A no-match 401(k): Still worth it

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NEW YORK (Money) -- Question: My employer offers a 401(k), but no match. Given that I'm already maxing out my Roth IRA, would I be better off investing in a taxable account rather than contributing to my no-match 401(k)? - Luis Gonzalez, Denver, Colorado

Answer: Life would indeed be a sweeter if your 401(k) plan came with a matching employer contribution, as most plans do. But remember: A 401(k) offers a nifty tax break in that the funds you contribute, as well as all of your account's earnings, aren't taxed as long as they stay within the account. And that tax-deferred compounding is a valuable benefit that can boost the size of your nest egg over the long term.

So even without the match, I think you're more likely to do better in the 401(k) than foregoing and investing in a taxable account. How much better can vary depending on the assumptions you make, but let's take a look at a reasonable scenario.

Let's assume you're in the 25 percent tax bracket and that you have $5,000 in earnings that you can put into your 401(k) or invest in a taxable account.

If you opt for the 401(k), the entire five grand goes into your account. And if we assume you earn a return of 8 percent a year, after 10 years your $5,000 would be worth $10,795. Of course, you haven't paid tax on any of that money, so if we figure a 25 percent tax hit, then your 401(k) balance is effectively worth $8,096.

Now let's see what happens if you invest your $5,000 in a taxable account. Well, the first thing that's going to happen is that you'll have to pay tax on that $5,000 since you're not sheltering it in your 401(k). With a 25 percent tax rate, that means you really have only $3,750 to invest after taxes. Plus, since this is a taxable account, you would have to pay tax on investment gains.

How much tax? Well, that depends on several factors, such as how much of your gain comes in the form of interest and short-term capital gains that are realized each year (and, thus, subject to ordinary income tax rates that year), how much comes in the form of long-term capital gains (subject to the lower long-term capital gains rate) and on how often those long-term gains are realized. If, for example, half that 8 percent annually came in the form of annual interest payments or annual short-term capital gains from trading, then a portion of your return would be taxed each year, leaving less to compound.

But let's assume a very generous taxing arrangement. In fact, just for argument's sake, let's figure that none of your gains are taxed until the end of 10 years and that at that time your entire profit is taxed at the maximum long-term capital gains rate of 15 percent.

If that's the case, then after 10 years of 8 percent annual returns, your $3,750 would be worth $8,096. This is the same amount that you would have after-tax in the 401(k), except you've now got to pay tax on the profit in your taxable account.

Assuming you would owe 15 percent tax on your profit of $4,346 (your $8,096 account balance minus your original investment of $3,750), you would have to fork over $652 to the IRS, leaving you with $7,444 after taxes.

Which is $652 less than the $8,096 you would have after taxes in the 401(k).

That may not seem like much, but, remember: we're looking at only one contribution here, and I've painted a very optimistic case for the taxable account. In the real world I don't think you would be able to actually get a 15 percent tax rate on all your gains, plus I doubt that you would be able to defer paying all taxes for 10 years. Most likely, you would face both ordinary and long-term capital gains tax rates and you would have to pay at least some tax every year. And that would lower your after-tax return and the balance in your taxable account.

Is it possible that the taxable account could come out ahead? Sure. You could move into a higher tax bracket when you pull the money out of the 401(k). Or your long-term capital gains could be taxed at an even lower rate than 15 percent. But it's also possible that you could move into a lower tax rate in retirement, which would make the 401(k) look even better than in the scenario above.

Fact is, predicting the tax rate you'll face in the future is iffy at best. Combine that uncertainty with the fact that you're not likely to wring maximum tax efficiency out of your taxable account, and I think it's pretty clear that the 401(k) is the surer bet.

Besides, the 401(k) has one other thing going for it that I consider a huge advantage: convenience. Your contribution is automatically deducted from your paycheck before you can get your mitts on it and spend it. That means the money is more likely to actually make its way into your account.

One final note: I'm not suggesting that you totally forego investing in taxable accounts. Indeed, I'm a big advocate of what I like to call "tax diversification," a strategy that calls for hedging your nest egg's tax exposure by spreading your retirement savings among three "pots," so to speak: 401(k)s and regular deductible or rollover IRAs (where withdrawals are taxed at ordinary income rates); Roth 401(k)s or Roth IRAs (where withdrawals aren't taxed at all); and, taxable accounts (where you've got a shot of at least some gains being taxed at lower long-term capital gains rates).

You've already got a Roth, so the 401(k) is your next logical move. (In fact, given its convenience and tax benefits, I really consider the 401(k) the first step.) But once you've got those two covered, by all means feel free to start plowing any additional savings into taxable accounts. (For investment options for that portion of your savings, click here.)

I can't promise that this three-pot recipe will lead to the largest nest egg. But I can say that following it will give you more flexibility for managing your tax bill and the after-tax size of the withdrawals from your nest egg in retirement.