401K vs taxable brokerage account

[cardtrick]

I just thought of this... What's the tax benefit with using a 401K? Assuming that you are going to be in the same tax bracket for ever, there is no difference between investing in a 401K vs investing in your taxable account. Actually, you'd be better off investing in your taxable, since gains will be taxed at the long-term capital gains rate, assuming you hold each stock for at least a year. If you just put everything into a 401K, you'd be paying regular income tax on distributions. And besides, 401K money can't be taken out before the age of 59.5?

I'm considering dropping my 401K contributions to the minimum required to get the match and investing the rest in my taxable account. Good idea? Bad idea?

[feh]

I just thought of this... What's the tax benefit with using a 401K? Assuming that you are going to be in the same tax bracket for ever, there is no difference between investing in a 401K vs investing in your taxable account. Actually, you'd be better off investing in your taxable, since gains will be taxed at the long-term capital gains rate, assuming you hold each stock for at least a year. If you just put everything into a 401K, you'd be paying regular income tax on distributions. And besides, 401K money can't be taken out before the age of 59.5?

I'm considering dropping my 401K contributions to the minimum required to get the match and investing the rest in my taxable account. Good idea? Bad idea?

Your logic is correct, but there's no way to know if your assumption of being in the same tax bracket post-retirement is correct. For most people, it is expected they will be in a lower tax bracket post-retirement (my wife and I certainly will be).

We also don't know how tax brackets and rates will change between now and retirement. Given these unknowns, I think it's wise to invest in both tax-advantaged and taxable accounts, although I would max out tax advantaged first.

[KTP]

I just thought of this... What's the tax benefit with using a 401K? Assuming that you are going to be in the same tax bracket for ever, there is no difference between investing in a 401K vs investing in your taxable account. Actually, you'd be better off investing in your taxable, since gains will be taxed at the long-term capital gains rate, assuming you hold each stock for at least a year. If you just put everything into a 401K, you'd be paying regular income tax on distributions. And besides, 401K money can't be taken out before the age of 59.5?

I'm considering dropping my 401K contributions to the minimum required to get the match and investing the rest in my taxable account. Good idea? Bad idea?

It really depends on your income level. If you are in the 25% tax bracket, then any money you put into the 401K has 25% more purchasing power vs a taxable account because it comes out of your paycheck without any taxes applied.

This compounds nicely over a 30 or 40 year period into quite large gains.

Say you could get full match with just a $7500 contribution. You then choose to stop 401K contributions and not continue the additional $10,000 allowed per year. You will only get $7500 of the $10,000 in your paycheck because of the 25% tax bracket. Thus you only have $7500 available to invest in the market.

Assuming a real (inflation adjusted) market return of 4%, the $2500 extra in the 401K will grow to $8,100 in 30 years or $12,000 in 40 years. Even if you pay 35% tax on that during retirement, you will be ahead.

Dividends and capital gains from rebalancing will also grow quicker in the 401K because the taxes are deferred.

[jIM_Ohio]

I just thought of this... What's the tax benefit with using a 401K? Assuming that you are going to be in the same tax bracket for ever, there is no difference between investing in a 401K vs investing in your taxable account. Actually, you'd be better off investing in your taxable, since gains will be taxed at the long-term capital gains rate, assuming you hold each stock for at least a year. If you just put everything into a 401K, you'd be paying regular income tax on distributions. And besides, 401K money can't be taken out before the age of 59.5?

I'm considering dropping my 401K contributions to the minimum required to get the match and investing the rest in my taxable account. Good idea? Bad idea?

The first and second paragraph are not discussing the same thing. The jump from paragraph 1 to the conclusion needs a lot more information to see the forest through the trees.

The key is to have a plan, set goals, and use the tools you have (401k, brokerage) towards those goals.

The first $400k of a 401k come out tax free for a married couple. About $250k for a single person. So you get a deduction going in, and tax free coming out. Sounds good to me.

