Don't fret if your 401k sucks

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Don't fret if your 401k sucks

Postby bberris » Mon Mar 25, 2013 7:21 am

I've seen a few posts about what to do if your 401k has all bad choices. Here is a link to some research on after tax returns of stocks, bonds, real estate and commodities. It will probably open your eyes to a few interesting facts. The important one for me: For stocks, it does not make much difference whether you invest in or out of a tax-deferred plan. The reason is simple. You lose the tax-favored status of capital gains and dividends in a tax-deferred account.

With bonds, you don't have the tax-favored income, so returns are better in a deferred account.

So if your stock fund choices are all bad in your 401k, just say no.

http://www.thornburginvestments.com/lit ... alreal.pdf
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Re: Don't fret if your 401k sucks

Postby bUU » Mon Mar 25, 2013 8:12 am

Did the analysis take into account the effect of tax-free municipal bonds, for folks in high-state tax states?
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Re: Don't fret if your 401k sucks

Postby Majormajor78 » Mon Mar 25, 2013 10:15 am

An interesting article but the data they present is only valid for some very specific, very wealthy individual situations. Look at the way they treat taxes:
Tax rates were obtained from the Internal Revenue Service. The taxable account scenario applied
the highest marginal tax rate in each calendar year allowable per the IRS to compute hypothetical
dividend and interest taxes. The study assumes all equity dividends are qualified for the periods
covered under The Jobs and Growth Tax Relief Reconciliation Act of 2003. The tax deferred account
scenario applied the highest marginal tax rate at the end of the 30-year period.

In particular think about how this will impact the data for the stocks in the 401K. It almost sounds like the study is assuming that you'll withdrawl everything from the 401K when you retire and have the government take 35% (study done in 2012) of the entire nestegg. But in reality people should start taking withdrawls a little every year to keep a stable income. Under this scenario most peoples income from a 401K would be much lower and so would their effective tax rate. By the time I retire I expect my withdrawls to be around the cusp of the 15%-25% cuttoff point. Throw in deductions and my effective tax rate will be much smaller than that thus overturning the study's assertion that stock funds have higher returns in a taxable account than a tax-deffered account.

The other point of the articel that bonds should have a priority on tax advantaged space is of course correct. However, I do take issue with the claim that stocks are penalized in tax-deffered accounts. For most middle class people the gains from tax defferal outweigh the negatives while the drawbacks to tax defferal don't wash out the benefits until you start approaching truly high income levels. It's something to be aware of sure, but the blanket nature of their claims and focus on solely high income situations make this article at best irrelevant to most people and at worst misleading.
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Re: Don't fret if your 401k sucks

Postby grabiner » Mon Mar 25, 2013 2:48 pm

What I believe this article missed is the tax benefit of investing in a 401(k). It is true that $10,000 invested in stock in a 401(k) and $10,000 invested in stock in a taxable account will have similar after-tax returns. However, if you are in a 25% tax bracket, your choice is between investing $10,000 in stock in a 401(k) (with $2500 back in taxes) and investing $7500 in stock in a taxable account, and that gives the 401(k) a huge advantage.

You have to have a very bad 401(k), and be stuck with it for a long time, to wipe out that advantage. If you expect the same after-tax value for $10,000 in either account, then you have to lose 25% of the 401(k) to expenses while it remains a 401(k), not rolled to an IRA to destroy its tax advantage. If you pay an extra 1.5% in the 401(k), you have to expect to stay with the same employer for 20 years to lose 26% of the 401(k) to the higher expenses.
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Re: Don't fret if your 401k sucks

Postby bberris » Mon Mar 25, 2013 3:18 pm

grabiner wrote:What I believe this article missed is the tax benefit of investing in a 401(k). It is true that $10,000 invested in stock in a 401(k) and $10,000 invested in stock in a taxable account will have similar after-tax returns. However, if you are in a 25% tax bracket, your choice is between investing $10,000 in stock in a 401(k) (with $2500 back in taxes) and investing $7500 in stock in a taxable account, and that gives the 401(k) a huge advantage.
....



You forgot to pay taxes on your withdrawals from the 401k. Of course the 401k is better if you are in the 0 tax bracket in retirement.
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Re: Don't fret if your 401k sucks

Postby tfb » Mon Mar 25, 2013 3:21 pm

bberris wrote:So if your stock fund choices are all bad in your 401k, just say no.

The thread title is correct -- don't fret -- but the conclusion should be "invest in it anyway."
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Re: Don't fret if your 401k sucks

Postby Majormajor78 » Mon Mar 25, 2013 5:31 pm

bberris wrote:
grabiner wrote:What I believe this article missed is the tax benefit of investing in a 401(k). It is true that $10,000 invested in stock in a 401(k) and $10,000 invested in stock in a taxable account will have similar after-tax returns. However, if you are in a 25% tax bracket, your choice is between investing $10,000 in stock in a 401(k) (with $2500 back in taxes) and investing $7500 in stock in a taxable account, and that gives the 401(k) a huge advantage.
....



