maxing a 401k

[johndenver]

Some nits at work are trying to peer pressure me into funding my 401k to the max (25%). They act like its crazy to do otherwise. I currently only fund to the full company match.

My logic is that I am currently in my 20s in the 25% tax bracket, I assume I will at least remain in this tax bracket when I retire.

It is my understanding that 401k withdrawals are taxed as normal income, whereas if i just take my own money and throw it in an index fund it would be taxed as capital gains ( cap gains tax <<< normal income tax )

So it seems like I would be losing money to taxes long term by maxing a 401k. Plus it seems like I would unnessecarily be putting my money in a lockbox for 40 years.

Am i thinking about this the right way?

Is there any real benefit to fully funding a 401k?

[Jimbo]

Are the people at work urging you to max out your 401k HCE's? (highly compensated employees) If they are and you are not, well let's just say I used to do the same thing. [img]/images/graemlins/smile.gif[/img]

The more non-HCE's contribute to their 401K's the more I was allowed to contribute without getting mandatory taxable contributions refunded to me and losing some of my matching funds.

Jimbo

[johndenver]

[ QUOTE ]
Are the people at work urging you to max out your 401k HCE's? (highly compensated employees) If they are and you are not, well let's just say I used to do the same thing. [img]/images/graemlins/smile.gif[/img]

The more non-HCE's contribute to their 401K's the more I was allowed to contribute without getting mandatory taxable contributions refunded to me and losing some of my matching funds.

Jimbo

[/ QUOTE ]

haha actually they might be

that is so evil

[jackblack73]

Are you also contributing to a Roth IRA? Whether you want to (or are able to) save 25% of your income is up to you. But I would contribute to your 401K up to the company match, then contribute to a Roth IRA, so you have tax diversification. If you want to contribute more after your Roth is maxed out, then put more in your 401K.

[TLC]

Don't forget to factor in taxes for dividends and capital gains distributions on the taxable account scenario. In the tax deferred account, keeping all of those and having them work for you increases your returns significantly over time.

If you never sell the index fund until you retire (that's an iffy assumption over a 40 year period), I suspect that the two scenarios are pretty equivalent. If you just swap the index fund once in that 40 year period for another one (e.g., the fund closes down, etc.) and have a decent capital gain, the equivalent, after-tax portfolio values would heavily favor the tax-deffered scenario even though it would be treated as ordinary income.

I encourage you to spend 5 minutes in a spreadsheet playing with the numbers. You'll need to make assumptions like whether the spread between the capital gains and ordinary income tax rates will widen from the current favorable situation, etc. The Vanguard 500 index fund has had an after-tax return "hit" of about 0.5% per year over the last 10 years. That assumes a high tax bracket, so you could tame that down a little if you want to 0.4%.

Another thing to consider is the investment choices in your 401k. If they are vastly inferior (i.e., high expenses) to what you would use in a taxable account, then that may sway things a bit towards the taxable account. Although with the way people jump between jobs these days, that may be a moot point as there will probably be several opportunities for you to transfer the funds to a self-directed rollover IRA.

Good luck with your decision.

[AL5AcE]

Yea, what he said above. Your 15% capital gains will be taxed every year, preventing you from reinvesting this money, which would have worked to compound a lot over 40 years. When you withdraw your 401k and the tax is applied, the two net results are close but still significant.

I also recommend you spend 5 min. figuring out your future tax bracket, and calculating the difference between the capital gains tax and the tax deferred option.

[Jimbo232]

[ QUOTE ]
Are you also contributing to a Roth IRA? Whether you want to (or are able to) save 25% of your income is up to you. But I would contribute to your 401K up to the company match, then contribute to a Roth IRA, so you have tax diversification. If you want to contribute more after your Roth is maxed out, then put more in your 401K.

[/ QUOTE ]

QFT. For most people the optimal retirement savings strategy is to:

1) Contribute enough to your 401(K), 403(B), TSP, etc. to maximize the company match
2) To diversify your tax benefits max out Roth IRA to IRS limits ($4K in 2007, $5K in 2008)
3) If you have extra money to save and the desire to do so contribute additional funds to your 401(K), etc. up to the IRS max ($15.5K in 2007, $16K in 2008)
4) Funnel any additional retirement savings into a regular taxable brokerage account. A low cost index fund is a pretty tax efficient investment to hold in a taxable account.

[petp_the_greek]

contribute only to the company match.
since youre in your mid 20's you have other things to save for....house, wife, kids, college, car, beer....etc.

[spider]

401k's are basically the same as traditional IRAs (tax deductible) except the limits are much higher (IRA limit is $4,000) but many don't qualify for a deductible IRA at all. What might be confusing about this is that you take an explicit deduction for a deductible/traditional IRA whereas with a 401k it doesn't even show up on your W2 (although they still take out FICA). But because it isn't showing up on your W2, that makes it an implicit deduction. Either way, your taxes are reduced by your marginal rate multiplied by the deduction (implicit or explicit).

It's possible to have a long discussion about Roth vs traditional IRAs vs 401k's vs Roth 401k's but the bottom line is whatever amount of money you save should go in any of the above 4 options before it goes into an ordinary taxable account.

So if you'd prefer to put some amount of money in a Roth rather than your 401k, that's fine, whatever. Just put it in one or the other rather than a taxable account.

Also, some company 401k's offer crappy investment options (i.e. brokerage mutual funds with ridiculous expense ratios). In that case, you still want to conribute to the match but maybe not beyond that. But also keep in mind that when you leave the company, you can roll everything into an IRA.

[spider]

[ QUOTE ]
For most people the optimal retirement savings strategy is to:

1) Contribute enough to your 401(K), 403(B), TSP, etc. to maximize the company match
2) To diversify your tax benefits max out Roth IRA to IRS limits ($4K in 2007, $5K in 2008)
3) If you have extra money to save and the desire to do so contribute additional funds to your 401(K), etc. up to the IRS max ($15.5K in 2007, $16K in 2008)
4) Funnel any additional retirement savings into a regular taxable brokerage account. A low cost index fund is a pretty tax efficient investment to hold in a taxable account.

[/ QUOTE ]

Yeah, great advice for about 99.9% of all workers in US. I'll add one thing, which is that with a Roth you can later withdraw your original contribution amount with no penalty whereas you generally don't have that sort of option with the other tax-protected accounts, or at least not with the same ease the Roth offers.