http://www.fool.com/news/Take/2002/take020715.htmThis is a rehash of the claim that it is bad to max out a 401K, because if you put the money in stocks in a taxable account, you'll end up paying less taxes (capital gains vs. marginal rate).Let me say again, these "experts" are working for untenable assumptions. They assume that portfolios should be grossly stock heavy, they assume no one will ever sell or rebalance, and they assume people will gradually drip money out of stocks during retirement.Where have they been the last 2 years? I only wish I could put more money into a non-deductible IRA for my CDs.
Just a coda:One point the cited piece makes is that if one has to choose between maxing out a 401k and putting money into a Roth, it may be better to go for the Roth, forgoing the current tax deduction on income for saving on future taxes on earnings. This is a legitimate possibility and needs to be calculated for individual circumstances, similar to deciding whether or not to convert a traditional IRA to a Roth (pay taxes now or later).It's the argument that you pay more taxes with a 401K than with the same low turnover stock investment (e.g., an index fund) in a taxable account that I find totally misleading—it's theoretically true, just not a good investment plan in the real world.
It's the argument that you pay more taxes with a 401K than with the same low turnover stock investment (e.g., an index fund) in a taxable account that I find totally misleading—it's theoretically true, just not a good investment plan in the real world.While it is theoretically true is many circumstances, it is hardly universally true. When I look at my "expected" situation, I find that the 401k is clearly better even assuming a higher tax bracket in retirement than I currently pay...unless I am doing something wrong anyway. Here is my set of assumptions (simplified somewhat for this forum): Taxable 401kReturn 8% 8% (same investments in both places)Fed Tax Rate 27% 36% (assume tax rate will increase at retirement)State Tax Rate 6% 6% (already in GA's top bracket)Cap Gains Rate 18% ---Time 30 yrs 30 yrs (I am 30, so lots of time)Starting $ $ 670 $1,000 (gotta pay those taxes if you don't put the money in the 401k)Pre-tax End $6,742 $10,062Post-tax End $5,649 $5,836Thsi set of assumptions clearly favors the 401k...and this is ignoring the fact that there will be some taxes every year on the $670 placed in the taxable account due to dividends and other mutual fund distributions...even the best index funds have some of these.So...the 401k ends up superior by about $200 even though the tax rate is higher in retirement than it is presently. And that ignores taxes on distributions and the flexibility of moving between investments to rebalance the portfolio once every year or so. And it ignores the 4% match my company gives me on the 401k. The down side of the 401k, on the other hand, is that you must begin mandatory distributions from the 401k at 70.5.I max out both my 401k and my Roth IRA, so it is not a choice between those two...it is just a choice between 401k and taxable investments. And unless I am missing something, I think the 401k is clearly the better option for me at this time (the crossover from taxable being better to the 401k being better occurs at about an 18-year time horizon, but since I am only 30 I have much longer than that).Is there anything I am missing here? ACME
Taxable 401kReturn 8% 8% (same investments in both places)Fed Tax Rate 27% 36% (assume tax rate will increase at retirement)State Tax Rate 6% 6% (already in GA's top bracket)Cap Gains Rate 18% ---Time 30 yrs 30 yrs (I am 30, so lots of time)Starting $ $ 670 $1,000 (gotta pay those taxes if you don't put the money in the 401k)Pre-tax End $6,742 $10,062Post-tax End $5,649 $5,836
Acme,Excellent example of how, even if one does assume investing in a low ongoing tax generating option, it is very hard for the taxable account to catch up to the tax deductible account. Of course, if you assume higher annualized returns, the catch up point is faster. On the other hand, if the taxable account does generate any ongoing taxes (say 1% annual dividends for a total market index fund, which is very far on the low end), that's going to extend the catch up point even further. So the scenario really works best for individual, non-dividend yielding, stocks that you hold until you need to cash them in, which means finding companies that you are virtually certain will continue to be good investments, and pay no dividends, for 30 years. Good luck.My point is that there are not "many" scenarios where choosing a taxable account over a 401K is preferable, only one. You have to choose stocks or stock funds that generate minimal ongoing taxes and you have to hold onto those stocks or funds until very near the time you need the money.I frankly don't think there are many circumstances where RMDs are a disincentive, unless you are going to continue generating enough income to live on past age 70 (and don't be surprised if the start date gets extended, along with the start date for when you can collect social security). If our RMDs, plus social security, are more than enough than we need come age 70, I will be so thankful to our politicians for not having screwed things up, I'll be more than happy to pay the taxes.
