Is the 401K option as good as it used to be?

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idoc2020
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Is the 401K option as good as it used to be?

Post by idoc2020 »

I currently have a 401K plan which I offer to my 6 employees. The plan costs me $7,000 a year which includes the administrative costs plus the 3% match I give each employee. The maximal deferral I could make would be $39K.

However, recently I am no longer sure that the 401K is so worthwhile. Since taxes are almost certainly going up, the monies that you put in now are going to be taxed at a higher level in the future. Furthermore, most of my investments are index funds which spin off very little dividends and which I never sell. Therefore, even if the capital gains rates goes up by 5% I essentially pay fairly low taxes on the appreciation. The 401K, however, forces me to pay full income tax rates on the monies that I withdraw rather than the much lower capital gains tax. If the income tax rates 15 years from now are higher than now, then whatever advantages the 401K may have may be diluted. Furthermore, I will always be in the highest income tax bracket. As it stands now, I pay about $7K upfront for the privilege of deferring $39K for the next 15 years (granted that I am also helping out my employees). If you remove the employee happiness factor, is this a good trade-off?
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Post by neverknow »

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Last edited by neverknow on Mon Jan 17, 2011 6:12 am, edited 1 time in total.
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ddb
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Re: Is the 401K option as good as it used to be?

Post by ddb »

ilan1h wrote:I currently have a 401K plan which I offer to my 6 employees. The plan costs me $7,000 a year which includes the administrative costs plus the 3% match I give each employee. The maximal deferral I could make would be $39K.

However, recently I am no longer sure that the 401K is so worthwhile. Since taxes are almost certainly going up, the monies that you put in now are going to be taxed at a higher level in the future. Furthermore, most of my investments are index funds which spin off very little dividends and which I never sell. Therefore, even if the capital gains rates goes up by 5% I essentially pay fairly low taxes on the appreciation. The 401K, however, forces me to pay full income tax rates on the monies that I withdraw rather than the much lower capital gains tax. If the income tax rates 15 years from now are higher than now, then whatever advantages the 401K may have may be diluted. Furthermore, I will always be in the highest income tax bracket. As it stands now, I pay about $7K upfront for the privilege of deferring $39K for the next 15 years (granted that I am also helping out my employees). If you remove the employee happiness factor, is this a good trade-off?
Your argument is based on a false premise, i.e. that "taxes are almost certainly going up". Nobody knows what will happen with our tax system short-term or long-term. Probably best to make decisions based on current tax law, and then adapt once new laws actually put into place.

Also, not sure how you can contribute $39K to a 401k plan. Your maximum deferral would be $22K if you're over 50, and I don't think you get could an additional $17K from the employer match.

- DDB
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Post by livesoft »

If he pays 3% match to all employees, why couldn't he get a $17K match for himself? If he pays himself $500K a year and his 6 employees make $20K each, then 3% of $90K, .... I believe the 3% meets a safe-harbor for such plans. Anyways, you should get the idea.

I would guess that one should ask the employees what they would think if the plan was terminated.
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Post by nisiprius »

They're certainly not as good as they used to be, for three reasons.

1) The flattening of the graduated income tax means that even if there are no changes in the tax laws, it's likely that the difference has narrowed between your marginal tax rate at time of contribution and time of withdrawal.

2) The (re-)institution of the capital gains tax break has lowered the tax rate paid by taxable investors, and thus narrowed the gap between 401(k) and taxable investing. (This means, incidentally, that one kind of tax increase--reducing or eliminating the capital gains tax break--would make 401(k)'s more attractive).

3) Just a mental thing, but the importance of nontaxable compounding depends heavily on what you think earnings are going to be, and when contemplating a 401(k), and these days I don't think people are assuming the 15% to 20% annual returns on their stock market funds that people used to assume. (Yes, really).

People used to assume wildly overoptimistic returns and the result was to greatly exaggerate the importance of nontaxable compounding.
Last edited by nisiprius on Mon Nov 23, 2009 1:37 pm, edited 2 times in total.
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DSInvestor
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Post by DSInvestor »

ilan1h wrote:The 401K, however, forces me to pay full income tax rates on the monies that I withdraw rather than the much lower capital gains tax.
Yes, 401k withdrawals are taxable at marginal tax rates but depending on what other income you have in retirement the tax rate could be very low for some of the withdrawals. The more you withdraw, the more you'd move up the tax brackets. In 2010, if you are married filing jointly taking 2 exemptions/std deduction and 401k was your only income, you could withdraw 86K and stay in 15% tax bracket. Your effective tax rate will be lower than 15% because some of the income will be taxed at 0%, some at 10%, some at 15%. You could withdraw close to 160K from 401k and stay in 25% tax bracket.

