Are you a sucker to invest in a 401(k)?

Discussion in 'Economics' started by crgarcia, Feb 21, 2008.

  1. Are you a sucker to invest in a 401(k)?

    One theory making the rounds these days holds that 401(k)s are tax traps. Here's why that's wrong.

    By Cybele Weisser
    February 21 2008: 9:54 AM EST

    (Money Magazine) -- 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?
    Strictly by the numbers

    Let's say you put $10,000 in your 401(k) and invest in a stock-index fund that earns an average of 8% a year. After 20 years it will be worth $46,610. Withdraw the money all at once and you'll pay $13,051 in taxes, assuming you're in the 28% bracket, leaving you $33,559 to spend.

    But what if instead you had bought that tax-efficient stock fund outside your plan? Wouldn't your tax bill be lower?

    Yes, but that's the wrong way to look at it.

    If you skip your 401(k) in favor of a taxable account, you must first shell out taxes on that $10,000, which leaves you with just $7,200 to invest (assuming the same 28% bracket).

    Plus, over the next 20 years, you'll have taxes on any dividends and gains the fund pays out. Even though you will get a lower 15% rate on your gains when you sell, you end up with $28,950, or about $4,600 less than with the 401(k).

    A tinier final tax bill can't make up for having to pay taxes all along.
    But wait...

    What if you find yourself in a higher tax bracket later on? Well, in this example, you'd have to be in a 38% tax bracket 20 years from now to have made the wrong decision.

    While Congress may (okay, will) have raised taxes by then, your bracket might not increase if your income drops in retirement. And the longer you wait to take the money, the more you stand to gain by keeping the money in your 401(k).

    Plus, comparing a 401(k) with a stock-index fund is the toughest test, since index funds generate little in the way of tax bills before you sell. If you buy a bond fund, where income is taxed at your ordinary rate, or an actively managed stock fund that distributes more gains than an index fund and triggers a far bigger tax bill for you every year, the difference in favor of the 401(k) account will be even greater.
    ...and furthermore

    This math ignores an employer match in your 401(k), which you are likely to get on at least part of your contribution. Add that in and the 401(k) looks better still.
    You do the math

    With the 401(k) savings calculator at, you can compare investing in and out of a 401(k), including the effect of having an employer match in your plan.
    The bottom line

    Rest assured that deferred investing yields more after-tax dollars.
  2. danoXP


    Article is CRAP.

    One of the most important factors in looking at ANY investment is the ability to reverse your decision or "undo" it - LIQUIDITY!

    LIQUIDITY factor would argue that having 100k in a cash account available to withdraw and use as needed is worth a hell of a lot more than 130k tied up until I am 65 ... or wait maybe 85 by the time congress gets done with the the rules and we are ready to withdraw. One thing that you can bet on is that the rules will only get worse.

    100 years ago there was NO Federal Income tax and NO State Income tax. The trend on taxes is not your friend. Pay now, not later. Later could be a lot worse.

    Yes, i would advise a 401k to only those that have an innate mental inability to "save". Have a hefty employer match. Or are in the maximum marginal tax bracket and want to hedge against the chance of a lower tax bracket in the future. Unfortunately, this is the majority of the American Public has the inability to save ... so, 401k is better than nothing.

    Otherwise, especially for young people in the lower tax brackets without an employer match - 401k, and IRAs are the biggest tax ripoff.

    Essentially, the government will only let you defer monies into an IRA if the taxes you would have paid on the monies are LESS than the maximum marginal rate.

    IMHO, 401k, IRA, are unfairly represented as positive vehicles by the financial planners and financial institutions that manage these vehicles ... charge and annual fee ... and get to "bank" on your money and their fee, essentially for the rest or YOUR life.Assets Under Management the can count on because you can't withdraw or select a new asset manager.

    my 2 cents. Sorry. Hit a sore spot.
    Pet peeve of mine for 13 years now and no one has been able to debate this with me effectively.

  3. Dano , you are right on . The 401k is better than nothing but thats about it. A forced savings plan with a small company match. Maybe a dozen investment choices to choose from and no way to move the account unless you quit. Former employee's have the best accounts of all because they are able to rollover into a brokerage account with real funds availible to invest in. So the system restricts the current employee and rewards the ex employee. Its a sore spot for me to. :(
  4. 401k is for losers.....thats all your setting yourself up for...being a loser....someone who is worse off at 65 then when you were 40. The whole premise behing 401k is you pay less taxes on it after you retire cause you will be in a lower tax bracket.....

    make your money work for you so at 65 you are making more than when you were at 45.....then 401k becomes pointless.

    you want to set yourself up for failure...invest away in those 401k

    you want to have a good retirement....start creating a revenue stream that doesnt quit when you stop working.
  5. Dano,

    What's your take on using a Whole Life Insurance policy for retirement? You ever heard of the LEAP system or the Infinite banking process? Both use whole life insurance as a base for building wealth.
  6. Amazing the amount of completely idiotic advice handed out in this thread.

    1. If your employer matches your contribution dollar for dollar (up to whatever limits the employer or the IRS sets), not contributing to your 401k pisses away free money. If an employer matches 6% on a $100,000 / year income, your $6000 instantly becomes $12,000 for each year you invest - before rate of return. Are you all in the habit of turning down free money?

    2. When one leaves employment and moves to Fulltime Trader Status (as I did), rolling over the 401k into a Self Directed IRA, allows near full access to the capital. One can then trade the funds, invest in property, buy or sell investment vehicles even purchase 'retirement' property which can then generate a 'rental income' for the Self-directed IRA. You can even 'borrow' against the funds for certain purposes (certain restrictions do apply) outside of investing.

    3. Compound Interest. Since one need not pay taxes until withdrawl, even with an increase in the current tax rate for retirees, your returns are higher because of the Compound Interest Formula. Your account grows more rapidly becuase you do not need to withdraw funds to pay Uncle Sam each year.

    Good Trading to you all.

    - Spydertrader
  7. My biggest problem with 401k is the limitation of products you can invest in. All i can pick from are a bunch of crappy mutual funds. I wouldnt mind so much if it lets you pick individual stocks, then i would just use it as my long term investment account.

    But my company matchs dollar for dollar up to 5k a year, so i just dump about 5k in there for a risk free 100% gain each year. Should be a nice chunk of change when you are 65 and drooling on a wheelchair all day
  8. poyayan


    Call your 401k sponsor, you might be able to setup a brokerage account that is linked to your 401k.
  9. Spyder hit the nail about the free money. You would be an idiot to not at least put the minimum amount in to get the maximum match.

    but complaining about the mix of funds? come on learning how to trade a limited market is ideal for learning to play in the tall weeds with the big boys.

    first forget about DCA, unless you just have no discipline.

    look at the mix of funds. what are the rules of the plan. how do the funds correlate to one another. do they move in tandem? in opposite direction. can you use the rules to your advantage? how often can you move the money? What can you learn about portfolio management using a simple 401k? Is there a weakness you can take advantage of?

    while you are not going to make triple digit or high double digit returns, you can definitely crank up the heat on the total return of the portfolio.

    using just 3 funds (domestic, intl, and a bond) we were able to almost triple the markets in the girlfriend's 401k. and she is up for the month of January this year.

    Remember, the first rule in trading is completely understanding the market you are trading. Find a weakness and exploit it.
  10. Adobian


    My 401K plan at Charles Schwab let me choose my own stocks
    #10     Feb 22, 2008