As I learn more about investing, my 401k DOESNT look so great....

[MasterBlaster]

Capital gains are at most 15 percent.

If you are in a lower tax bracket then you can either pay 5 percent or nothing (depending on your income level).

 

[Nords]

3) put any extra funds in an after tax, low turnover, low expense ratio index fund.

gains in the after tax account when you take it out will be taxed at (lower) capital gains rates rather than (higher) ordinary income tax rates of a 401K. Between better tax treatment and the low expense ratio of the after tax index fund versus much higher expense ratios and hidden (wrap) fees in the 401K you probably will end up with significantly more real after tax income with this strategy.

I agree with #1 & #2.

But here's a more complicated alternative for #3:
What about continuing to invest in the 401(k) (assuming it meets one's diversification & allocation needs) for the annual tax-free compounding.  Then after leaving the company, roll the 401(k) to a conventional IRA.  ERs go through a significant portion of their lives between quitting work and drawing SS, and that low-income period allows lots of room to convert the IRA to a Roth.  Conversion taxes would be at the 10-15% rate and, if the taxes were paid from outside the IRA, would have the additional effect of sheltering even more money in the Roth.  If the conversion was finished before SS eligibility then SS income might not be subject to taxes either.

This scenario has a few assumptions:
- That future tax rates won't be any lower than current tax rates.
- That Roth withdrawals will continue to be tax-free.
- That funds are available from taxable accounts to pay the conversion taxes.
- That the conversion can be done within the 15% bracket or lower, which might take a few years.
- That tax-free compounding beats the 1.5% ER and any other "hidden" costs or fees.  This is the most difficult assumption to make since you'd have to assume that a 401(k) would outperform only if an index taxable mutual fund (with, what, a 0.1% ER?) was paying at least that 1.4% difference in taxes.  That would depend on its annual distributions.

I guess this is why few people contribute past the 401(k) match.

Does your employer offer a self-directed 401(k)?

 

[MasterBlaster]

Nords:

I may need some enlightenment on your strategy.

If someone is in a 15 percent federal bracket then their capital gains taxes would only be 5 percent. Now compare that to the 10-15 percent ROTH conversion taxes. Considering also the very high expense ratio and wrap fees of the 401K I just don't see the advantage of your strategy.

What am I missing here ?

 

[Nords]

Nords:

I may need some enlightenment on your strategy.

If someone is in a 15 percent federal bracket then their capital gains taxes would only be 5 percent. Now compare that to the 10-15 percent ROTH conversion taxes. Considering the very high expense ratio and wrap fees of the 401K I just don't see the advantage of your strategy.

No, your math is correct for a mutual fund whose only returns consist of unrealized cap gains and doesn't pay a lot of annual distributions.

But not everyone invests in mutual funds like that, and even fewer people bother to look at (1) the impacts of a Roth conversion with taxes paid using funds outside the IRA and (2) the impact of IRA income on their SS taxation. I'm just suggesting that people do the math for their situation.

One issue with your plan is that cap gains taxes might not stay at 5%, although of course Roth distributions might not stay tax-free, either. But the Roth conversion taxes would be paid sooner (and only once) while the cap gains taxes would remain for the rest of one's life. I'm betting it'd be easier for 21st-century Congresses to raise cap gains taxes than it would be to eliminate the Roth tax-free distributions.

 

[justin]

Along these lines other people think

1) pay into the 401k enough to get all of the match
2) max out the Roth
3) put any extra funds in an after tax, low turnover, low expense ratio index fund.

gains in the after tax account when you take it out will be taxed at (lower) capital gains rates rather than (higher) ordinary income tax rates of a 401K. Between better tax treatment and the low expense ratio of the after tax index fund versus much higher expense ratios and hidden (wrap) fees in the 401K you probably will end up with significantly more real after tax income with this strategy.

The after tax money that you invest is going to be taxed twice - when you earn it and when you withdraw it far in the future. The 401k money only gets taxed once - when you withdraw it. Assuming your future rates will remain the same as the present, you're better off, tax wise, investing in a 401k. Your future tax rates would have to increase in order for the taxable account to be a better option.


(edited to add excel calcs)

 

[thefed]

Not so sure what a self-directed 401k is. I decide what funds to allocate where, if that's what u mean. But I assume all 401ks are the same.

As far as capital gains, I just got done reading and that make me think even harder. Essentially, if I wasn't working for a year (I retired) and pull out money from a taxable account....long term capital gains would apply.

Given my current #'s, I should have about 450k in an array of investments when I'm 45. The ROTH should be tax-free 15 years after that. The 401k will be taxed at my going rate after 15 more years.(I think my rate will be higher than now, I'm in a low bracket right now).