Here's a tfb page on the case against ROTH 401k which does a good job of describing how tax brackets are filled at withdrawal (from the bottom). Contributions are taken from the top tax brackets. If you have no other income consuming your lowest tax brackets, the 401k withdrawals may be taxed at a much lower rate that you think.
http://thefinancebuff.com/2008/03/case- ... -401k.html

Even if marginal tax rates rise in the future, there will almost certainly be the 0% tax brackets for exemptions and deductions and then lower tax brackets.

If you terminate your 401k plan, would you need to increase the salaries for your employees to make up for the lost employer match? If yes, there would be no savings on the that front. In fact, you may have to pay more in the employer side of the payroll taxes for social security and medicare. I believe 401k employer match are not subject to payroll taxes.
Last edited by DSInvestor on Mon Nov 23, 2009 4:33 pm, edited 2 times in total.
Rodc
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Post by Rodc »

The 401K, however, forces me to pay full income tax rates on the monies that I withdraw rather than the much lower capital gains tax.
If you use a regular taxable account don't you pay income tax now AND cap gains taxes later? It would seem income tax would have to go up a pretty fair amount, and cap gains taxes not go up, to make a taxable account a better bet.
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Post by ddb »

livesoft wrote:If he pays 3% match to all employees, why couldn't he get a $17K match for himself? If he pays himself $500K a year and his 6 employees make $20K each, then 3% of $90K, .... I believe the 3% meets a safe-harbor for such plans. Anyways, you should get the idea.

I would guess that one should ask the employees what they would think if the plan was terminated.
Depends on the match formula being used, but I haven't seen many cases where the match could be that large. I was just wondering how he gets to the $39K.

- DDB
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Post by Cloud »

For myself it's a no brainer. Pay 0 tax now on monies I would otherwise be paying 28% on, then when I retire draw the first xxx dollars each year out at 0,10, & 15% progressive tax brackets.
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Re: Is the 401K option as good as it used to be?

Post by grabiner »

ilan1h wrote:I currently have a 401K plan which I offer to my 6 employees. The plan costs me $7,000 a year which includes the administrative costs plus the 3% match I give each employee. The maximal deferral I could make would be $39K.
You shouldn't count the 3% match as a cost; if you discontinued the match, you would have to pay 3% more to hire employees.
As it stands now, I pay about $7K upfront for the privilege of deferring $39K for the next 15 years (granted that I am also helping out my employees). If you remove the employee happiness factor, is this a good trade-off?
If you are in the highest tax bracket now and will retire in the highest tax bracket, then your tax-deferred investment of $39K is as good as a tax-free investment of $26K. If you would otherwise lose 1% a year to taxes, and will spend the money over 30 years of retirement beginning 15 years from now, that's a savings of almost 30%, which compensates for a lot of the risk in changing tax rates.

You could also offer a Roth 401(k) instead, which would reduce the risk of changing future tax rates.
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iceport
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Re: Is the 401K option as good as it used to be?

Post by iceport »

ilan1h wrote:If the income tax rates 15 years from now are higher than now, then whatever advantages the 401K may have may be diluted.
"whatever advantages the 401K may have" are HUGE. With identical tax rates during accumulation and withdrawal stages (an unlikely theoretical scenario), the 401k advantage is tax-free growth.

"may be diluted" yes, but it would take huge tax increases to completely wash them away.

I believe David Grabiner's analysis is exactly correct.

That said, I've never understood this position:
ddb wrote:Nobody knows what will happen with our tax system short-term or long-term. Probably best to make decisions based on current tax law, and then adapt once new laws actually put into place.
ddb is far more knowledgeable than I'll ever be on investing, and this idea is often expressed by others as well. But it just doesn't seem to make sense. Nobody knows what the market returns will be in the short- or long-term, either. But nobody here advocates basing your investment decisions on the last few years alone and adapting in the future if the market doesn't comply with that assumption. What is advocated is a review of what's happened over the short- and long-term in the past, careful consideration of the range of possibilities for future returns, and attempting to position yourself so that the outcomes are reasonably tolerable under all scenarios.

Why, then, isn't the same kind of analysis equally valid when considering future tax rates? Try to position yourself so that you will be in reasonably good shape under a range of possible tax scenarios.