Second, tax rates change over time, even if your income does not. No way I could have predicted 15 years ago what my life would be like now, tax a tax deduction if its there, and at 25% marginal rates, there are not many better tax deductions now (save 25% on way in, get first $400k out tax free sounds good to me).

Third, the estate tax changes often, the capital gains rate is the second tax rate I see change frequently. Clinton changed it, Bush II changed it, Obama has changed it twice, I think (or Bush II changed it twice). I would not bank on it being lower long term, because it was not that way when Bush I was president.

Fourth, 401k money can be converted to a Roth, where as a brokerage account could not. If you have excess tax deductions in retirement, you could convert to a Roth and not pay tax on money above $400k.

[feh]

Related thread at bogleheads:

http://www.bogleheads.org/forum/viewtopic.php?f=10&t=129801

[disneysteve]

What's the tax benefit with using a 401K?

The benefit is pre-tax contributions and tax-free growth. That is going to put you far ahead in 20 or 30 or 40 years compared to someone who invested after-tax income and had to pay taxes on growth and dividends every year.

[cardtrick]

Thanks for the bogleheads link. It appears that if I want to go the tax-free route, I should just invest in a Roth 401K instead of taxable. I think I need to find other things to do with my time. It seems that I'm over-thinking this whole thing.

[MonkeyMama]

cardtrick - you make very good points.

As a tax professional, I do not agree that "most people" see a decrease of taxes in retirement. Many pay more taxes in retirement.

We generally advocate for 401k contributions because they are the most generous deductions in the tax code (well, generous as far as keeping your own money). The tax code also changes frequently, so might as well go for the sure thing. The current tax deduction is a sure thing. The future is, "who knows?" In addition to all that, you can't get back your retirement contributions (annual limit) if you change your mind later.

Others have also mentioned that you can convert retirement money into ROTHs. You can, I have done just that, and I have my parents on an aggressive ROTH conversion strategy in early retirement. BUT, ROTH conversions were very restricted until around 2010. I wouldn't exactly count on that any more than any other tax rule, as far as the future.

One thing I like about 401ks and IRAs, is tax simplicity. Dividends, gains, interest - who cares. Don't need to amass tax forms for tax time.

When we were younger and starting out (& in a higher tax bracket) we took the sure thing. In lower income years we converted to ROTHs. I am in a low tax bracket and so the ROTH is a no-brainer. At some point for me the question will be "ROTH or Traditional IRA"? Just to say I haven't been in a place to overly ponder "taxable versus 401k", for myself. But if I was, I would ponder the same thing.

One point not brought up. I lost a very significant retirement plan benefit at my job (10% of income matched) in 2010. I do not miss it one bit. I had no control over investments (which is about same as anyone who has very limited investment choices). Most in my office are 25+ years my senior so the money was invested too conservatively for my age. Fees, Fees, Fees and red tape. Thankfully I was able to roll it to an IRA since the plan was shut down. If I am offered a 401k in the future I would very seriously consider skipping it. Being able to eventually roll it into an IRA is okay. If you change jobs every few years, this would be of less concern. (I knew I could invest better and would pay infinitely less fees in an IRA, but even I Was shocked by how "not any worse off" I felt when all was said and done).

As to your question - there is no right or wrong answer. I'd weigh odds of certain outcomes, or just consider a 50/50 plan to cover all bases.

[KTP]

MM, your 401k must be REALLY bad if you would consider skipping it and giving the government 20 years or so of the use of your money for free. Either that or you are in a super low tax bracket.

[cardtrick]

cardtrick - you make very good points.

As a tax professional, I do not agree that "most people" see a decrease of taxes in retirement. Many pay more taxes in retirement.

We generally advocate for 401k contributions because they are the most generous deductions in the tax code (well, generous as far as keeping your own money). The tax code also changes frequently, so might as well go for the sure thing. The current tax deduction is a sure thing. The future is, "who knows?" In addition to all that, you can't get back your retirement contributions (annual limit) if you change your mind later.