SO, I think I need 15-20 years of income from something other than the ROTH or 401k...a taxed account. OTHERWISS, what will I draw on at 45 yrs old? The roth or 401k will hit me with penalties of 10% etc.

AGE 45:
SO, assuming I pulled 30k/yr from stocks, and another 15k from part-time work and real estate. That'd put me in the 25% bracket.

How would capital gains work there?

MY GUESS: THE FIRST 7K OF REGULAR INCOME TAXED AT 10%. THE LAST 8K IS TAXED AT 15%. THEN, CAPITAL GAINS IS ONLY 5% UP TO 30K (SO ABOUT THE FIRST 15K OF THE STOCK PROCEEDS). THEN, THE LAST 15 IS TAXED AT 15%.

IS THAT RIGHT? 15K@ 5%, 7K @ 10%. 23K @ 15%

I know this isnt a tax place, but I'm trying to find out what would be most advantageous

My big question is also: what should I be withdrawing from at 45? Roth and 401k's have stiff penalties for taking out earnings early....

 

[MasterBlaster]

Justin:

That's an interesting little analysis you showed that I will ponder.

However you haven't factored in the much higher 401K expense ratios and wrap fees in your analysis.

Clearly in the original posters situation the low cost, low turnover, after-tax index fund would serve him much better.

 

[thefed]

JUSTIN: Nice spreadhseet there. Only thing is, 40% seems a bit high for the 401k. Granted, nobody knows, I think 30-35% would be more reasonable, and THAT, would put them about dead even

interesting...

 

[justin]

Justin:

That's an interesting little analysis you showed that I will ponder.

However you haven't factored in the much higher 401K expense ratios and wrap fees in your analysis.

Clearly in the original posters situation the low cost, low turnover, after-tax index fund would serve hime much better.

True enough. I changed the analysis to reduce the growth from 8% per annum to 6.5% per annum to reflect an extra 1.5% expense ratio due to crap 401k options. (see spreadsheet below) Clearly, in this particular case, you should go with the after tax investment option.

My original post was meant to show that saving in the 401k was better than saving after tax, investment options being equal. Not the case here (and in many other cases, I presume).

TO DOG51: regarding fidelity as a 401k provider, that is who we have at my workplace. See if you can get them to include their major index funds as your funds you can pick from. We have only 2 index funds at my workplace (total market and extended market - no international index and no bond index). Fidelity has a few great Spartan indexes with 0.10% ERs. Not sure why they aren't in every plan... Oh wait, it's so they can charge you 1.2% ER for a similar mutual fund!

 

[ats5g]

Fed et. al,

Ed Chang wrote an article, Looking at Expenses of 401K Plans and has a free accompanying spreadsheet - to see just how high of an expense ratio one can tolerate in a 401(k), depending on a number of factors.

- Alec

 

[justin]

JUSTIN: Nice spreadhseet there. Only thing is, 40% seems a bit high for the 401k. Granted, nobody knows, I think 30-35% would be more reasonable, and THAT, would put them about dead even

interesting...

Yes, 30% would make the situations about even. I was attempting to illustrate that higher future tax rates (in this example, 30+%) would put the 401k investment on par with the after tax investment, with respect to taxation.

 

[thefed]

Yes, 30% would make the situations about even. I was attempting to illustrate that higher future tax rates (in this example, 30+%) would put the 401k investment on par with the after tax investment, with respect to taxation.

gotcha. now using the updated 6.5 on 401k returns, can you figure out the break even tax-rate of the 401k vs the taxable account, assumign my current tax rate is 15%. At what tax rate in the future would the earnings match each other.

 

[justin]

gotcha. now using the updated 6.5 on 401k returns, can you figure out the break even tax-rate of the 401k vs the taxable account, assumign my current tax rate is 15%. At what tax rate in the future would the earnings match each other.

Tehfed,

I will perform financial analysis for you for my normal hourly rate.

My (free) recommendation, if you want to be financially savvy (and wealthy), is to get a copy of microsoft excel and become extremely proficient.

 

[thefed]

Tehfed,

I will perform financial analysis for you for my normal hourly rate.

My (free) recommendation, if you want to be financially savvy (and wealthy), is to get a copy of microsoft excel and become extremely proficient.

ahhh, what a guy. it'd take ya 5 minutes!

I USED to be ok with Excel, but the newer versions I havent used at all and are confusing. I was ok using EXCEL about 8 years ago, btu not using it has made me rusty.

Thanks for the offer though.

 

[justin]

ahhh, what a guy. it'd take ya 5 minutes!