In that sense, it's appropriate to ask the question, "How will I be affected if tax rates go up -- a lot?"

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Post by spam »

1) I know that my future income will be less than my current income.
2) Demographically, I am part of the group which has the highest percentage of voters.
3) There is no viable alternative which allows me to save $16,500 with the same tax benifits as a Roth

Therefore, (for now) the 401k is my best option for retirement saving. And, I have really crappy 401k choices ! We need an alternative.

Why not have a universal retirement savings account? Many workplaces offer direct deposit, so how much could it cost to directly deposit retirement contributions into a universal account? We would probably all get free toasters ! Once there, I should be able to transfer the money into any other qualified plan. I would choose an account with Vanguard. The limits need to change too. Why $16,500 in a 401k and $6000 in an IRA? It should be $22,500 (sum of both) per year to the account of my choice.

I agree with ddb's assumption on taxes. It might prove to be wishful thinking but I suspect my age group may vote in its self interest.

For me, the biggest problem is the lack of choices. Choosing low fees would offset the same degree of future tax liability.
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Post by ajbibi »

I think one shouldn't underestimate the advantages of having a tax deferred portfolio for allocating bonds as a way to avoid taxes. Even with constant or mildly rising marginal tax rates it's very helpful to have tax free growth in your bond portfolio while having more of your taxable investments in equities.
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Re: Is the 401K option as good as it used to be?

Post by jeffyscott »

ilan1h wrote:I currently have a 401K plan which I offer to my 6 employees. The plan costs me $7,000 a year which includes the administrative costs plus the 3% match I give each employee.

...

If you remove the employee happiness factor, is this a good trade-off?
Why not ask the employees if they would be even happier if you terminated the 401K and gave each of them a raise of $1000?
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Re: Is the 401K option as good as it used to be?

Post by junior »

ilan1h wrote:I currently have a 401K plan which I offer to my 6 employees. The plan costs me $7,000 a year which includes the administrative costs plus the 3% match I give each employee. The maximal deferral I could make would be $39K.

However, recently I am no longer sure that the 401K is so worthwhile. Since taxes are almost certainly going up, the monies that you put in now are going to be taxed at a higher level in the future.
In terms of taxes, I think its fair to say ( and therefore not political, I think) that democrats are more likely to raise taxes in the higher margins. People making over 250,000 was the number proposed in the most recent presidential election. Some advocates suggest higher margins, for maybe income over 1 million.

I have no idea what the republicans would propose if they wanted to raise taxes.

My point is to say that taxes going up is not the same thing as taxes on your particular employees going up.

This seems like a very speculative area.
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Post by leonard »

if you are paying $7k in administrative costs for a 401k for 6 employees, you are overpaying.

I think you could bring that cost down substantially with one of the low cost providers that have been mentioned on this forum.

Also, it is pretty easy to figured out if the cost of the 401k exceeds the tax deferral benefit. Just calculate the $7k admin costs as an administrative expense ratio per year. Deduct that percent to get the after administrative cost rate of return. Then, compare that to the after tax rate of return for the average employee in a taxable account (average tax costs across employees, not just your own). Should be pretty straightforward to determine if the extra admin costs are worth the extra expense.

Then, there is the employee quality factor - do you really want to hire employees with so little concern for their future that they don't care if you have a 401k?
Leonard | | Market Timing: Do you seriously think you can predict the future? What else do the voices tell you? | | If employees weren't taking jobs with bad 401k's, bad 401k's wouldn't exist.
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Post by idoc2020 »

leonard wrote:if you are paying $7k in administrative costs for a 401k for 6 employees, you are overpaying.

I think you could bring that cost down substantially with one of the low cost providers that have been mentioned on this forum.

Also, it is pretty easy to figured out if the cost of the 401k exceeds the tax deferral benefit. Just calculate the $7k admin costs as an administrative expense ratio per year. Deduct that percent to get the after administrative cost rate of return. Then, compare that to the after tax rate of return for the average employee in a taxable account (average tax costs across employees, not just your own). Should be pretty straightforward to determine if the extra admin costs are worth the extra expense.

Then, there is the employee quality factor - do you really want to hire employees with so little concern for their future that they don't care if you have a 401k?
Leonard,
My administrative costs are under $1000. The $7K included the amounts that I need to match my employees.
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You can forecast taxes

Post by cannedham »

I disagree that you can't forecast tax rates. If per capita deficit goes up in real terms, it will eventually need to go down or nobody will lend to the government. The cost of paying the deficit will either be paid through higher inflation that inflates away the real value of the debt (which hurts taxable accounts due to higher taxable dividends and capital gains), or higher marginal tax rates (which also hurts taxable accounts).

