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My employer offers a 401k program *without a match* and based on my calculations I am not convinced it's so much better than investing the same amount of money myself in diversified indexes which I am comfortable at.

First there's the funds vs. S&P argument that mutual funds perform poorer:
http://www.forbes.com/sites/rickferri/2012/10/11/indexes-bea...

And now the math of 401k vs. own investment using the compound interest formula:

My own investment - 600 per month after tax (7200 total, 8% rate of return, 30 years)
7200 * (((1+0.08)**30 - 1) / 0.08) = 815639.12

401k - 1100 per month pre-tax (13200 total, same rate of return but with 1.6% fee = 6.4% return, 30 years)
13200 * (((1+0.064)**30 - 1) / 0.064) = 1120053.13

With the 401k when taking funds they will be taxed - I calculated the retirement tax assuming my income is only 2333 per month. This results in 1840 after tax or 78% of the money.

So the 401k actual post tax is worth: 873641.44

---

There's 70k difference between them. Is the 70k worth having the money in a 3rd party who's investment strategy I don't control and the money is locked until age 67?
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A few things...

My employer offers a 401k program *without a match* and based on my calculations I am not convinced it's so much better than investing the same amount of money myself in diversified indexes which I am comfortable at.

Are the investment choices main-stream mutual funds? What is the management company? What are your choices?

First there's the funds vs. S&P argument that mutual funds perform poorer:

You will get no argument from me here!

My own investment - 600 per month after tax (7200 total, 8% rate of return, 30 years)

vs.

401k - 1100 per month pre-tax (13200 total, same rate of return but with 1.6% fee = 6.4% return, 30 years)

I'm not sure this is a completely fair comparison in terms of amounts invested. For this to be accurate, you would have to be paying about 45% in Federal/State income taxes on the money that would otherwise have gone into the 401(k).

For most people, it would be a better comparison to say that you are investing \$700/month on your own. Unless... you don't think you are disciplined enough to do the same equivalent amount either way.

(If that discipline thing is a factor, then the 401(k) wins no matter what because it happens before the money hits your account. You can counter the discipline issue by having your payroll deposited to multiple accounts with the investment money going straight to the company where it will be invested.)

My own investment - 600 per month after tax (7200 total, 8% rate of return, 30 years)
7200 * (((1+0.08)**30 - 1) / 0.08) = 815639.12

You are missing 3 very important factors here...

1. Part of this gain is from dividends; there will be annual taxes that must be paid on these.

2. Almost all mutual funds -- even very efficient index funds -- have capital gains distributions during the year; there will be annual taxes that have to be paid on these.

3. When you eventually start using this money and selling shares, you will have to pay taxes on the capital gains.

Because of these 3 factors, you don't really have \$815,639.12 in this example.

401k - 1100 per month pre-tax (13200 total, same rate of return but with 1.6% fee = 6.4% return, 30 years)
13200 * (((1+0.064)**30 - 1) / 0.064) = 1120053.13

Are there no lower-fee options in the account?

With the 401k when taking funds they will be taxed - I calculated the retirement tax assuming my income is only 2333 per month. This results in 1840 after tax or 78% of the money.

Why do you expect to pay 22% in taxes in retirement? For just income taxes, my wife and I pay less than 25% combined (Federal/state) with dramatically more income than you are projecting.

You can add in your expected Social Security distributions and build a model tax return based on today's rates -- or any other rates. At the least, you get the standard deductions.

And don't forget that "bracket creep" increases the levels at each tax bracket over time. So if your numbers are not inflation-adjusted, you will actually owe LESS in taxes than this return will show.

Unless you will spend your retirement in an ultra-high tax state and/or tax rates go up substantially, I don't see your combined tax rate in retirement being 22% using the numbers you have given. After all, 30 years from now, the current 10% Federal tax bracket likely will extend to over \$15,000 in taxable income (after deductions) and the current 15% bracket will likely extend to over \$60,000!

There's 70k difference between them. Is the 70k worth having the money in a 3rd party who's investment strategy I don't control and the money is locked until age 67?

As I have indicated, I don't think your calculations are correctly handling the critical issues. You may not be making a fair comparison in terms of amounts invested; you may not be looking at the returns on your 401(k) correctly; you are not handling taxes on the non-401(k) investments correctly; and you may not be looking at taxes correctly.

