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Author: joelcorley Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 201  
Subject: Re: Invasion Date: 6/19/2001 1:29 AM
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BizDani,

codefusion wrote, you wrote,

So it's a pension.

Thanks. :-)


To which you wrote, Of sorts, yes,... A tax-free pension.

Oops. A 401k is definately not a tax-free pension.

A pension is a type of Defined Benefit Plan. IRAs and 401ks are types of Defined Contribution Plans. All are tax-deferred, not tax-free. There's a huge difference. You pay taxes on the money when you retire at your retirement tax rate -- which should answer codefusion's original question of what a 401k tax is.

The reason it's a complex problem is because taxes on IRAs & 401ks [and 403(b)s and other Defined Benefit Plans] are taxed at your personal income tax rate during retirement. If instead you invest the after-tax money directly in the stock market, your profits may be eligable for a much lower capital gains tax rate.

To complicate things further, you have no idea what final tax rate you will be liable for when you retire. Also, you don't know what your marginal rate might be.

The trick in planning your investments is to ensure that you'll have enough in tax-deferred accounts to provide a basic income up to (or just a little beyond) the point that your retirement marginal rate matches your current capital gains rate. Beyond that point, you should invest post-tax directly in the market -- preferably in the most tax-efficient vehicle you can.

Finally, 401k & IRA accounts are owned directly by the individual -- unlike pensions -- which means the owner can take the money out when they want, and they can also know exactly how much is in it at any given moment. But unless the individual follows the IRS distribution rules, there are additional penalties that apply to these distributions -- which will (almost) always make your withdrawal less tax efficient than an equivilent post-tax investment.

And that's the complexities of the US's Defined Contribution Plan system in a nut-shell.

BTW: It also may explain why so many people don't understand them and why so few take advantage of them. That misunderstanding may also explain why raising IRA and 401k contribution limits can become a big campain issue, even though contributing at those higher limits will likely result in the contributor paying more taxes at retirement.

- Joel Corley
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