Thursday, October 28, 2010

Why my 401K scheme won't work

This year I've jumped a tax bracket (15% to 25%), thanks to having a real job (not a graduate student stipend) and working real hard at it. But I had an idea of how to dip back into the lower tax bracket by saving more for retirement.

Here's how it would work

Say I have $40,000 of taxable income this year. The 25% tax bracket starts at $34,000. I figured that if I opened a retirement account that uses pre-tax dollars (like an individual 401K), I could claim that deduction. If I contributed $6,001 to that fund, I'd deduct that and have a taxable income of $33,999, putting me in the 15% tax bracket. Instead of owing 25% of $40,000 (which is $10,000), I'd owe 15% of $33,999 (which is $5,100). I'd have locked up $6,001 to save $4,900.

I asked some people about this scheme.

I read some money blogs (investing for retirement, frugality, etc.) and decided to ask one of them about my scheme. He wrote a blog post answering my question (and renamed me), but didn't really address the scheminess of my scheme. Sure, it's great to save more for retirement, and it doesn't make much sense to have two IRAs (a Roth and a Traditional), but would it really reduce my tax burden so dramatically? No.

Here's why it wouldn't work

I didn't understand how tax brackets work. I thought that I'd pay 15% of all my $33,999 taxable income (total=$5,100) or 25% of all my $34,000 taxable income (total=$8,500), with no middle ground. But it's not like that. EVERYBODY pays 10% on the first $8,375, then 15% on the next ($34,000-$8,375=) $25,625, then 25% on any amount over that, and so forth.

So if I had carried out my scheme, my tax burden (on $33,999) would be $4,681. Without opening the new retirement account, I'd have a taxable income of $40,000, and a tax burden of $6,181. It would really only save me $1,500, which is what you'd expect from a $6,000 deduction in the 25% tax bracket.

Conclusion

I realize this may be jibberish. The point is that there isn't much to be gained (or lost) by jumping tax brackets. It's not that big a deal.

I'll probably open a 401K anyway. It doesn't hurt to save money when possible.

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