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Finance - Investments Sub-forum: Non-Actuarial Personal Finance/Investing

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  #1  
Old 04-28-2006, 10:42 AM
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Default Wisdom of 401k Contribution Maximization

I am not a financial newbie, but I recognize that there are people here who have even better financial backgrounds than my own.

I can see contributing to the point of maximizing your employer's match. Beyond that is a different story. I could be paying a 25% marginal federal tax on those dollars now. What if my marginal rate is 50% when I retire? Will the tax deferral of earnings for the next 30 years overcome a drastically more progressive tax structure (DMPTS)? A DMPTS that will be necessitated by the trainwreck that is social security.
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Old 04-28-2006, 10:46 AM
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You'll be defering that tax until you retire (45-0 years). You can figure out the time value of that deferral. I contribute 14K to my 401k but I also contribute about 2K to my Roth for tax diversification.
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Old 04-28-2006, 10:54 AM
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Quote:
Originally Posted by Jack
You can figure out the time value of that deferral.


In order to make this calculation, I need to make assumptions about 1) when I'll retire 2) rate of return over the next 25 years both nominal and real 3) tax structure I'll face in when I retire 4) portion of total rate of return I can defer via capital gains on post tax investments


number 3 concerns me the most.
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Old 04-28-2006, 11:43 AM
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Quote:
Originally Posted by DeepPurple
I am not a financial newbie, but I recognize that there are people here who have even better financial backgrounds than my own.

I can see contributing to the point of maximizing your employer's match. Beyond that is a different story. I could be paying a 25% marginal federal tax on those dollars now. What if my marginal rate is 50% when I retire? Will the tax deferral of earnings for the next 30 years overcome a drastically more progressive tax structure (DMPTS)? A DMPTS that will be necessitated by the trainwreck that is social security.
You ask a very good question...I've been thinking of dropping my contribution a bit for a couple of reasons:

1) I'm also not convinced that tax rates will necessarily be lower when I retire...in fact I feel like they'll go up
2) Money in a 401K is taxed at ordinary income tax rates when you withdraw it, no matter whether it is invested in stocks or bonds...so if you took some of the money in your 401K that you allocate to stocks, and instead invest it in a taxable account, you'll likely be paying tax at the long term capital gains rate when you withdraw it...so unless you think that there will be no differential between ordinary income tax rates and capital gains tax rates in the future, the tax deferral of the 401K loses some of its luster
3) Expenses in funds in a 401K tend to be higher than those in a mutual fund...in my 401K, the S&P 500 Index Fund has an expense load of 30 bps, and the bond index fund has an expense load of 50 bps...at Vanguard I pay expense loads of 9 bps and 11 bps, respectively, for the S&P 500 Index Fund and the total bond market index fund

So I would say that it's very clear that you should invest enough in a 401K to get the maximum employer match...beyond that, I am not certain that you might not be better off investing outside the 401K, particularly for money going into equities
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Old 04-28-2006, 12:05 PM
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Dollars contributed today reduce your top marginal rate. Dollars pulled out in retirement will come out at your then effective tax rate which after even the standard deduction is often considerably lower than your marginal rate. Something to at least consider.

There is a good article on this where they weigh the pros and cons of Roth-401(k) v. trdaitional 401(k) in CCH's Journal of Pension Benefits (subscription required).
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Old 04-28-2006, 09:48 PM
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First contribute enough to the 401(k) to maximize the company match. Then contribute the maximum allowed into a Roth. Then save money towards a home down payment if you haven't bought one yet. Then if you have more money to save for retirement put it in the 401(k).

When it comes to choosing to put the extra dollars in a 401(k) vs. a taxable account, it's not just the tax rate that matters it's also the turnover rate you expect. The 401(k) money gets taxed once at the end when you take it out, while the money in the taxable account is taxed on the dividends and the gains are taxed on every trade. Not to mention that you are taxed on the activity within your mutual funds, even though you haven't sold any shares of the fund itself. Run different scenarios, and you'll find that the 401(k) beats the taxable account most of the time unless the time horizon is relatively short (like <20 years) or the stocks/funds in the taxable account are held for a long time between trades (~5 years or more).

And like yankeetripper pointed out, the dollars going into your 401(k) now are shielding you from the high marginal rate, but many of the dollars that come out of it in retirement will be tax-free (assuming a standard deduction still exists) and other dollars taxed at low rates (assuming graduated tax rates are still in effect).
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Last edited by Incredible Hulctuary; 04-28-2006 at 09:52 PM..
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Old 04-29-2006, 12:59 PM
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I tend to think there's little benefit to contributing more to your 401(k) than is necessary to get your company's match. There are just better alternatives usually. Like someone else mentioned, I don't think my tax rate at retirement will be any lower than it is now. I think tax rates can only go up over the next 35-40 years.

If you're getting your company's full match and want to invest more, put the money in either a Roth IRA or your home. With either investment, you won't have to pay taxes on the gains when you realize them.
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Old 04-29-2006, 05:24 PM
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Remember it's not just a comparison of "tax rates" being higher or lower. When you're retired and taking 401(k) money you can juggle things differently.

For example, if you're retired (and over 59.5 yrs old) and take $25K out of your Roth, and $12K out of your 401(k), you'd pay only $700 in fed taxes that year ($5K standard deduction and 10% on the next $7K). If they increased the rate of the lowest bracket from 10% to 20%, that's just $1400 in taxes, which still leaves you better off than if you were taxed on the money back when you earned it.

By all means put money into a Roth as much as you can; but after that, the 401(k) can be much better than taxable investments even if tax rates go up.
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Last edited by Incredible Hulctuary; 04-29-2006 at 05:39 PM..
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Old 05-01-2006, 02:12 PM
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Quote:
Originally Posted by DeepPurple
In order to make this calculation, I need to make assumptions about 1) when I'll retire 2) rate of return over the next 25 years both nominal and real 3) tax structure I'll face in when I retire 4) portion of total rate of return I can defer via capital gains on post tax investments


number 3 concerns me the most.
So, you're really worried that they'll tax the hell out of everyone's 401(k) distributions to save Social Security? You don't think it will occur to anyone that that doesn't make a tremendous amount of sense?
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Old 05-01-2006, 02:27 PM
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Also, the fact that the inside buildup (regardless of whether money is in a 401K/IRA or a Roth IRA) avoids being taxed (repeatedly) until the money is taken hout is a huge benefit.
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