Okay, just for the fun of it, I decided to take Acme's example and factor in dividends in something like the Total Market Index Fund. I'm assuming about 1.2% dividends, with 33% combined taxes. I'm using 36% as the after-retirement tax rate. In reality, of course, the taxes on dividends would go up as one approaches the 36% tax rate.In a taxable account, an initial $670 investment with a pre-tax return of 8% and post-tax return of 7.6% would be worth $5066.84 if cashed in after 30 years (18% captial gains taxes). At 11% pre-tax return, 10.6% post tax, it would be worth $11406.26.In a 401K, $1000 initial investment at 8%, with 36% taxes when cashed in, would yield $6440.32. At 11%, with 36% taxes we get $14650.88.Let's even up the after retirement taxes to 46% (about the max I can think of in any tax bracket with an state taxes): we still get $5434.02 and $12361.68 from the 401K.I know the numbers crunch better if you're comparing a taxable account with a non-deductible IRA, again if you assume leaving the money in a tax efficient stock portfolio until near when you need it (bad assumption). They may also crunch better if you're talking to someone with very low current taxes anticipating being much wealthier later—but quite frankly, I don't think such people should touch stocks in a taxable account until they reach a sufficient cash reserve, and by then they will be in a higher tax bracket.In other words, to suggest not maxing out a 401K in order to put money in stocks in a taxable account because you pay taxes on 401K withdrawals at you marginal rate instead of at long term capital gains rate as a plausible option is irresponsible.I suppose this is one of those times where someone came up with an idea that goes against common sense and wanted to make a splash. Usually common sense prevails.
In a 401K, $1000 initial investment at 8%, with 36% taxes when cashed in, would yield $6440.32. At 11%, with 36% taxes we get $14650.88.Loki: Did you consider the employers free matching funds? If not, that makes it even more compelling in favor of the 401(k).Splotto
Splotto,They're talking about maxing out 401Ks beyond the match. I don't think I've heard anyone suggest not going up to the match, even when talking about people who cannot afford both a 401K and a Roth.
Loki: OK. Just checking.Splotto
I max out my pre-tax 401k, and it's all in bonds. My question is, how worthwhile is it to add post-tax dollars to the 401k? The post-tax dollars would also be bonds.One thing that worries me about the 401k is that the government may decide to limit withdrawals or put other limitations on it by the time I am able to retire.
"My question is, how worthwhile is it to add post-tax dollars to the 401k?"Huh? Unless I've completely missed something, you can't put after-tax dollars into a 401K. There is a non-deductible Traditional IRA option for those with too much income to qualify for a Roth."One thing that worries me about the 401k is that the government may decide to limit withdrawals or put other limitations on it by the time I am able to retire."I strongly advise against making financial decisions based on paranoia about what government may or may not do. Given political realities, I would think with baby boomers retiring, government will not do anything to tick them off—more likely, we'll see some way of reducing the impact of taxes on retirement fund withdrawals. If we get a couple more big name corporate collapses, there may be some political support for preventing too much company stock in 401Ks, and with Roths becoming more important, if we do get government in a paternalistic mood, we may see some restrictions to prevent the young and the restless from gambling away what is supposed to be a nest egg for retirement, but I doubt it.
Unless I've completely missed something, you can't put after-tax dollars into a 401KUnder some conditions, you may be allowed to make after-tax contributions to a 401k:http://www.mpowercafe.com/retirement/faq/faq.220.127.116.11.html#7
Post-tax End $5,649 $5,836This set of assumptions clearly favors the 401k I hope you don't mind me jumping over here from the retirement investing board. While the assumptions give you more back at the end, you have given up some flexibility in the use of the money during the assumption time period. The 401K also requires distributions at 70.5 and doesn't allow(depending on the schizo nature of the estate tax and cost basis thing) you to pass on the captial gains untaxed.I would never argue against funding a 401K up to the point of the match. After that, I would suggest thoughtful review of one's own situation. rad
I hope you don't mind me jumping over here from the retirement investing board. I don't mind at all! The more the merrier.While the assumptions give you more back at the end, you have given up some flexibility in the use of the money during the assumption time period. Absolutely. You cannot get the favorable tax status without some sacrifice! :) Seriously though, I think bigger than the loss of flexibility is the potential loss of adequate investments. In my case, my 401k is with Vanguard where I would keep the money regardless...so I use the same investments and the costs are the same. If the costs are high for another person doing these calculations, they might need to use a lower return for one side of the equation than the other.Also, I could argue that the decrease in flexibility leads to an increase in "safety" for the person long-term. By making it harder to get at the money, the person might be less likely to spend their retirement money unnecessarily. So this issue is a balancing act in many regards.The 401K also requires distributions at 70.5 Yup...something I acknowledged in my post....and doesn't allow(depending on the schizo nature of the estate tax and cost basis thing) you to pass on the captial gains untaxed.This is a definite negative to the 401k compared to after-tax investments. However, I am far less worried about leaving a large inheritence than planning my retirement. I will make sure my [future] children are taken care of...but I'm not going to short-change my personal possibilities to make sure they get even more.(Of course, I might not be a fair "general" comparison in this regard since I can afford to max out my 401k at $11,000 and max out the Roth IRA and still invest/save additional money after-tax. So I fully expect to give my kids seed money -- such as funding Roth IRAs for them when they have summer jobs and other savings for their short- and long-term prosperity -- but I also plan to either spend my retirement money or leave the bulk of it to worthy causes.)I would never argue against funding a 401K up to the point of the match. After that, I would suggest thoughtful review of one's own situation. I agree 100%. This is why I run the numbers periodically. I just have never seen a situation -- for me -- where the taxable account was even close to the 401k. Down the road, this might change. But for the time being, I will be maxing out my 401k...which means with my contributions and my company match, I am puting away 22% of my salary for my retirement...plus my Roth IRA...and saving for a house.ACME
LOL - just for reference - I'm 47, married for 26 years and have kids ages 20,18 and 14. I'm not planning to leave anything but if I had owned AT&T stock for a long time, leaving it would be easier than figuring out the cost basis.I just have never seen a situation -- for me -- where the taxable account was even close to the 401k. If you save/invest well, the forced distributions may make you rethink. If I had it to do over again, I would re-think the traditional IRAs but choices were limited and taxes were higher back in the olden days. So I fully expect to give my kids seed money -- such as funding Roth IRAs for them when they have summer jobs and other savings for their short- and long-term prosperity I've written a lot about my kids - both Fribbles and posts(much in the early days of the Family Fool board) - as Recovering Fool. rad
If you save/invest well, the forced distributions may make you rethink. If I had it to do over again, I would re-think the traditional IRAs but choices were limited and taxes were higher back in the olden days. I save well...invest terribly. I learned a couple years ago that I am not good at investing on my own -- I either get too emotional and make bad decisions...or it stresses me out and I have trouble sleeping (whether my stocks go up or down). So I invest almost exclusively in index funds now.I think it is a fair comment to say that I might regret my thinking...but I have to base my decisions on something and hope for the best. For now, I am using the method that maxes my money down the road. If it works out wrong, I'll still be set financially...just maybe a little less set!
