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Author: Rhodnius Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 25242  
Subject: Re: tax deferred money in 401k Date: 2/8/2006 3:16 PM
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When you defer taxation with a 401k, there also exists an effect dubbed "bracket shifting". This effect can result in you paying less taxes overall even if you're in the same marginal tax bracket in retirement.

Suppose you make $60000 in 2005 as a single filer and put nothing in the 401k. You're in the 25% marginal bracket and your tax liability is $11665, calculated as $4090 + 25% of the amount over $29700. (see here for the bracket schedule: http://www.fairmark.com/begin/bracket.htm )

Now, suppose you make the same $60000, but deposit $30000 in a tax-deferred 401k amount, then you withdraw that amount in the year 2030 when you're retired. You're still in the 25% marginal bracket in both years. But your tax liability this year is only $4165, and your tax liability in the future year is also only the same $4165, for a total of $8330. That's almost $3000 less!

Why did this happen? Because you got to take advantage of the low-end brackets (10% and 15%) in two separate years rather than in just one year. If you took the upper half of your income in 2005, all of it would be taxed at 25%. But you can instead shift that income into the low-end brackets in 2030 so that only some of it is subject to the 25% marginal rate.

Hope that helps,
- Erik

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