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March 06, 2008


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Agreed, to skip the 401(k) because of some deceiving "math" is a tragedy. The tax deferral over long periods definitely trumps the difference in LTCG tax rates and ordinary income tax rates. However, I will give one piece of advice that our firm gives to our clients. If you have a global allocation of say 80/20 (80% equities/20% fixed income), put your fixed income in your 401k or IRA. Put your tax efficient, low turnover, equities which would generate long term capital gains in your taxable account. Of course, the relative balance of each account is a factor. But you get the idea.

I agree with their premise. It is foolish to pay ordinary income taxes on money that you otherwise could be paying capital gains on. But I also agree that the match often makes it worth it. My dilemma comes when I decide to contribute above the match. I have made the decision to invest outside of my 401k for precicely this reason, as well as having access to the money earlier than age 59.5. The fees are a non-issue because I will invest in index funds outside of my 401k as well. (The same exact fund actually.)

It does not make mathematical sense to contribute more to a 401k than the company match unless you lack the discipline to invest it yourself and need it to be taken out before you see it.

If your company doesn't match your 401-K, is it still that great of a deal if you've got 40 years of work left? Will Income tax be lower 40 years from now? Probably not. So where is the benefit of a 401-k vs an IRA, etc.

Does anyone know what percentage of employers offer a match to 401k contributions? Every article I read pounds that home that it's such a great benefit, but I've never worked for an employer that offers a match.

Steve --

91% of employers offer a match.


what about the up front tax deferral of a 401k?

any money that you put into a taxable account has been taxed already! duh! what a stupid article.

not to mention the fact that the capital gains tax is extremely likely to increase (practically gauranteed if a dem is elected). in fact, i read somewhere recently that Clinton would raise it to 20% and Obama to 24%.


edit: not a stupid article. the argument to invest in a taxable over a 401k is stupid.

I will throw out the question. Are the 9% of folks not covered by a match better off in taxable accounts?

If you work and make $1000 today, is it better to pay the tax on the $1000 and put it into a taxable account OR do the benefits of this hypothetical $1000 perform better over 40-years inside a 401k?

Both scenarios are guessing future tax rates, but maybe someone with formulas and time could back-test 25-40 years (say 1968) using a simple $1000, one-time deposit into an S&P fund using the initial tax break now and the different and then you withdraw the money in 2008.

I bet the dividends being reinvested and the person paying taxes on them would hurt, but I would becurious to see who comes out ahead.

Zook --

From what I've seen most advisors would say to invest some in a 401k and some in a Roth IRA. That way you are diversifying your tax risk.

Question: Are you technically losing more with a regular investment account than a 401k due to not only the capital gains tax of 15% but also the 15/25% income tax you paid on that after-tax money you pay capital gains taxes on? Or am I missing something?

Here’s an exercise I did. I assumed $50k salary, 28% income tax bracket, 3.5% inflation, and 10% investment return over 30 years. I considered 4 scenarios: contributing $5000 to each of a 401(k) with no match, a 401(k) with a 50% match, a Roth IRA, and regular taxable accounts. For comparison, I calculated the future value of the income tax that is paid today in each scenario. The math shows that a 401k without a match really isn’t worth it. Let me know if you find an error in my calculations.

$5000 contribution to 401k with a $2500 match.
Taxes are 28% of $45000=$12,600.
In 30 years, that investment is worth ~$119k. Taxes are $33,312 (28% income tax)
The future value of the $12,600 income tax you paid is $35,366.
NET FUTURE INCOME: 118,973-33,312-35,366 = $50,295

$5000 contribution to Roth.
Taxes are 28% of 50000=$14,000.
In 30 years, that investment is worth ~$79k. Taxes are $0 (not taxable)
The future value of the income tax you paid is $39,295.
NET FUTURE INCOME: 79,315-39,295-0 = $40,020

$5000 contribution to Taxable account.
Taxes are 28% of 50000=$14,000.
In 30 years, that investment is worth ~$79k. Taxes are $11,897 (15% capital gains)
The future value of the income tax you paid is $39,295.
NET FUTURE INCOME: 79,315-39,295-11,897 = $28,123

$5000 contribution to 401k.
Taxes are 28% of 45000=$12,600.
In 30 years, that investment is worth ~$79k. Taxes are $22,208 (28% income tax)
The future value of the $12,600 income tax you paid is $35,365.
NET FUTURE INCOME: 79,315-35,365-22208 = $21,741

After researching this question, I came across this website that has more (not necessarily better!) information:

There are clearly many options for retirement investing, and without knowing the tax circumstances under which one will retire, you are incapable of knowing exactly what will happen.

I realize there are some "up-front" benefits to 401k investing, but there are a few reasons I think the Roth 401k will win out. First, I don't believe that tax brackets will keep up with inflation, which will push more middle and low income earners into progressively higher tax brackets. The current situation with AMT illustrates this beautifully. Also, I personally believe that taxes will go up in the near AND distant future, meaning that I am better of paying roughly 30% in taxes today on a pre-growth number and maxing out my ROTH 401k, rather than a Traditional 401k where I think I will pay a significantly higher percentage, plus I will have to pay on the growth as well as the principal.

If your employer offers a Roth 401k and any match, this will allow you to diversify, because all employer match money is pre-tax. If your employer doesn't offer this benefit, I would encourage you to ask them to do so. In most cases, it just requires someone near the top to fill out a few forms.

