A reader named Jen recently sent me an email about 401k retirement accounts. James Altucher, a former hedge fund manager, had posted a video on Business Insider on why you shouldn’t invest in a 401k. When I first saw the video, I thought it was a parody. I didn’t realize he was being serious!
Here's the video:
There are a lot of problems with Althucher’s views on 401k. For starters, you can withdraw money from a 401k penalty-free at age 59 1/2, not 65 as he claims. Second, his claim that 401k’s only return 1.5% is nonsensical. A 401k doesn’t return anything; it’s a type of retirement account. Returns are dictated by the investments inside a 401k, which vary from one plan to the next and on each of our investment choices.
The issue I want to address in this article (and podcast), however, is his suggestion that tax deferral is of little or no value. That’s simply false, and one would expect a former hedge fund manager to know that. Deferring taxes on any investment can add significantly to returns over time. That’s one reason having tax efficient investments in a taxable account is so important.
Let’s look at some numbers. We’ll assume a 25% tax bracket both at the time of contributions to and at the time of distributions from a 401k. We’ll also assume 15% long-term capital gains tax rates applied on gains at the time of distribution. Let’s look at some examples.
A Simple Example
To start with, imagine investing $10,000 in a 401k. We’ll compare that option to paying taxes on the money and investing the remainder, $7,500, in a taxable account. We’ll also assume that over an investment period both accounts double in size and then we withdraw the entire balance.
$5,000 taxes ($20,000 x 25%)
$15,000 after taxes
$7,500 contribution (after paying 25% in taxes)
$1,125 taxes ($7,500 gain x 15%)
$13,875 after taxes
The 401k beats the taxable account.
A More RealisticExample
Here we’ll assume a $10,000 investment in a 401k or a $7,500 investment in a taxable account over 40 years. Both earn 8%. Here are the numbers.
|Balance after 40 years at 8%||$2,590,565.19||$1,942,923.89|
|After tax balance||$1,942,923.89||$1,696,485.31|
The results underscore just how powerful tax deferral can be.
While the 401k balance looks impressive, its outperformance of the taxable account is far more fragile than it appears. Add an administrative fee to the 401k of just 50 basis points, and the after-tax balance of the 401k falls to an amount equivalent to the taxable account.
Several Things to Keep in Mind
- Tax Rates are Key: The above examples assume the same tax rate for contributions and distributions. That's a big assumption. If tax rates are lower in retirement, the benefits of a 401k or IRA are even great. If tax rates are higher, the benefits decrease substantially, which is why a Roth 401k or Roth IRA can be ideal for those in low tax brackets.
- Dividends, Interest, and Capital Gains: The above examples also assume that the capital gains from a taxable account will be paid at distribution. That’s almost never the case. For the vast majority of investments, investors will be taxed on dividends and interest each year, and may also pay taxes on capital gains distributions in mutual funds. These annual taxes, while they may appear small, can easily drag down annual returns by 30 basis points or more.
- Don't Fear All Actively Managed Funds: While 50 basis points may wipe out the 401k advantage, that doesn't mean that actively managed funds that charge more than this in a 401k are a bad deal. There are many "low cost" actively managed funds that will make up some or all of their cost. I look for actively managed funds that charge no more than 80 basis points.
- Think Long Term: Even if you have an expensive 401k, it still may be worth contributing the maximum allowed. If you plan to leave your job in the next few years, you’ll be able to roll over the 401k either to your new employer’s 401k or an IRA. Alternatively, you may have success convincing your employer to lower the costs.