Is a 401(k) a good idea?

I talk to a lot of people.  In those conversations, people usually ask "What do you do?".  My answer can vary based upon the day, but usually I tell them that I own my own wealth management firm where we focus on planning for financial events like retirement.  Undoubtably, a typical response is "I invest in my companies 401k plan, is that a good idea?".

Currently, our tax environment provides us with some of the lowest rates and a lot more tax payers are able to  claim the standard deduction.  So, the question is, Is investing in your 401(k) a good idea.  Since everyone is different and has different financial circumstances, the answer is, IT DEPENDS.

Does reducing your income today push you into a higher tax bracket tomorrow?  Lets look at an example.  A young family, husband works, makes $100,000 per year, and they have decided for the wife to stay home and raise their child.  The husband has a traditional 401(k) plan through his employer and is contributing 10% ($10,000) per year.  Let's look at their expected tax return for 2024.

• Gross Income:                                                                      $100,000
• 401k Contribution:                                                                  $10,000
• Standard Deduction:                                                               $29,000
• Adjusted Gross Income (AGI):                                                $61,000
  • AGI is gross income less deductions
• Estimated Income Tax based upon 2024 tax brackets:  
  • 1st $23,200 is taxed at 10%:                                           $2,320
  • Remaining is taxed at 12%:                                             $4,536
  • Tax:                                                                                  $6,856
  • Child Tax Credit:                                                               $3600
  • Net Tax                                                                             $3,256
  • Effective Tax Rate
    • Total Tax/Gross Income :                                        3.256%

Let's take the same family, and assume that the employer offers a Roth 401(k) as an option:

• Gross Income:                                                                         $100,000
• No Reduction for Roth 401(k)
• Standard Deduction:                                                                  $29,200
• AGI:                                                                                           $70,800
• New Estimated Tax based upon 2024 Tax Brackets
  • 1st $23,200 at 10%:                                                           $2,320
  • Rest at 12%:                                                                      $5,712
  • Tax:                                                                                     $8,032
  • Child tax credit:                                                                    $3600
  • Net Tax:                                                                               $4,432
  • Effective Tax Rate:                                                               4.432%

Why would anyone pay more in taxes than they have to?  Generally, we assume that tax rates will go up from here, as well as this family's income.  It come's back to the question, how much of your 401(k) plan do you own?  Typically, the answer is "Not all of it".  This is because when you withdraw from a 401(k) plan, and assuming after 59.5, it is all taxable income.  Where will taxes be when you get there, what will the standard deduction be?  What I see in this example is that this family would pay an extra $1,176 in taxes today to have the ability and luxury of taking every dollar out of that ROTH 401(k) in retirement TAX FREE.

Where do you think tax rates will be when you retire?  Do you want to have other places to take money from other than an account that is 100% taxable?  These are the simple questions, additionally, based upon today's tax laws, you have to take RMD's at age 73 from a 401(k), if you pass away and leave a 401(k) to your heirs (non spouse), they have to take it all out within 10 years and add that to their income.  With all the uncertainty regarding taxes, in the future, why not pay taxes at the rates you know to have tax fee income in the future?