FLU, I did a comparison of your 401k vs. using those funds in a taxable account at a benchmarked rate of return (I also included a generic 401 & ROTH 401, assuming it had existed at the time).
Newblet – the general analysis is at the bottom.
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I made these assumptions:
28% income tax rate (on contribution amounts you listed & dividends)
15% capital gains rate
Buy and hold the SP500 as investment vehicle (SPY index ETF, w/ 1.8% dividend yield, reinvested). This should meet FLU’s requirement for someone with basic financial capabilities (on a side note, the majority of professionals & funds do NOT beat the index…)
I started the analysis at the beginning of 1996 to current, which is closer to 12 years.
I applied the annualized rate of return (derived from the total return of the last 11.9 years) to each years contribution & prior balance.
FLU, the 20k you left out included your company match & subsequent returns.
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FLU’s 401k:
You contributed 140.5k over ~12 years ending up with 240k total (220k less match). So, the following is your annualized rate of return:
~7.25% on just your contributions
~8.75% with the match (which is really what counts).
240k pre *income* tax.
Taxable A/C:
If you had contributed the same amounts after tax (~101k over 12 yrs.) to a standard account, bought and held an SP500 index fund you would have:
~9.25% annualized return (~8% return on SP + 1.25% div)
~181k pre *cap gains* tax.
ROTH IRA:
Same contribution amount after tax (~101k), same SP index fund & return, slightly hihger annualized return & total funds (div not taxed).
~10%
~187k w/ no tax liability
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Now the important part, how much is each scenario approx. worth after tax? There are many variables, permutations, and uncertainty regarding future tax laws, but for simplicity lets assume nothing changes, and there are no further additions or returns during withdrawls:
FLU’s 401k:
240k -> 173k if withdrawing at a 28% tax rate
240k -> 161k lump sum (33% tax)
Taxable:
180k -> 171k if withdrawing at 15% cap gains or lump sum
180k -> 157k if trading account (short term gains, paying 28% each year on returns).
Roth IRA/401:
187k -> 187k (no tax)
Assuming a std 401k that returned the SP500 w/ div. (~10%):
NO Employer match
260k -> 187k withdrawing at 28% tax rate
260k -> 174k lump sum (33% tax)
With match @ 1/5 of max contribution (e.g. $3100 in 2007), returning ~10%:
312k -> 225k withdrawing at 28% tax rate
312k -> 209k lump sum (33% tax)
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Of course, compounding over time has a greater effect, but the ratios are about the same:
Amounts for the next 12 years (24 total), assuming the same annualized rate of return & contributions as of 2007:
FLU’s 401k:
995k -> 715k if withdrawing at a 28% tax rate
995k -> 665k lump sum (33% tax)
Taxable:
785k -> 715k if withdrawing at 15% cap gains or lump sum
785k -> 575k if trading account (short term gains, paying 28% each year on returns).
Roth IRA/401:
845k -> 845k no taxes withdrawing or lump sum.
Assuming a std 401k that returned the SP500 w/ div. (~10%):
NO Employer match
1175k -> 845k withdrawing at 28% tax rate
1175k -> 785k lump sum (33% tax)
With match @ 1/5 of max contribution (e.g. $3100 in 2007), returning ~10%:
1410k -> 1015k withdrawing at 28% tax rate
1410k -> 945k lump sum (33% tax)
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With all that laid out FLU, there would have been no advantage using a taxable account vs. the slightly lower return your 401k has provided. Also, the ROTH 401 wasn’t around when you started, so you can’t really take that into account. In addition, many people who don’t use payroll deduction and/or have easy access to their savings tend to either save less or dip into their funds.
For the general debate on 401’s, comparing the options with the same investment vehicle and return (i.e. not FLU’s case), a few patterns become evident.
1) Choosing a taxable account is considerably worse.
2) Trading in a taxable account is far worse, requireing a significantly higher return to balance income taxes.
3) The ROTH vs. 401k are EXACTLY the same, if the tax rate going in (saved or payed) is the same as the 401k tax rate during withdrawls.
4) The free money, and compounding thereof, is substantially better in a MATCHED 401k then ANY other option.
5) Tax sheltered accounts, even withdrawn in a lump sum (and after enough time, even with a 10% penalty), will result in larger gains than using a taxable account.
6) Large distributions will favor ROTH’s over non-matched 401’s (but not matched ones).
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From this the following “rules” can be applied:
1) If your employer offers a ROTH 401, contribute the maximum possible to that. Your employer should provide the maximum match and deposit it into a *traditional 401k*.
2) If your employer does NOT offer a ROTH 401, contribute to your standard 401k to receive the maximum match from your employer (unless you are *sure* that you will not be there long enough to vest at least 20%).
.
2A) Additional funds should go to your ROTH IRA, to
the maximum.
2B) If you haven’t maxed out your 401 contribution,
and you still have money to save, it is probably best
to put it into the 401, unless you plan on using
those funds before retirement.
Caveats: If you plan to be in a substantially smaller tax bracket during retirement (and forsee income tax rates not increasing, and you won’t be taking large distributions), then a std. 401k may be better. Balance this with the ability to retire earlier with a ROTH 401/IRA (since you can withdraw contributions tax free, anytime after 5 years, and no rules forcing distributions at 70…).
If your 401k offerings are truly abyssmal, or have very high fees, AND you don’t get a match, your return may be comparable to taxables accounts – the upside is that you can eventually rollover your 401 into an IRA and avoid these problems, so probably still better to go with the 401…
After all the tax talk, don’t forget that the rate of return is critical, a few percent makes a large difference overtime, so making sure you don’t underperform can be more important than the tax consequences. If you have more then a decade before retirement, investing 100% in equities & matching (or better) the general market is important (without too much risk of course). Staying out of bear markets will dramatically increase returns, but that is a whole other thread… So if I was Newblet at 24, I would be aggressive.
As a smart poster mentioned above, run any tax strategies past an expert before proceeding.
Apologies for the length, I wrote far more than anticipated…
If anyone is interested in playing with these scenarios, I’ll see if I can post a link to the spreadsheet.
