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| Thursday, February 21, 2008 |
| Are you a sucker to invest in a 401(k)? |
The Money Magazine article: Are you a sucker to invest in a 401(k)? does the math to prove that no, you are not a sucker to invest in a tax deferred vehicle like a 401(k). As a Money reader, you're likely well aware of the wonders of a 401(k). You don't pay up-front taxes on the money you contribute, and you don't owe taxes on your investment earnings until you withdraw the cash in retirement.
But some financial advisers (and a couple of books) have begun to voice a dissenting view: If you invest in your 401(k), they say, you'll end up paying more in taxes than you have to.
On the face of it, this argument looks plausible. If you buy stocks or stock mutual funds in a regular brokerage account, you will pay a 15% long-term capital-gains rate when you eventually sell. But you'll have to pay ordinary income tax rates of 28% or even 35% on your 401(k) withdrawals. Could the 401(k) skeptics be right?
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| posted by Boston Gal @ 9:57 AM *
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| 4 Comments: |
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I think the article has a point. However, they're neglecting the fact that a lot of people may be in a lower tax bracket at retirement. Also the tax benefit allows people to contribute more upfront. To max out your 401k, you need $15,500 pre-tax. To put that same $15,500 in a taxable account, you'd actually need to make ~$20K pre-tax. A lot of people may not be able to accomplish that.
Personally, I prefer a 'tiered' system - max out the 401k, max out the IRA then put any extra retirement savings into taxable account. This way, I have some 'diversification' in terms of taxation when retirement comes.
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The main reason I've stayed with my 401k for the bulk of my retirement savings is that my employer has a generous 401k match. If that was not the case, I would enact what some advisors call "tax diversification". This would entail putting some some in a pre-tax 401k and some in a post-tax vehicle. Then you don't have to guess what future tax rates will be, nor what bracket you'll be in.
-Mr. T
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Wow, that's so much nonsense. The 15% capital gains tax only applies to post-tax money. You don't get the tax deferment if you put your money in a taxable account and use the long-term capital gains rate. So you pay (current tax rate) on it upfront and 15% on the earnings later on. With a 401(k), you pay nothing upfront and (later tax rate) on both the principal and the earnings later on.
With a Roth 401(k), you get a clearly better deal. Now, both schemes pay nothing upfront, while post-tax pays 15% on earnings down the road and the Roth 401(k) pays nothing.
It is, of course, possible that you could be better off paying taxes upfront and 15% down the road rather than using a 401(k). If you have a very low marginal rate now and a very high one in retirement, I can see it happening. But it's pretty unlikely.
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Correction to my previous post: I said that a Roth 401(k) and a taxable account both pay nothing upfront. Obviously, I meant they both pay (current tax rate) upfront.
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I think the article has a point. However, they're neglecting the fact that a lot of people may be in a lower tax bracket at retirement. Also the tax benefit allows people to contribute more upfront. To max out your 401k, you need $15,500 pre-tax. To put that same $15,500 in a taxable account, you'd actually need to make ~$20K pre-tax. A lot of people may not be able to accomplish that.
Personally, I prefer a 'tiered' system - max out the 401k, max out the IRA then put any extra retirement savings into taxable account. This way, I have some 'diversification' in terms of taxation when retirement comes.