I've been doing a lot of thinking about 401K's lately. Almost every financial professional screams from the top of his/her lungs that it's a great deal. If your company offers matching funds it's probably a great idea to take advantage of that. If you are like me and your company doesn't offer a 401K match, should you still contribute? I used to think yes. Now that I've done some math, I'm not sure. Let's look at some of the reasons why I wouldn't want to contribute to my 401K:
- Today's tax rates are relatively low in the large scheme of things (see this website for evidence). With a 401K you are basically deferring paying today's low tax rates for whatever the future's tax rates are. I don't have a crystal ball, but if taxes are low now and we have health care and social security problems in the future, I would suspect they'd be on the rise.
- With 401Ks, you can face a penalty if you need to get your money early. Sure you can take a loan, but if you want to leave your job, you have pay that back immediately or pay a penalty on the money. If I invest the after tax money myself and I need it for whatever reason, I can sell the investment at no penalty.
- With 401Ks, you are limited in where you can invest your money. Often times your choices have high administrative fees and expense ratios. Free Money Finance says that the average large cap equity fund has an expense ratio of 1.28% while some exchange traded funds are typically under 0.15%.
- When you withdraw money from your 401K plan, it is taxed at ordinary income, currently 25% for many people. If you invest the money after taxes, you can take advantage of long-term capital gains and dividends rates, currently 15%. Again, I have no crystal ball to know what things will be like in 30 years, but if we use today's rates as a guideline, I'd rather pay 15% over the 25%.
- The Math:
401k Regular Account Starting $15,000 $15,000 After Starting Tax $15,000 $11,250 Growth Rate 9% 10% Year 1 $16,350 $12,375 Year 2 $17,822 $13,613 Year 3 $19,425 $14,974 Year 4 $21,174 $16,471 Year 5 $23,079 $18,118 Year 6 $25,157 $19,930 Year 7 $27,421 $21,923 Year 8 $29,888 $24,115 Year 9 $32,578 $26,527 Year 10 $35,510 $29,180 Year 11 $38,706 $32,098 Year 12 $42,190 $35,307 Year 13 $45,987 $38,838 Year 14 $50,126 $42,722 Year 15 $54,637 $46,994 Year 16 $59,555 $51,693 Year 17 $64,915 $56,863 Year 18 $70,757 $62,549 Year 19 $77,125 $68,804 Year 20 $84,066 $75,684 Year 21 $91,632 $83,253 Year 22 $99,879 $91,578 Year 23 $108,868 $100,736 Year 24 $118,666 $110,809 Year 25 $129,346 $121,890 Year 26 $140,987 $134,079 Year 27 $153,676 $147,487 Year 28 $167,507 $162,236 Year 29 $182,583 $178,460 Year 30 $199,015 $196,306 Tax Rate 25% 15% After Tax $149,261.38 $166,859.91
Here I took $15,000 and showed how it might grow over 30 years in a 401K vs. a regular after tax account. With the 401K, I don't take taxes out until in the end. I assume it grows at 9% due to extra fees and adminstrative expenses. With the after-tax account, I immediately take 25% off (to pay taxes) and assume 10% growth (an extra percent that can be saved by going to low-expense funds). At the end, I take the 15% off for long-term capital gains tax.
So is it possible that the after-tax route is really better than a 401K? It appears to me that it very well could be. I may be missing some of the minor details or my math may be off.Â If that's the case, please help me fill in the gaps in the comments.
Update: As I was getting ready to post this, I happened across a similar article at My Pocket Change. It goes into a lot more details about the advantages and disadvantages of a Traditional IRA vs. a regular account. It's definitely worth checking out.
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