No. of Recommendations: 2
If your tax rate stays the same and there is no company match, a 401(k) has no advantage over conventional savings. You can prove this algebraically, or with a few simple examples. In fact, with today's tax structure where capital gains and dividends are taxed a a lower rate than ordinary income a non-matched 401(k) has a disadvantage. It moves both capital gains and dividends into the higher ordinary income bracket.
The last time someone tried to show me this, that person started by ignoring the pre-tax benefit of contributing to a 401(k), which of course invalidates any comparison from that point on.
Let's take a simple example: someone in the 25% marginal tax rate, 15% future capital gains rates, an investment in either a good 401(k) or taxable investment grows by an annualized 9%, investment horizon of 30 years, then liquidated (ignoring effect of being pushed into a higher marginal tax rate--presumably the brackets would increase).
401(k) example Taxable example
$10,000.00 $10,000.00 Amount of wages to invest
0.00 -2,500.00 Taxes before inveting
$10,000.00 7,500.00 Amount that gets invested
132,676.78 99,507.59 Future Value (30 years @ 9%)
92,007.59 Amount of growth (assuming all
capital gains)
-13,801.14 Capital gains taxes
-33,169.20 Income taxes
99,507.58 85,706.45 After-tax amount.
So, at least from the numbers I cranked out above, the 401(k) is better than taxable investments.
Some of the assumptions are over-simplifications. For example, taxable investments tend to have some capital gains and dividend distributions, which would reduce the overall growth (making taxable investments lag even more than the idealized 100% capital gains all realized after 30 years assumption), and many 401(k) plans have more expensive investment options, which would reduce the 401(k) final amount.
Howeve, within the scope of the simplifying assumptions presented above, the 401(k) is clearly superior to taxable investments if the objective is to maximize after-tax income.