Others have also mentioned that you can convert retirement money into ROTHs. You can, I have done just that, and I have my parents on an aggressive ROTH conversion strategy in early retirement. BUT, ROTH conversions were very restricted until around 2010. I wouldn't exactly count on that any more than any other tax rule, as far as the future.

One thing I like about 401ks and IRAs, is tax simplicity. Dividends, gains, interest - who cares. Don't need to amass tax forms for tax time.

When we were younger and starting out (& in a higher tax bracket) we took the sure thing. In lower income years we converted to ROTHs. I am in a low tax bracket and so the ROTH is a no-brainer. At some point for me the question will be "ROTH or Traditional IRA"? Just to say I haven't been in a place to overly ponder "taxable versus 401k", for myself. But if I was, I would ponder the same thing.

One point not brought up. I lost a very significant retirement plan benefit at my job (10% of income matched) in 2010. I do not miss it one bit. I had no control over investments (which is about same as anyone who has very limited investment choices). Most in my office are 25+ years my senior so the money was invested too conservatively for my age. Fees, Fees, Fees and red tape. Thankfully I was able to roll it to an IRA since the plan was shut down. If I am offered a 401k in the future I would very seriously consider skipping it. Being able to eventually roll it into an IRA is okay. If you change jobs every few years, this would be of less concern. (I knew I could invest better and would pay infinitely less fees in an IRA, but even I Was shocked by how "not any worse off" I felt when all was said and done).

As to your question - there is no right or wrong answer. I'd weigh odds of certain outcomes, or just consider a 50/50 plan to cover all bases.

Thanks for the detailed explanation. I also have a pension at work which is entirely pre-tax. If I were to stick around, I won't need any other assets to finance me in retirement.

Another huge consideration for me is my world tour plan. And, the option to "retire" early. Maybe, one day I will want to go the Mr. Money Mustache route and live very frugally. For these, I definitely will need money in taxable accounts and lots of it.

Tough decisions!

[MonkeyMama]

After I posted I saw your ROTH 401k option. That is also an entirely different option.

I didn't have all day so didn't get into how taxes are often higher in retirement. That's kind of the average experience, but most people haven't gotten that memo.

A Money Mustache type retirement is totally different. But again, that is based on taxes in the here and now. I can't speak about several decades in the future. It's easy to have a tax-free retirement in that type scenario. The short answer to what hits people in retirement is they tend to lose all their deductions, they tend to file single (widowed + "single penalty" - it used to be a marriage penalty but now it goes the other way), and pension + RMD + social security + taxable investments = a crapload of taxes. My dad is pretty savvy with taxes, for an average joe blow, but he didn't understand any of this. He didn't even know social security income is taxable if you have other income. (Most people don't).

This might not be average average, but this is "average" if you are a saver and have very large sums in retirement funds.

Early retirement is a different beast because usually doesn't involve a pension. You can spend your low-income years converting IRAs into ROTHs. Lower RMDs means your social security income is tax-free. This in turn means you won't pay taxes on your investments. It's pretty simple to pay -0- taxes in this scenario. My parents think I am a genius, but they are given me too much credit for a wacky tax code. They are the ones who retired early and have no "taxable income" to speak of until they withdraw from their IRAs. & the government just happens to be allowing unlimited ROTH conversions, now, so I suggested they take advantage.

[cardtrick]

I decided to go with a 50-50 contribution to Roth 401k and regular 401K, totaling the limit of 17.5K this year. That way, I will have plenty of Roth savings and plenty of regular 401K savings that I can roll over during low income years. I plan on doing different things throughout my life depending on how my finances look, so I will have a few years of little to no earnings, if all goes as planned. I should be able to convert those tIRA assets to Roth. We also have the option to do an in plan conversion of 401K to Roth, so I can just leave the money in the plan if they expand fund options.