Another issue...how likely are you to stay in the current company for 30 years? If you ever change jobs, you can roll the 401(k) over to an IRA at Vanguard or Fidelity or another company of your choice and drop the fees to the same level as the other account. At that point, the 6.4% return you have used would rise us to match that of the other account...but without the annual taxes from distributions.

There really are a ton of things to consider, including many things which we cannot know until after the fact. One way to handle this -- split the difference and put \$550 into your 401(k) each month and \$300-400 into your taxable account each month.

I hope that helps!

Acme
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Forget the math. It will just give you a headache and you can twist the numbers to make any choice look good. I would look at it more simply. If my 401k had matching company contributions, I would direct just enough of my paycheck to the 401k to ensure I received the maximum amount of free money possible. Then I would contribute the max to my Roth IRA. If I was married, I would make sure my spouse's was fully funded as well.

If I had no company match in my 401k, or no access to a 401k, then I would contribute the max to my Roth IRA. If I was married, I would make sure my spouse's was fully funded as well. If I was self-employed, I would explore opening a solo Roth 401k and contribute as much as possible.

Fuskie
Who was talking to someone recently who wanted to restructure their retirement savings from Roth to Traditional in order to be able to claim additional tax deductions to offset the increases in taxes the feared was coming from Washington, but he countered that investment decisions should never be made out of fear or emotion, and that such a move would be short sighted and handcuff future earnings...
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One advantage of the 401k plan is that its payroll deductions are automatic and painless. The funds accumulate with little effort on your part. Other investments can work just as well, but they require discipline to make sure they happen. Some can be automatic with regular deductions from your checking account, but those are not common.

On your mutual funds vs the S&P comment, many 401ks have S&P 500 Index funds as one of their investment choices. You will want to check expense ratio and performance as some are expensive, but often you can choose an index fund to avoid the problems of managed funds, which tend to be expensive and under perform.

As Fuskie mentioned, Roth IRA is a reasonable alternative. But lower contribution limits make it difficult to accumulate the sums you need to retire on in a Roth with contributions alone. A rollover from a 401k can often be much larger.

No one knows how future tax laws will change, but for now investing in a taxable account in the long term buy and hold style (LTBH) is a decent alternative. You pay taxes only when you sell and then at capital gains rates. As 401k eventually gets taxed at ordinary income tax rates, some see LTBH as a better deal (if you have the skill to choose investments you can hold long term and the discipline to fund the program regularly).
No. of Recommendations: 1
Other replies have been excellent. A couple of more points.

You assume 1.6% in expenses for the mutual funds in your Plan. That seems quite high. You dont however factor in any investment expense in investing outside the Plan. Even low cost index funds have expenses.

You mention you don't control the investments in the 401k. Most 401k Plans provider a diversified menu of funds to select from and the participant allocates their money among these funds.

You say the money will be tied up until age 67. Many Plans allow for in service distributions at age 59 1/2. There are other instances where you can access the money penalty free even earlier. (age 55 or older and terminate employment, or 72t distributions).
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Thanks for the detailed reply Acme. I will answer the questions you raised.

1) I don't have the list in front of me now, but there is no Vanguard with low fees. They all charge 1.3+% fees. I choose two, one of them is NBSRX.

2) About 45% tax - I am in California and these are the numbers for me. I went to paycheck calculator and adjusted the deduction until my net gain lowered by the same amount. And I have no discipline issues when it comes to investments.

3) Math in my own investment - You are right the math is not perfect. I had to start somewhere. I will look into factoring dividend gains and taxing and taxation on reallocation.

If I add 0.15 tax on gains every year the number I get is:
656,128
(i used a small program to calculate this:
total = 0
30.times do |year| gain = total * 0.08; gain = gain - (gain*0.15); total = total + 7200 + gain; end
)

Now the difference is 200k which is more substantial.

4) Tax percent on retirement - I went to paycheckcity and entered 27996 yearly income and that's the number I got. And for the sake of simplicity I am making the calculations in today numbers for both my investment and the 401k.

I like the idea of splitting the investment.
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Thanks for the detailed reply Acme.

