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Author: ctriplett Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75523  
Subject: Why 401(k)? Date: 10/10/1999 8:22 PM
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Hey All - I'd like some help with seemingly contradictory advice re. 401(k)'s.

1. Foolish advice seems to be to save as much as possible in 401(k)'s to take advantage of tax-deferral and company matching contributions.

2. Shouldn't there be a point at which the (greater) return of a taxable investment outweighs the advantage of a tax-deferred one? I think the formula might be something like this?

TR = Marginal tax rate
Ra = Return expected in after-tax investment
Rp = Return expected in tax-deferred investment

Ra = Rp / (1 - TR)

So, if I'm in the 28% tax bracket, and I can expect 11% in my 401(k) index fund (with no matching contributions), the after tax return I would need to get to equal this would be:

Ra = .11 / (1 - .28)

= .11 / .72

= 15.28%

It is entirely possible that I'm missing something here, but it seems to me that:

3. The 18% returns I might expect by investing my retirement savings in an after-tax Fool 4 portfolio alone would far outpace the 11% index-funded-401(k).

4. Very Important Point - my employer's 401(k) DOES NOT Match contributions!

5. My trusty Quicken Financial Planner backs up these results: if I defer 10% annual income to a taxable account, the wife and I will have at retirement $4,449,741, given 18% annual returns, vs. only $1,992,444 in the tax-deferred 401(k) earning 11%.

6. So, am I missing something? Or would it be safe to say that for those of us who do not have the benefit of matching contributions, the 401(k) is an inferior investment vs. other Foolish strategies?

I sure hope TMF Pixy will weigh in on this one!
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Author: rjm1 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14369 of 75523
Subject: Re: Why 401(k)? Date: 10/10/1999 10:00 PM
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Hey All - I'd like some help with seemingly contradictory advice re.
401(k)'s.

1. Foolish advice seems to be to save as much as possible in 401(k)'s
to take advantage of tax-deferral and company matching
contributions.

2. Shouldn't there be a point at which the (greater) return of a taxable
investment outweighs the advantage of a tax-deferred one? I think
the formula might be something like this?

TR = Marginal tax rate
Ra = Return expected in after-tax investment
Rp = Return expected in tax-deferred investment

Ra = Rp / (1 - TR)

So, if I'm in the 28% tax bracket, and I can expect 11% in my 401(k)
index fund (with no matching contributions), the after tax return I
would need to get to equal this would be:

Ra = .11 / (1 - .28)

= .11 / .72

= 15.28%

It is entirely possible that I'm missing something here, but it seems to
me that:

3. The 18% returns I might expect by investing my retirement
savings in an after-tax Fool 4 portfolio alone would far outpace the
11% index-funded-401(k).

4. Very Important Point - my employer's 401(k) DOES NOT Match
contributions!

5. My trusty Quicken Financial Planner backs up these results: if I
defer 10% annual income to a taxable account, the wife and I will
have at retirement $4,449,741, given 18% annual returns, vs. only
$1,992,444 in the tax-deferred 401(k) earning 11%.

6. So, am I missing something? Or would it be safe to say that for
those of us who do not have the benefit of matching contributions, the
401(k) is an inferior investment vs. other Foolish strategies?


The math is ok. Your marginal tax rate will be closer to 20%. The 401k will be taxed at the regular income tax rate of 28% but the non tax deferred account should be taxed at 20% for the capital gains and 28% for the dividends.

Since I do not know the annual savings and number of years I can not check the end results but my guess is that you did reduce your non tax annual saving rate by the 28% tax.

I think the 18% is to high to count on and you should make it closer to the 11%.

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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14393 of 75523
Subject: Re: Why 401(k)? Date: 10/11/1999 9:51 AM
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Greetings, Ctriplett, and welcome. You wrote:

<<It is entirely possible that I'm missing something here, but it seems to me that:

3. The 18% returns I might expect by investing my retirement savings in an after-tax Fool 4 portfolio alone would far outpace the 11% index-funded-401(k).

4. Very Important Point - my employer's 401(k) DOES NOT Match contributions!

5. My trusty Quicken Financial Planner backs up these results: if I defer 10% annual income to a taxable account, the wife and I will have at retirement $4,449,741, given 18% annual returns, vs. only $1,992,444 in the tax-deferred 401(k) earning 11%.

6. So, am I missing something? Or would it be safe to say that for those of us who do not have the benefit of matching contributions, the 401(k) is an inferior investment vs. other Foolish strategies?>>


I agree that your math is correct. I also agree that using an 18% return is probably a little optimistic. Since 1961 the CAGR of the FF has only been a little over 16%. Also, bear in mind that to be successful in not using the 401k, then you must be just as disciplined outside of it as you are within it. Otherwise, the analysis I cite in Step 4 where you found this formula won't hold. You must make a deposit in the taxable account out of every paycheck, that deposit must increase at the same rate and at the same time as your pay does, and you cannot raid that account for other expenses. Also, it you intend taking this route, I suggest the first monies go into a Roth IRA to get the ultimate tax-free withdrawals. Aside from my emphasis on those points, I don't think you're missing anything.

Regards..Pixy


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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14412 of 75523
Subject: Re: Why 401(k)? Date: 10/11/1999 3:27 PM
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If you make identical investment returns inside and outside a tax advantaged plan like a 401K, the tax savings on the 401K and the matching make it the preferred account. But the fact is that numerous restrictions on the 401K plan usually give you better earnings potential outside the plan--if you make the right choices.

Everyones choices must be their own. For most people, the 401K is a better deal because they may have difficulty consistently exceeding returns with outside investments. Ergo, 401K/IRA is a lower risk strategy, but it is not the only one by any means.

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