To Your Wealth,


Nice post JK and Laura.

The benefits of capital gains deferral and lower taxes are about half that of retirement account deferral under low turnover index investing and similar taxes. The penalty for early withdrawal can consume much if not all of the benefit though.
It is desirable to have both in case you need to tap it early.

Laura, haven't quite figured out how you ended up with those future values. In the first case, taxes should be those saved on the contribution, not the total income. In 30 years, the investment should be worth 7500*(1+10%)^30, or 130k. Also, don't forget in a taxable account, dividends and realized gains (due to merger and acquisitions or index changes) are taxable en route to that 30 years, not just at the end. A 5k Roth contribution is larger than a 5k 401k contribution due to taxes; you might want to compare it to a grossed up 401k contribution. In addition, the Roth 401k allows larger deferred contributions since they have the same nominal limits as the 401k.

I have a question.

My employer doesn't do a match, rather we have profit sharing. So, I receive a lump sums (Usually 5-7% of my income) in my 401k every year regardless of what I contribute to the 401k. However, this money is profit sharing so it is possible that the company would do so bad I won't see that one year (it hasn't happened yet though). Right now I am also contributing 12% of my income to my 401k. I like this arraignment because it is easy and money I don't see is money I don't miss. However, I have been wondering if I should reduce my 401k contribution and put money in a ROTH. I have a traditional IRA from past jobs and other investments but no ROTH. I am 31 years old, so it is so long until I will be taking out this money that I just don't know what the tax situation would be when I can start withdrawing it.

Don't forget that putting money in a 401K lowers your AGI. The AGI is one of the factors affecting your qualification for numerous tax credits under the tax code. It may also decide whether you can add to a Roth IRA if your AGI is near the income cap. By forgoing the 401K, you may disqualify yourself from one or more of those.

Don't forget about 72t!

You can take early distributions as long the "distributions are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancy) of the employee and beneficiary," the early withdrawal penalty doesn't apply!

Great posts and a great discussion. Having seen some friends and client's 401k choices and 2.50% expense ratios and 1.00% deferred loads and a .75% 12b-1 fee, if you are starting with a company you might be iffy about and you don't get a match and could be moving in less than a year, why on earth would you save into a 401k? Now I know this probably speaks to only a small percentage of folks, but there are times, especially for low income folks with garbage options where they should direct their monies into a Roth or taxable account, IMHO, first.

This certainly isn't a stupid debate. What it really highlights is that it is probably a good bet to use a Roth 401(k), if you have one available. Just pay at your current tax rate (which is hopefully low, if you are not in your earning prime), and then be done with it.

Look, it is quite interesting to consider how you are taxed when you consider a 401(k).

What makes a 401(k) a bad deal to me is that it is social engineering by the government. Why not have something like the Fair Tax where you are taxed on consumption and you can save and invest however much you want without any penalties for withdrawals?

I must have been working for the other 9% that don't offer a match. I think I have had a string of around 6 employers that don't. Such is life with small companies - sometimes you are lucky to have a 401k at all.

I get a double match. Lucky me.

Investing in single stocks outside of retirement plans makes sense because cap gains rate < income tax rate. It would be stupid to invest in single stocks inside a tax-deferred retirement account.

Income tax rates will rise over time--look at demographics. We have an aging population who are going to suck giant resources out of the economy for social security and medicare--with fewer workers to support the old people.

The Roth rocks! Especially if you're younger and in a lower tax bracket, or older and have accumulated enough wealth to support your retirement and need to use it as a wealth/estate management tool.

Y'all need to read Ed Slott's books too, so the government doesn't seize most of your wealth when you die. You have to get things right with your retirement accounts. If you want to, you can turn them into multigenerational megawealthbuilding accounts that will change your family tree. (Although I think that tends to spoil the kids/grandkids and take away their work/achievement motivation.)

I recently compared my 401k, Roth 401k and Total Market ETF together (taxable account). The ETF does better for the following reasons:

The funds in my 401k (trad or Roth) get weak returns (<9%) and have high expenseses (1.25% to 2.25%). While the ETF is virtually free of expenses (<.2%) and the ETFs index strategy averages to about 10.5% return per year. Plus, the indexing and ETF funds limit your taxable money to almost zero, until it is withdrawn.

Of course, this could change if the long-term capital gains tax is raised, but it would have to be a significant raise to offset the difference in return )including expenses).

On top of that, if I retire early (before 59 1/2), which I hope to do, I can take this money out without having to jump through 50 different hoops.

Note: My company match goes into my 401k, whether I contribute or not. Thus, this is not an issue.

IMO the biggest issue with 401k is that it's employer sponsored. Why is the employer involved in my investment choices? They are involved because they've decided that having only 30 mutual funds to choose from (versus thousands if I approached Fidelity as an individual) is in my best interest. I feel I should be able to sue my employer for inserting themselves in my decision making process by choosing what investments are best for me!
Please contact your representatives in Washington and demand two things:
1. That the 401k stop being 'employer sponsored' and let it be self-directed (I tell my employer to send the payroll deductions directly to Fidelity in my personal account)
2. To allow a once per year rollover into a self-directed IRA to regain your personal freedom of investment choice.

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