You forgot to pay taxes on your withdrawals from the 401k. Of course the 401k is better if you are in the 0 tax bracket in retirement.

That wasn't his point. He was pointing out that many people who invest in a 401K can invest a heck of a lot more than they otherwise could if they were restricted to a taxable account. As his example shows a person in the 25% tax bracket could increase their savings rate by 33% by investing through the 401K as opposed to a taxable account.
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Re: Don't fret if your 401k sucks

Postby grabiner » Mon Mar 25, 2013 5:36 pm

bberris wrote:
grabiner wrote:What I believe this article missed is the tax benefit of investing in a 401(k). It is true that $10,000 invested in stock in a 401(k) and $10,000 invested in stock in a taxable account will have similar after-tax returns. However, if you are in a 25% tax bracket, your choice is between investing $10,000 in stock in a 401(k) (with $2500 back in taxes) and investing $7500 in stock in a taxable account, and that gives the 401(k) a huge advantage.
....



You forgot to pay taxes on your withdrawals from the 401k. Of course the 401k is better if you are in the 0 tax bracket in retirement.


Yes, but you will also pay taxes on your taxable investment (15% on qualified dividends, 25% on non-qualified dividends, and 15% on capital gains when you sell). The point of the original article is that $10,000 in either account has about the same after-tax value when invested for 30 years; my point is that the 401(k) still has a large advantage from the deduction on contibutions even if the after-tax values are equal.
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Re: Don't fret if your 401k sucks

Postby downshiftme » Mon Mar 25, 2013 6:13 pm

Using their rather pessimistic view of taxation at marginal rates on withdrawals from tax advantaged accounts, they managed to measure 5.78% in a fully taxable account versus 5.72% in a tax-advantaged account and concluded from that that there were no advantages in the tax advantaged account. I'm very unwilling to take a counter intuitive position (avoid tax advantaged accounts in favor of ordinary taxable accounts) for a net gain of 0.06%. Not to mention that I suspect that the specific assumptions they made about taxes and sequences of returns could easily move results more than 0.06%.
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Re: Don't fret if your 401k sucks

Postby EmergDoc » Mon Mar 25, 2013 6:56 pm

This should have been an analysis of a non-deductible IRA since it assumes no arbitrage of your contribution and withdrawal tax rates, the main benefit of using a 401K. Yes, tax deferred growth is nice, but it takes decades for it to mean more than a lower capital gains tax rate.
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Re: Don't fret if your 401k sucks

Postby z3r0c00l » Mon Mar 25, 2013 7:14 pm

Employer matching funds?
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Re: Don't fret if your 401k sucks

Postby petrico » Mon Mar 25, 2013 7:58 pm

bberris wrote:I've seen a few posts about what to do if your 401k has all bad choices. Here is a link to some research on after tax returns of stocks, bonds, real estate and commodities. It will probably open your eyes to a few interesting facts. The important one for me: For stocks, it does not make much difference whether you invest in or out of a tax-deferred plan. The reason is simple. You lose the tax-favored status of capital gains and dividends in a tax-deferred account.

With bonds, you don't have the tax-favored income, so returns are better in a deferred account.

So if your stock fund choices are all bad in your 401k, just say no.

Your take-away from this study is only briefly and vaguely mentioned in the following paragraph:

Thornburg Investment Management wrote:Most equities receive the majority of their returns from capital gains, but the effect the account type has on real real returns is similar. If gains are deferred until sale, they are taxed at the relatively favorable 15% rate for a taxable account. If held in an employer-sponsored plan, withdrawals are taxed as retirement plan distributions at ordinary income rates. The real real return over the past 30 years for large-cap equities (as represented by the S&P 500 Index) is 5.78% in a fully taxable account versus 5.72% in a tax-advantaged account. Again, account type matters and planning is key.

And these are some assumptions:

In calculating the real real returns you see portrayed in this study, we apply the highest ordinary income tax rate in place at the time the income was generated and we assume that taxes are paid from income received.

For purposes of this study, we apply the highest dividend tax rate in effect at the time of the investment.

For the purposes of calculating the real real returns portrayed here, we assume investments are held for more than one year, and apply the 15% rate at the time of sale.

Either the assumptions are grossly unrealistic, or as Grabiner said, the study failed to properly account for the after-tax returns in taxable vs. tax-advantaged accounts using equivalent pre-tax contributions into each type.

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Re: Don't fret if your 401k sucks

Postby ObliviousInvestor » Mon Mar 25, 2013 8:27 pm

tfb wrote:
bberris wrote:So if your stock fund choices are all bad in your 401k, just say no.

The thread title is correct -- don't fret -- but the conclusion should be "invest in it anyway."

:)

Based on the title, my first guess was that the article was going to be about the likelihood that you'd be at a new job in not-terribly-long anyway, at which point you can roll the old 401k to an IRA (or the new 401k if it's a better choice).
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