buying a home.

No, there are no special circumstances for a home with a 401(k). There are some special circumstances with a traditional IRA though.

 

[Joe DeFuria]

Daryl, you have some misconceptions about tax brackets and how they work. I'll respond in full later (I have to run right now).

 

[Joe DeFuria]

OK, first of all on tax brackets:

We have a graduated, progressive tax system. When you move to a "higher" tax bracket, this does NOT mean that all of your income is taxed at that new higher rate. It means every dollar you earn ABOVE that income level is taxed at that rate.

Second, the earnings that you widthraw from a tax deferred account like a 401k is taxed at your ordinary income rate. In other words, no different than a savings account.

Bottom line is, again, (for your situation) you should NOT use a 401(k) to invest tax-paid dollars. Just don't do it.

Now that that's done with, some advice (whether you want it or not) as you are saving for future goals.

1) Make sure you are contributing PRETAX dollars into your 401(k) at least to the level that you get whatever matching contributions your employer offers. You are just throwing away money if you don't.

2) Make yourself a budget with set goals for savings. This budget should include paying off any high interest debt as fast as possible. Make sure you are living within your means, and not increasing debt every month. TRACK your spending for a few months, and continuusly track your progress toward your savings goals.

3) If you are on pace to have a down payment on a house in about 5 years, I personally would not mess with anything other than savings / money market / CDs. Anything else is too volitle, and the last thing you want is for the market to be "down" at the time you want to take the money out for a down payment. I have first hand experience with this. Trust me, and learn from my mistakes. You can rates on savings / MM / Cds from 4.25-5%. And these rates will likely increase over the next few months.

4) If it's more like 10 years, a couple diversified mutual funds now (actively managed to get more conservative as you approach 10 years) is OK.

 

[3dcgi]

No, there are no special circumstances for a home with a 401(k). There are some special circumstances with a traditional IRA though.

That's probably what I was remembering then. Thanks.