You are most welcome.

1) I don't have the list in front of me now, but there is no Vanguard with low fees. They all charge 1.3+% fees. I choose two, one of them is NBSRX.

I just looked on Morningstar and the expense ratio is 0.89% for NBSRX. Are there other fees in your account that would not be included in Morningstar's report?

2) About 45% tax - I am in California and these are the numbers for me. I went to paycheck calculator and adjusted the deduction until my net gain lowered by the same amount. And I have no discipline issues when it comes to investments.

This means that your marginal tax rate is 33%. I was mistakenly thinking in terms of effective tax rates before, but the marginal rate is what applies here.

One note...when you are in this tax bracket, you are generally not eligible for Roth IRA contributions. Are you using the 2-step work-around to make your Roth contributions?

3) Math in my own investment - You are right the math is not perfect. I had to start somewhere. I will look into factoring dividend gains and taxing and taxation on reallocation.

If I add 0.15 tax on gains every year the number I get is:

Now I think you have gone too far with taxes! :) You are not likely to sell/buy every year. So there's no need to look at a 15% tax each year. You just have to take 15% of the GAIN (end amount minus contributions) away at the end. Even this is overly simplified, but it gets you close enough.

Of course, things we don't know -- such as future tax rates and future returns -- can push things far enough away from our initial assumptions that our results are just plain wrong. This is why I suggested the possibility of the split approach.

4) Tax percent on retirement - I went to paycheckcity and entered 27996 yearly income and that's the number I got. And for the sake of simplicity I am making the calculations in today numbers for both my investment and the 401k.

Did you exempt yourself from FICA and Medicare? (It looks like you had them withheld when I run the numbers.) You won't pay those taxes on 401(k) distributions.

Also, I know little to nothing about California tax law, but do you pay SDI on 401(k) distributions? It seems unlikely to me, but anything is possible in California!

Personally, I love the process of having 3 piles of money for retirement.

1. Roth IRA/401(k) -- tax free money
2. Traditional IRA/401(k) -- pre-tax money
3. Taxable Accounts -- partially tax-free; partially pre-tax

Each of these 3 items has different treatment under the tax code. There are times when each is favored.

Best of luck!

Acme
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Check and see if your 401k Plan has a Roth provision. You can make Roth Contributions up to \$17,500 this year in the 401k. (Not an additional \$17,5000). You only get the one \$17,500 contribution limit to the 401k. If your Plan allows Roth contributions, you can make some or all of that as a Roth. There are no income limits for Roth contributions to a 401k, unlike a Roth IRA.
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You received some excellent replies to your post. Just wanted to add one more thought. I know of very few people who build a 30 year plan and have things work out that way for all 30 years.
You might change jobs in 30 years. You may do that multiple times. You may have corporate mergers or buyouts that change your 401K.

I had 2 such events. I am on my 3rd 401K. All had matches. Present one has Roth option also.

The first 2 401K's were rolled over to IRA's. One was then rolled over to a Roth. I also have fully funded Roth's outside of these that are fully funded for myself and wife.

The point is that when I started working 40 years ago I was working for a Fortune 500 with a pension and no plans for 401K's or Roths.

Laws change, Needs change. Build your plan, Invest in it. Do a re-assesment every 5 years, to be sure you are still happy with the plan.

I am now on the other side thinking about how to make my money work for me during retirement.
Where do I draw money, where do I invest for Capitol Appreciation?
I have a pension and SS. I also have a 401K, an IRA Conversion, and 3 Roth accounts.

As an aside I also have an HSA (Health Savings Account) If I had one thing I would have changed it would have been to start the HSA much sooner.
If you are young and healthy, consider a High Deductable Health plan at work with an HSA account.

My original plan was Pension and SS.

You sound like you did all your homework and have an excellent plan. Just don't lock it in and forget.

Mike
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1) My employers use ADP and I guess they charge additional fee for managing the funds.

2) Wow, that was a very good to find out. This year my salary got passed the limit for Roth. But I am still eligible for 2012. Will see what to do this year.
No. of Recommendations: 1
2) Wow, that was a very good to find out. This year my salary got passed the limit for Roth. But I am still eligible for 2012. Will see what to do this year.