Do Indexers Need 401(k) Plans?

[BetaTracker]

After years of terrible 401(k) options, my employer finally switched to Vanguard. Now I can invest in the same index funds as in our brokerage account at Vanguard. My question is: Since we use a basic three-fund index portfolio, which is already very tax efficient, is there any real upside to contributing more in the 401(k) plan than what's required to take advantage of my employer's match?
I'm thinking that long-term capital gains in the taxable account will only be 20%, whereas my personal income tax rate is 28%. I realize that in a 401(k) account my money grows on a tax-deferred basis. But do you get taxed essentially twice in taxable accounts? Then again, I would lose the ability to count more of my 401(k) contributions off my taxable income, right?

[Avo]

You don't pay capital gains tax at all on gains on 401k money, whereas you do on taxable. You pay ordinary income tax on both.

Example:

You make $1000 that you contribute to your 401k. It grows by 50% to $1500. You take out the entire $1500. You pay ordinary income tax of 28% on the total, which is $420. You net $1080.

Or:

You do not contribute the $1000 to the 401k. You pay an immediate income tax of $280, and invest the remaining $720. It grows by 50% to $1080. You owe capitals gains tax of 20% on the $360 gain, which is $72. You net $1008.

So the 401k scenario saves you the capital-gains tax.

[carolinaman]

The advantage in the 401k plan is when your working marginal tax rate is higher than when you are retired. In that instance, you will pay less taxes by using the 401k. If the rate is the same or less while working, then you may pay less taxes in taxable account due to lower LTCG rate. Make sure you are using a very tax efficient index fund in taxable like Vanguard's Total Market Index Fund. Also, always take advantage of employer match in 401k.

[livesoft]

@BetaTracker, because of the way our tax laws are written, everybody gets some deductions for the first several thousand dollars of income that they have or withdraw from their 401(k) plan. You might have exemptions, standard or itemized deductions, and even tax credits.

It is important to know how income taxes and tax returns work or one will not be able to comprehend that money contributed to a 401(k) is not taxed when it is contributed and much of it is not taxed when it is withdrawn. Zero percent tax is better than 20% LTCG tax.

There are other ways of minimizing taxes, too. See this ZERO tax thread:
viewtopic.php?t=87471
but you have to start with proper decisions now because they will affect your future.

[aristotelian]

If there is any chance you will be in the 25% bracket in retirement, you are going to save 3% on unmatched contributions.

Also, dollars you are putting into a 401k would be taxed at your marginal rate of 28%. Even if you are in the same bracket in retirement, some of your 401k dollars would be taxed at lower rates. For example, if you have $20K in SS, $17,950 of your 401K withdrawal would be taxed at 15%, and up to $91,950 would be taxed at 25%.

[livesoft]

For example, if you have $20K in SS, $17,950 of your 401K withdrawal would be taxed at 15%, and up to $91,950 would be taxed at 25%.

How much of the 401(k) withdrawal would not be taxed (i.e. taxed at 0%) in your example?

[Finance-MD]

all of the bond interest and stock dividends are taxable each year in your taxable account (granted, if your marginal rate is 15% or less, your qualified dividends are taxed at 0%; municipal bonds are also taxed at 0% federal). In the 401k, these are tax protected.

think of your taxable account as a jar with a small hole in it, leaking gains every year due to taxable interest / dividends....
a tax protected account plugs the hole.
whether a tax protected account is pre-tax or post-tax, that hole is plugged while the money is inside.

[aristotelian]

For example, if you have $20K in SS, $17,950 of your 401K withdrawal would be taxed at 15%, and up to $91,950 would be taxed at 25%.

How much of the 401(k) withdrawal would not be taxed (i.e. taxed at 0%) in your example?

I think it would depend on your deductions.

[livesoft]

think of your taxable account as a jar with a small hole in it, leaking gains every year due to taxable interest / dividends....
a tax protected account plugs the hole.
whether a tax protected account is pre-tax or post-tax, that hole is plugged while the money is inside.

If one invests tax-efficiently in a taxable account, then the hole is smaller than the hole in a 401(k) caused by higher fees and expense ratios in the 401(k).

[ruralavalon]

After years of terrible 401(k) options, my employer finally switched to Vanguard. Now I can invest in the same index funds as in our brokerage account at Vanguard. My question is: Since we use a basic three-fund index portfolio, which is already very tax efficient, is there any real upside to contributing more in the 401(k) plan than what's required to take advantage of my employer's match?
I'm thinking that long-term capital gains in the taxable account will only be 20%, whereas my personal income tax rate is 28%. I realize that in a 401(k) account my money grows on a tax-deferred basis. But do you get taxed essentially twice in taxable accounts? Then again, I would lose the ability to count more of my 401(k) contributions off my taxable income, right?

Since you get high quality low expense ratio funds use your 401k to the limit of the maximum employee contribution. You get a tax deduction for your contributions at the 28% rate, the account grows and compounds tax-protected, and you will likely be in a lower tax bracket in retirement when you withdraw your money.

You do not get taxed twice since you get a deduction for the contributions if you are making traditional rather than Roth contributions to your 401k.

[Spirit Rider]

No tax liability for balancing or change of investment due to change in IPS.

[dbr]

Tax deferral is a benefit that should be optimized.

[BetaTracker]

Thanks everyone -- sure saves me money asking ya'll rather than going to a CPA's office! Since everything's now at Vanguard, both our personal taxable accounts, IRAs and now the 401k), think it's best to max out the 401(k).

[Finance-MD]

think of your taxable account as a jar with a small hole in it, leaking gains every year due to taxable interest / dividends....
a tax protected account plugs the hole.
whether a tax protected account is pre-tax or post-tax, that hole is plugged while the money is inside.

If one invests tax-efficiently in a taxable account, then the hole is smaller than the hole in a 401(k) caused by higher fees and expense ratios in the 401(k).

+1 to livesoft
yes... multiple holes...
fees and ER are like a drain at the bottom of a tub without a stopper... always leaking no matter what... high fees + high ER = bigger drain; low fees + low ER = smaller drain.
taxes on interest and dividends = more like the overflow drain... affecting 'gains' preferentially... (which applies more to the interest than the dividends... but anyhow)

in a tax-efficient taxable account with total stock market index, munis, TLH, donating appreciated shares... yes, those holes can be super small.

[goingup]

My question is: Since we use a basic three-fund index portfolio, which is already very tax efficient, is there any real upside to contributing more in the 401(k) plan than what's required to take advantage of my employer's match?

Advantages of contributing to your 401K include:
*Lowers taxable income
*Automates saving in a tax-deferred account
*Protects assets from creditors
*Protects assets from lawsuits
*Ability to take loans from your plan
*Not reported on FAFSA
*Keeps your retirement assets separate so you will use them for retirement and not homes, cars, remodels, etc.

Our taxable account is much larger than tax-advantaged. Like most late-stage accumulators, we wish there was more tax advantaged space. Don't squander yours.

[Dottie57]

After years of terrible 401(k) options, my employer finally switched to Vanguard. Now I can invest in the same index funds as in our brokerage account at Vanguard. My question is: Since we use a basic three-fund index portfolio, which is already very tax efficient, is there any real upside to contributing more in the 401(k) plan than what's required to take advantage of my employer's match?
I'm thinking that long-term capital gains in the taxable account will only be 20%, whereas my personal income tax rate is 28%. I realize that in a 401(k) account my money grows on a tax-deferred basis. But do you get taxed essentially twice in taxable accounts? Then again, I would lose the ability to count more of my 401(k) contributions off my taxable income, right?

Tax deferment.