Posted on 11/19/2007 7:46:24 AM PST by hripka
Question: My employer offers a 401(k), but no match. Given that I'm already maxing out my Roth IRA, would I be better off investing in a taxable account rather than contributing to my no-match 401(k)? - Luis Gonzalez, Denver, Colorado
Answer: Life would indeed be a sweeter if your 401(k) plan came with a matching employer contribution, as most plans do. But remember: A 401(k) offers a nifty tax break in that the funds you contribute, as well as all of your account's earnings, aren't taxed as long as they stay within the account. And that tax-deferred compounding is a valuable benefit that can boost the size of your nest egg over the long term.
So even without the match, I think you're more likely to do better in the 401(k) than foregoing and investing in a taxable account. How much better can vary depending on the assumptions you make, but let's take a look at a reasonable scenario.
The 401(k)
Let's assume you're in the 25 percent tax bracket and that you have $5,000 in earnings that you can put into your 401(k) or invest in a taxable account.
If you opt for the 401(k), the entire five grand goes into your account. And if we assume you earn a return of 8 percent a year, after 10 years your $5,000 would be worth $10,795. Of course, you haven't paid tax on any of that money, so if we figure a 25 percent tax hit, then your 401(k) balance is effectively worth $8,096.
The taxable account
Now let's see what happens if you invest your $5,000 in a taxable account. Well, the first thing that's going to happen is that you'll have to pay tax on that $5,000 since you're not sheltering it in your 401(k). With a 25 percent tax rate, that means you really have only $3,750 to invest after taxes. Plus, since this is a taxable account, you would have to pay tax on investment gains.
How much tax? Well, that depends on several factors, such as how much of your gain comes in the form of interest and short-term capital gains that are realized each year (and, thus, subject to ordinary income tax rates that year), how much comes in the form of long-term capital gains (subject to the lower long-term capital gains rate) and on how often those long-term gains are realized. If, for example, half that 8 percent annually came in the form of annual interest payments or annual short-term capital gains from trading, then a portion of your return would be taxed each year, leaving less to compound.
But let's assume a very generous taxing arrangement. In fact, just for argument's sake, let's figure that none of your gains are taxed until the end of 10 years and that at that time your entire profit is taxed at the maximum long-term capital gains rate of 15 percent.
If that's the case, then after 10 years of 8 percent annual returns, your $3,750 would be worth $8,096. This is the same amount that you would have after-tax in the 401(k), except you've now got to pay tax on the profit in your taxable account.
Assuming you would owe 15 percent tax on your profit of $4,346 (your $8,096 account balance minus your original investment of $3,750), you would have to fork over $652 to the IRS, leaving you with $7,444 after taxes.
Which is $652 less than the $8,096 you would have after taxes in the 401(k).
It's all about taxes
That may not seem like much, but, remember: we're looking at only one contribution here, and I've painted a very optimistic case for the taxable account. In the real world I don't think you would be able to actually get a 15 percent tax rate on all your gains, plus I doubt that you would be able to defer paying all taxes for 10 years. Most likely, you would face both ordinary and long-term capital gains tax rates and you would have to pay at least some tax every year. And that would lower your after-tax return and the balance in your taxable account.
Is it possible that the taxable account could come out ahead? Sure. You could move into a higher tax bracket when you pull the money out of the 401(k). Or your long-term capital gains could be taxed at an even lower rate than 15 percent. But it's also possible that you could move into a lower tax rate in retirement, which would make the 401(k) look even better than in the scenario above.
Fact is, predicting the tax rate you'll face in the future is iffy at best. Combine that uncertainty with the fact that you're not likely to wring maximum tax efficiency out of your taxable account, and I think it's pretty clear that the 401(k) is the surer bet.
Besides, the 401(k) has one other thing going for it that I consider a huge advantage: convenience. Your contribution is automatically deducted from your paycheck before you can get your mitts on it and spend it. That means the money is more likely to actually make its way into your account.
Spread the wealth
One final note: I'm not suggesting that you totally forego investing in taxable accounts. Indeed, I'm a big advocate of what I like to call "tax diversification," a strategy that calls for hedging your nest egg's tax exposure by spreading your retirement savings among three "pots," so to speak: 401(k)s and regular deductible or rollover IRAs (where withdrawals are taxed at ordinary income rates); Roth 401(k)s or Roth IRAs (where withdrawals aren't taxed at all); and, taxable accounts (where you've got a shot of at least some gains being taxed at lower long-term capital gains rates).
You've already got a Roth, so the 401(k) is your next logical move. (In fact, given its convenience and tax benefits, I really consider the 401(k) the first step.) But once you've got those two covered, by all means feel free to start plowing any additional savings into taxable accounts. (For investment options for that portion of your savings, click here.)