Dernit...hit send by accident! Continuing...I've written a lot about my kids - both Fribbles and posts(much in the early days of the Family Fool board) - as Recovering Fool. Had no idea you were the same person. I am sure I have read all of those Fribbles. I like to read things that disagree with my view...makes me re-think why I chose to go the route I did. I re-test my logic periodically...someday I might have to go a different way, but for now I'm going to max my 401k.Fool on!ACME
While the assumptions give you more back at the end, you have given up some flexibility in the use of the money during the assumption time period.Bingo!!I am glad someone pointed this out. It is the giving up of flexibility that worries me. How much is that worth? One cannot put a price on that, although one can put a price on the potential penalty in case of early withdrawals. But that is the crux of the debate, IMO. -hack
I think it is a fair comment to say that I might regret my thinking...but I have to base my decisions on something and hope for the best.This wasn't my intention. I was explaining why I had a few regrets. My hope for others is that they think and question financialisms and make their own decision. I would have a hard time thinking of something that was an absolute "one size fits all" for personal finance.rad
Let me try to bring this back to my original point, which was to object to throwing out, without explaining the assumptions and running the calculations, the idea that one was likely to get a better after tax return by not maxing out a 401K and, instead, putting money into stocks in a taxable account, because capital gains taxes are less than being taxed at your marginal rate. I still maintain this is irresponsible.For those who are well enough off that they are likely just to be leaving a 401K to the kids, the situation is different. Fine, then explain that to be the audience.I don't insist that maxing out a 401K is always the best idea; just that this "paying less tax" scenario is a very unlikely reason.Certainly, for those who may need the money for purposes before retirement, it is a mistake to max out a 401K, and as I said if you have to make a choice of 401K or Roth, that choice needs to be calculated.I think the issue of flexibility, in the sense of what your investment options are, is an important one. If the options available for a 401K are poor, then it may be better to seek other options. But then it is necessary to be clear what greater flexibility entails—for example, if you want to get into aggressive trading, including short selling, you probably can't do that in a 401K. Or are we talking about limited fund availability—TIAA-Cref does not have a value fund in its retirement accounts, and a blend fund that is too growth oriented for stocks, which I regret, but there are enough options, I'm not going to do better by paying taxes now—I do my own rebalancing.I really don't worry about the RMD issue. If my RMD is more than I need to live on, then I'm not going to hassle the taxes, and again it really boils down to how much I can leave in my will.Anyway, although I'm glad this provided an opportunity to raise some related issues, I stand by my basic point that the "better return by not maxing out the 401K and putting the money in taxable account because of the difference between capital gains and marginal rates" argument is irresponsible. I fully acknowledge there may be other reasons for not maxing out a 401K.
... I stand by my basic point that the "better return by not maxing out the 401K and putting the money in taxable account because of the difference between capital gains and marginal rates" argument is irresponsible. I think "irresponsible" is a poor choice of word.rad
"I think "irresponsible" is a poor choice of word."No, I think it is precisely the right word.To present a hypothetical situation, with highly limited applicability, to a mainstream audience, without all the appropriate provisos to understand just how limited the applicability is, is irresponsible.If the argument was presented as: you know folks there may be some rare circumstances under which you end up with better returns in a taxable account than with an IRA and here are the cirumstances, then I'd have no problem with it. But every time I've seen the argument, the implication is that the difference between capital gains taxes and marginal rate taxes means not maxing out your 401K and putting it in stocks (or an index fund) in a taxable account is a widely applicable strategy. It's not. And that's why I insist on spelling out the unlikely assumptions on which the argument is based, and why I think it is important to crunch realistic numbers, as Acme helped us do.
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