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Q&A: "How Can I Calculate Likely Tax on 401(k) Withdrawals to Figure Out What the Best Tax Strategy is for Me?"

Retirement Accounts Tax

Question and background: 

How can I calculate likely tax on 401k withdrawals to figure out what the best tax strategy is for me? 

I am 53, contribute the max (including catchup) to my 401k. Company does not offer a Roth 401k, but matches first 4.5%. California resident. Income is too high for Roth IRA contributions, and balance in regular IRA is sort of high with a low basis, so converting regular IRA to Roth results in large taxable event. I'm wondering if I am better off just getting my 401k match and contributing after tax to my brokerage account. There is a decent chance I will leave California before starting 401k withdrawals. I'm thinking my retirement tax rate will be lower (much lower if I leave CA) and paying the lower capital gains tax in a brokerage account withdrawal would be better than the current tax savings of $22k into the 401k. Is there a calculator site that might help with this decision?


I suspect you won't find any public site calculators that adequately address your question. There are a number of moving parts, including unknowable assumptions about the future. But here are some thoughts that may be of help....

It is a good strategy to accumulate different types of retirement resources that are taxed differently. You want to give yourself options to tax-manage your future retirement income by drawing down whatever combination of resources in retirement that creates the least tax hit. So your thinking is definitely on the right track. 

You mentioned that your income is too high for Roth IRA contributions but didn't share specifically what your income level is or your marital and tax filing status. So let's look at some examples.

In 2014, eligibility to contribute to a Roth IRA phases out for a single filer with Modified Adjusted Gross Income (MAGI) between $114,000 to $129,000. It's $181,000 to $191,000 for married filing jointly. 

Now, maybe your income is a great deal higher than those Roth IRA thresholds. But let's assume for this example that it's somewhat higher. Depending on your tax deductions, you're likely in the 28% marginal federal income tax bracket and the 9.3% marginal California income tax bracket. So let's assume that every dollar you contribute to your 401(k) is worth about 37% in current combined federal/CA tax savings to you, plus you get tax-deferred compounded growth (hopefully) while the funds are in the retirement plan.

You'll have to use some assumptions here, but what's the likelihood that you'll be in a marginal tax bracket in retirement that's a great deal lowerthan 37%? And you mentioned the possibility of leaving California before retirement...what's the likelihood of moving to one of the seven states that currently levy no income tax? (Of course, that could change between now and retirement.)

With investments into a regular brokerage account, you'll (1) get no tax deduction up front, (2) pay ordinary income taxes along the way on interest, dividends and any distributed short-term capital gains from funds, and (3) pay (currently) 15% federal capital gains tax on realized long-term gains. And don't forget the California taxes. 

So while there's no silver bullet answer...it seems to me the 37% marginal tax deduction right now plus the potential of tax-deferred growth would be pretty valuable in your situation.

A couple of additional ideas if you want to accumulate tax-free Roth retirement resources.... 

Why not just ask your company to add a Roth 401(k) to the plan? It's not difficult for them to do. In fact, I'd suggest that most well-managed plans these days are offering it.

Your income may well be too high for this idea...but if your income is just a bit over the threshold for contributing to a Roth IRA, maxing out your 401(k) contributions at $22,500 may help you get under that threshold. How? When calculating Modified Adjusted Gross Income (MAGI), Traditional IRA deductions get added back into Adjusted Gross Income, but contributions to qualified retirement plans (i.e. 401(k) and such) do not. So a 53 year old single tax filer with income of $132,000 who contributes $22,500 to their 401(k) will have MAGI of $109,500 (if they have no other deductions to add back in). Since the lower threshold for Roth IRA contribution eligibility is $114,000 they could make the full contribution. 

You're definitely on the right track to be thinking about these things. Unfortunately, since there are no black-and-white answers, you'll have to make certain assumptions based on how you see your future unfolding.

Hope that helps. All the best!