I'm in the 33% marginal tax rate and I put all of my money in Roth 401(k)s as opposed to 401(k)s or taxable accounts. It's a near certainty that marginal tax rates or inflation have to go up as debt loads go up. This is not a political statement and has nothing to do with majority/minority parties -- this merely reflects the reality of the US balance sheet.
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Post by leonard »

ilan1h wrote:
leonard wrote:if you are paying $7k in administrative costs for a 401k for 6 employees, you are overpaying.

I think you could bring that cost down substantially with one of the low cost providers that have been mentioned on this forum.

Also, it is pretty easy to figured out if the cost of the 401k exceeds the tax deferral benefit. Just calculate the $7k admin costs as an administrative expense ratio per year. Deduct that percent to get the after administrative cost rate of return. Then, compare that to the after tax rate of return for the average employee in a taxable account (average tax costs across employees, not just your own). Should be pretty straightforward to determine if the extra admin costs are worth the extra expense.

Then, there is the employee quality factor - do you really want to hire employees with so little concern for their future that they don't care if you have a 401k?
Leonard,
My administrative costs are under $1000. The $7K included the amounts that I need to match my employees.


In that case, i don't think the $7k is a true opportunity cost. I think you would have to pay most of it in salary, if you didn't have the match.

Also, how much of the admin costs are the employees bearing directly? $1k is very cheap, so my guess is that employees are bearing some admin costs over and above the ER's on the funds?

Admin costs of $1k seems pretty reasonable (actually, who are you using? seriously), assuming you have any level of employee participation in the plan above the match, that $1k should work out to a very low extra "expense ratio" on the overall 401k investment balance. Seems hard to believe $1k would make a 401k have a lower return than taxable index investing.
Leonard | | Market Timing: Do you seriously think you can predict the future? What else do the voices tell you? | | If employees weren't taking jobs with bad 401k's, bad 401k's wouldn't exist.
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Post by idoc2020 »

leonard wrote:
ilan1h wrote:
leonard wrote:if you are paying $7k in administrative costs for a 401k for 6 employees, you are overpaying.

I think you could bring that cost down substantially with one of the low cost providers that have been mentioned on this forum.

Also, it is pretty easy to figured out if the cost of the 401k exceeds the tax deferral benefit. Just calculate the $7k admin costs as an administrative expense ratio per year. Deduct that percent to get the after administrative cost rate of return. Then, compare that to the after tax rate of return for the average employee in a taxable account (average tax costs across employees, not just your own). Should be pretty straightforward to determine if the extra admin costs are worth the extra expense.

Then, there is the employee quality factor - do you really want to hire employees with so little concern for their future that they don't care if you have a 401k?
Leonard,
My administrative costs are under $1000. The $7K included the amounts that I need to match my employees.


In that case, i don't think the $7k is a true opportunity cost. I think you would have to pay most of it in salary, if you didn't have the match.

Also, how much of the admin costs are the employees bearing directly? $1k is very cheap, so my guess is that employees are bearing some admin costs over and above the ER's on the funds?

Admin costs of $1k seems pretty reasonable (actually, who are you using? seriously), assuming you have any level of employee participation in the plan above the match, that $1k should work out to a very low extra "expense ratio" on the overall 401k investment balance. Seems hard to believe $1k would make a 401k have a lower return than taxable index investing.
THe way my program works is that I give my employees a 4% match to satisfy the "safe harbor" provisions. This means that if their salary is $40,000, I match them $1600 each. If I do this it means that I can match myself 4% plus the $16,500 that I am allowed to defer. On top of this, I can give them a profit share. If I do this, I get to triple the profit share that I give myself eg: if I give them 1%, I give myself 3%. Therefore, a 4% match+3% profit share would cost me $11,250 in employee matching/sharing and would allow me to defer the maximal $49,000 for 2009. The administrative cost is about $1000 which brings the total cost to $12,250. This is a pure "perk" for my employees, meaning that if I eliminated this program I would not need to supplement their salaries in any way (they are well paid). I do, however, use this program as a substitute for the annual year end xmas gift ie: instead of the usual $500 gift they get $1600 or more in their 401K (this saves me $3000 in xmas gifting). In total then, I spend $9250 to defer $49,000.

I realize that this is awfully detailed but I think it provides some useful info for others who have wondered about this option for their businesses and may stimulate some discussion on alternatives.
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