I can't promise that this three-pot recipe will lead to the largest nest egg. But I can say that following it will give you more flexibility for managing your tax bill and the after-tax size of the withdrawals from your nest egg in retirement.
2. Aren't Long-term capital gains actually zero under the latest rules, if you are in the lowest brackets?
3. Aren't all retirement plans a long-term bet on the level of future tax rates? With Baby Boomers collecting Social Security and Medicare, and government in general STILL growing, aren't those rates just going to keep on going UP?
P.S. Democrats are awful, and Republicans aren't helping much.
The government has provisions where minimum withdrawals from your 401(k) accounts are mandated, which can, if you’ve saved well, put you in the very top tax bracket.
If it’s non-matched, generally, no, you can do better elsewhere regardless of being able to save pre-tax.
However...if you’re of the mindset that you just won’t save money if it’s not automatically taken out pre-tax directly out of your paycheck, then go for it!
Future tax policy is a macro economic issue. High taxes will affect everything, even if indirectly. Yes, taxes are going up to pay for the present socialist schemes and policies.
Perhaps, but look for the favorable treatment of capital gains and dividends to disappear if the Dems win next year. This could also influence the equation. My bias is to shelter as much as possible for as long as possible.
I think 15% capital gains ends in 2011 unless it is extended.
I am actually getting ready to retire and will shortly be starting to draw funds out of my retirement accounts. I expect my tax rate and overall tax burdens to be pretty much the same as they are now. However, I am not at all sure I would have had the discipline to accumulate a sufficient "nest egg" for retirement had I done it all on my own.
People are living longer and the 401k payouts are gone in an average of 12 years.
The payout is taxable and if you've paid off your home, you'll be in a higher tax bracket.
I recommend you read Missed Fortune 101. Best wishes.
I have a Roth 401K in which you pay the tax going in but not coming out. It is matched 100% @ 5%. I figure this is the best way. There is no income limit as there is for a Roth IRA, and it can be rolled into an IRA someday for more investment flexibility.
I don’t think I’ll be paying less tax in retirement. Will probably work some and with the future 15% tax on dividends and capital gains doubtful no matter who wins the White House, I think I’ll be paying as much tax as I am now.
2. Aren't Long-term capital gains actually zero under the latest rules, if you are in the lowest brackets?
1. No. 401K withdrawals are simple income. They might contribute to pushing you into a higher tax bracket, but it's a nonsense point as to what particular source of income is taxed at what part of the sliding scale. You could count the 401K withdrawal as your first $ as correctly as the last $.
2. Everything is 0% if you are in the lowest bracket. The lowest bracket is 0%.
bump
The author failed to address the "liquidity" differences. Current deductions are nice, but you can effectively defer with mid-cap stocks with little current dividentd taxble income and get the benefit of long term cap gain rates and preserve liquidity. Afterall, when cash is king you might just buy some nice real estate at fire sale prices.
You can put more in a 401(k).
Maybe, but with Rangel as chair of Ways and Means and Hillary as president that could be repealed as early as the beginning of '09.
Self directed ROTH is a better choice IMHO... pay the tax on the contributions but all money earned is completely tax free.
I won’t bash a 401k, but the tax free nature of them is a bit overrated, especially when most are limited to crappy funds in them anyway.
Yeah, I don’t think it will be extended and would suspect that it will be repealed in 09. Democrats don’t like capital gains taxed less than income from labor. They don’t account the risk factor in investing. Nobody ever risked loosing everything by working a salary/hourly position.
ping
It’s my understanding that if it’s financially possible, First: Roth IRA, Second: 401K if it’s not matched. If the 401K is matched, that should be first up to the matched amount.
Reason - earning on the Roth IRA are not taxed when they are withdrawn within restrictions. Earnings on a 401K are taxed, as well as the original contribution.
Yes, they are.
Oddly enough, under current Federal tax law an ideal long-term savings plan might involve investing in stocks OUTSIDE your 401(k) for long-term capital appreciation and investing in bonds INSIDE your 401(k) for regular income (tax-deferred).
You sure about that? LOL.
I think there's a very good chance that the tax rules regarding Roth IRAs and 401(k) accounts will be different in 20+ years than they are today.
Oh -- and it will be applied retroactively, too.
No, the withdrawal tax rate depends on how much income you have in retirement, and what portion of it comes from your 401-k. It is likely that at least some, if not all, of your 401-k withdrawals will fall into a lower bracket, than the original contributions.
2. Aren't Long-term capital gains actually zero under the latest rules, if you are in the lowest brackets?
No, the lowest long-term capital gains tax rate is 5%.
How do all of us poor schlubs with 401K’s figure all this stuff out? I have no idea if the funds in our 401K are good are not. Is there a book or two I can read to try to learn, or is it best to go to a financial adviser?
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.