I USED to be ok with Excel, but the newer versions I havent used at all and are confusing. I was ok using EXCEL about 8 years ago, btu not using it has made me rusty.

Thanks for the offer though.

In all sincerity, pick it back up. I'm not sure how I'd get by without excel. Once you're proficient, you can do analysis on pretty much anything quantifiable in minutes. It is a very valuable tool for budgeting, investing, comparing scenarios, etc.

 

[thefed]

$10k @ 4% x 30 yrs. = $583,283 - 25% taxes = 437,462

$7.5k @ 5.75% x 30yrs.= $600,114 - 15%LT tax= 510,097

This i found on another site, but it relates. The first is a 401k with 2% expense ratio. The second is a taxable account with a .25% ratio. Both assume the same 6% overall eprformance.

Even though the second is taxed 2x, it's more efficient by far. This is assuming at the beginning that the person is int he 25% bracket. Being in the 15% bracket puts the taxable, second option, way ahead of the game!

I'll have to re-calculate assuming my specific scenario, 1.5% Expense ratio, and 15% tax bracket to see...

EDIT: assuming the 401k earned 6%, had a 1.5% Expense ratio, and you contributed 10k pre-tax money yearly for 30 yrs, after a 25% tax in 30 yrs you'd be at 477k, 541k if taxed at 15%

Assuming .3 ER on the taxable account leaves 572k, assumign a 15% capital gains tax


ADVATNAGE: TAXABLE by either 95k, or 30k


summary:


401k

10k/yr, for 30 yrs @ 4.5%=637k minus 25% tax=477k, 15% tax=541k


Taxable

8500/yr, for 30 yrs @ 5.7%=673k minus 15% cap gains=572k , @ 5% cap gains=640k!!

25% bracket: 7500/yr @5.7%=594k minus 15% cap gains= 505k, 5% cap gains =564k.

SO, if you are 15% now, taxable wins hands down

If you are 25% now, and end up in 25% bracket, taxable wins by 28k

If you are 25% now, and end up in 15% bracket, taxable wins by 13k


Is my math flawed?

 

[laurence]

And then you have to think about whether you are a "pay the house off" or "enjoy the spread between mortgage and investments" type. With no house payment, you are withdrawing a much smaller amount per year to live, lowering your marginal tax bracket further, so regular IRA/401k looks even more attractive. I go back and forth on this one. DW and I put 28k (max) in 401k, but also put 8k in Roth IRA. I have a regular IRA with 3 previous years contributions in it, as well. I just figure I'll be all over the map, then when I do retire, I'll draw from the best buckets for my current situation. I'm thinking next year the Roth is a better choice for me, if DW stays home with the kid, our tax situation will be pretty nice. I certainly hope to be in a higher tax bracket when I retire, let's put it that way!

 

[thefed]

But I think the overall gist of my last post is this:

If you are in either the 25% or 15% bracket now, and end up in either the 15 or 25% bracket in the future....a taxable account will win hands down. (provided the returns are equal, and the 401k expense ratio is about 1% greater than that of the taxable account). PERIOD.

This is very advantageous if you plan on withdrawing the money before age 60. You will pay penalties withdrawing from your IRA, ROTH, or 401k before 60.

 

[MasterBlaster]

TheFed: Didn't I say that already ?

Anyone that pays early-withdrawel penalties on qualified account withdrawels is mis-informed.

There are ways to eliminate these taxes.

 

[laurence]

72t baby.

 

[justin]

Principal contributions to Roths are also withdrawable (is that a word??) at any time. The principal contribution is what you put in each year (the up to $4000 amount). The earnings on contributions are subject to penalties and taxes if withdrawn early (unless SEPP under 72t).

 

[MasterBlaster]

For the elimination of the early-withdrawal penalty, Here's a link that discusses the SEPP under 72t

http://www.retireearlyhomepage.com/wdraw59.html

 

[thefed]

Right. I forgot about that...lol. I learn so much that some stuff gets pushed to the back.


SO,I could take equal payments for 5 yrs miniumum and avoid the 10% penalty. But do they tax you?

 

[brewer12345]

Right. I forgot about that...lol. I learn so much that some stuff gets pushed to the back.


SO,I could take equal payments for 5 yrs miniumum and avoid the 10% penalty. But do they tax you?

Yes, and there are lots of rules that you have to obey, but its not tat burdensome.

 

[thefed]

Ok. Do they tax you as regular income, or capital gains? Cap gains would be more beneficial obviously.

Also, it appears al though there's a "Cap" on how much could be withdrwan using this SEPP method. If I needed it to last me 15 years only, that wouldnt work well. I wouldnt be able to draw it down fast enough....right?