Pre-tax Contribution

  

Categories: Accounting, Retirement

You're saving dough...pre-tax. (See: HSA). That is, before you get taxed on that last 6 grand of earnings you had last year, you are deferring your taxes on it by placing it in your 401(k) plan, thus making a pre-tax contribution to your retirement. You'll pay tax on that 401(k) when you take out the money, but for now, you get to compound it as an investment and then distribute it to yourself as presumably a lot more ordinary income.

See: Required Minimum Distribution.

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Finance: What are IRA distributions, and...1 Views

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Finance allah shmoop what are ira distributions and well how

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do they work Well the big idea here iras or

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individual retirement accounts are not tax free Yeah you do

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pay tax but only when you withdraw the money out

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of the ira Ok so backing up b b pete

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you make eighty grand a year is a union told

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booth worker in california taking five dollar bills from drivers

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and putting them in the little slot thing here Brutal

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rigorous highly stressful job Yes you have a pension that

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the government you work for contributes taxpayer dollars to pay

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for You also have an ira and you contribute five

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grand a year to that ira Well that five grand

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comes out of the eighty grand you'd normally be fully

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taxed on But instead of the eighty grand that the

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irs would normally worry about well as faras they're concerned

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this year you didn't make eighty grand You made seventy

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five grand Why Because you contributed voluntarily five grand to

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your ira and it'll sit in that separate special account

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likely invested in the stock market so that it compounds

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away doubling about every six seven eight nine years until

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you retire with five grand contributions year after year after

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year you'll have a full million bucks in there By

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the time you retire at sixty five and maybe a

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little more maybe it'll left and you'll have the option

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to start withdrawing from the ira at that point Or

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you can wait to start withdrawing the money until you've

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hit the maximum age of seventy and a half at

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which point the law makes you start to withdraw the

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money And there's a whole schedule on when you can

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withdraw it how you can withdraw and all that Anyway

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That withdrawal process is kind of a big deal because

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small tweaks in it make a huge difference Like if

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you had saved money beyond the ira i e Your

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personal savings accounts and could live on that another five

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and a half years Well then if the market followed

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historical patterns instead of beginning your ira withdrawals from a

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base of a million dollars in there While you have

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compounded that million bucks another five and a half years

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worth it so that it was then worth maybe a

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million six or a million seven by the the time

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you were seventeen and a half That's an extra six

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or seven hundred grand there that would happen just for

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you being ableto wait to start withdrawing Well why is

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there a must in there like the government needs to

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tax you somehow right So that's why you must start

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withdrawing it at some point And remember that money went

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into the ira and sat there compounding tax free for

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decades But now when you take it out you'll pay

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ordinary income rates on it So why not the cheaper

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long term gain rates Well why Because it was income

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active income you earned and quote should have been unquote

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taxed as ordinary income when you earned it But you

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weren't so well now it's time for the tax man

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teo You know coming the logic behind the creation of

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the ira was that investors in it would be paying

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a lower tax rates when they were old I e

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making less money as geezers than they did when they

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were in the peaks of their careers So under the

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progressive tax system whose rates look something like this instead

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of paying a marginal rate of say forty three percent

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on that five grand that was saved as a geezer

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taking out relatively small amounts toe live on Well you're

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paying more like thirty percent or less on that marginal

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dollar So how much do you take out of the

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ira Alright well there's that schedule thing again And the

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focus is the minimums you must withdraw What you khun

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distribute to yourself more than the minimums But then you

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have to take out a set percentage each year So

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here's how that works Look at the table here Right

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here They ira required minimum distribution worksheet in eight seventy

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You're going to divide us Say at a million bucks

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in there you're gonna divide that by twenty seven point

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four That's the amount you have to distribute this year

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Let's say the market went up Whatever One twenty seventh

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is more than that even And well then all the

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sudden of a million two or a million three Well

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by aged call it eighty You have to distribute whatever

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that amount is divided by eighteen point seven You get

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all the way to one hundred Well you have to

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basically divided by six and that's the amount you have

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to distribute So let's say you had a i'll say

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had six hundred thousand dollars in there at eight hundred

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you're going divided by six point three means that six

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hundred thousand You have to distribute one hundred grand back

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to yourself leaving you five hundred grand Yeah that's kind

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of how the system works in more or less Anyway

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that twenty seven numbers the denominator in the total assets

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in the ira get divided by it And that's the

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number The ira beneficiary which would be you if it's

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your ira must take out of the ira fund in

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this year and notjust how much age matters here In

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fact it's kind of everything in this calculation So let's

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look at age seventy seven for example the divisor here

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is twenty one point two That means that whatever the

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total assets worrying the ira as of the end of

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the year that amounts divided by twenty one point two

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And it's that amount that must be taken out of

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the ira and quote distributed to you unquote usually in

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the form of your writing A check out of the

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ira to yourself that's housed in your normal brokerage account

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So let's say that at seventy seven you had a

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million bucks from your hard earned scrimping and saving You

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take a million dollars in the numerator and divided by

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twenty one point two to get forty seven thousand one

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hundred seventy dollars It's that amount that you'd have to

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take out of the ira and be taxed on at

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ordinary income rates and well hopefully live to fight another

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day Notice that the divisor increased dramatically as you get

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older here like we said And when the iris starts

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at age seventy divide by twenty seven point four We

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only have to distribute a small amount of doughty yourself

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a few percent and be taxed on it But by

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eight hundred here Yeah you're doing the six point three

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dance Meaning that the government doesn't think you're gonna live

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much longer Well why do they do that Yeah well

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here's the guy thing is knocking really loud by age

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one hundred Very few people live past that age And

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those who d'oh well usually have trouble hearing the doorbell

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