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Are you a sucker to invest in a 401(k)?

One theory making the rounds these days holds that 401(k)s are tax traps. Here's why that's wrong.

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By Cybele Weisser

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(Money Magazine) -- As a Money reader, you're likely well aware of the wonders of a 401(k). You don't pay up-front taxes on the money you contribute, and you don't owe taxes on your investment earnings until you withdraw the cash in retirement.

But some financial advisers (and a couple of books) have begun to voice a dissenting view: If you invest in your 401(k), they say, you'll end up paying more in taxes than you have to.

On the face of it, this argument looks plausible. If you buy stocks or stock mutual funds in a regular brokerage account, you will pay a 15% long-term capital-gains rate when you eventually sell. But you'll have to pay ordinary income tax rates of 28% or even 35% on your 401(k) withdrawals. Could the 401(k) skeptics be right?

Strictly by the numbers

Let's say you put $10,000 in your 401(k) and invest in a stock-index fund that earns an average of 8% a year. After 20 years it will be worth $46,610. Withdraw the money all at once and you'll pay $13,051 in taxes, assuming you're in the 28% bracket, leaving you $33,559 to spend.

But what if instead you had bought that tax-efficient stock fund outside your plan? Wouldn't your tax bill be lower?

Yes, but that's the wrong way to look at it.

If you skip your 401(k) in favor of a taxable account, you must first shell out taxes on that $10,000, which leaves you with just $7,200 to invest (assuming the same 28% bracket).

Plus, over the next 20 years, you'll have taxes on any dividends and gains the fund pays out. Even though you will get a lower 15% rate on your gains when you sell, you end up with $28,950, or about $4,600 less than with the 401(k).

A tinier final tax bill can't make up for having to pay taxes all along.

But wait...

What if you find yourself in a higher tax bracket later on? Well, in this example, you'd have to be in a 38% tax bracket 20 years from now to have made the wrong decision.

While Congress may (okay, will) have raised taxes by then, your bracket might not increase if your income drops in retirement. And the longer you wait to take the money, the more you stand to gain by keeping the money in your 401(k).

Plus, comparing a 401(k) with a stock-index fund is the toughest test, since index funds generate little in the way of tax bills before you sell. If you buy a bond fund, where income is taxed at your ordinary rate, or an actively managed stock fund that distributes more gains than an index fund and triggers a far bigger tax bill for you every year, the difference in favor of the 401(k) account will be even greater.

...and furthermore

This math ignores an employer match in your 401(k), which you are likely to get on at least part of your contribution. Add that in and the 401(k) looks better still.

You do the math

With the 401(k) savings calculator at dinkytown.net, you can compare investing in and out of a 401(k), including the effect of having an employer match in your plan.

The bottom line

Rest assured that deferred investing yields more after-tax dollars.

For more, go to cnn.com/rightonyourmoney

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