Is a 401(k) Still the Smart Choice? Today's lower tax rates can tangle with your retirement strategies.
By Daniel Altman

(Business 2.0) – The Bush administration came into office determined to make the tax code kinder to stock investors, and the fruits of that labor should land in your mailbox any day now. If you made money in the market in 2003, your refund owes some of its heft to a plunge in the maximum tax rate on both dividends and long-term capital gains to just 15 percent.

But this bounty from Uncle Sam raises a question: Now that investment taxes are so modest, who needs a 401(k)? The main appeal of these stalwart retirement plans has always been their tax treatment. Invest under the shelter of a 401(k)--or IRA or similar program--and you get a deduction for every dollar saved; plus, all your interest, dividends, and capital gains build untaxed until you take the money out. Even though whatever you withdraw is taxed at the full ordinary income rate--as high as 35 percent--you'd almost always come out ahead. But now that you can pay taxes on those same investments at just 15 percent outside a tax-deferred account, doesn't the calculus change?

Yes it does, says James Poterba, an MIT professor of economics and a longtime retirement expert. In a paper written earlier this year, Poterba concludes that while the 401(k) and its cousins may still be the best choice for retirement investors, it's not smart to get too smug about them. A dollar inside such a plan is now worth far less than you might think compared with a dollar invested outside. "I suspect that at least some people get confused," Poterba says, "and overestimate the value of their 401(k) balances."

That's because you forget about Uncle Sam taking his share of a 401(k) upon withdrawal. By contrast, you've already paid taxes on the money initially invested in a regular stock portfolio--and whatever gains or dividends you collect on that stake in the future will lose just that measly 15 percent to the IRS. (In addition, because a stock portfolio comes with its own set of tax dodges--such as losses that you can net against gains--Poterba argues that the real, effective tax rate on gains is more like 7.5 percent.) The result, measured in after-tax, spendable income 10 years from now: $10,000 held in a 401(k) today can be equivalent to just $6,940 in a fully taxable stock account. Because the benefit of the 401(k)'s tax treatment increases with time, the 401(k) eventually closes the gap. But even if you planned to let your $10,000 401(k) balance compound tax-free for 30 years, it would still be equivalent to just $7,530 in a regular stock portfolio today.

Even so, for most investors most of the time, investing in a 401(k) still makes sense. For one thing, your company probably matches your contribution, which you shouldn't pass up. "That almost surely makes it a no-brainer," Poterba says. Also, most retirement portfolios include income investments--like bonds and stable value funds--which throw off interest taxable at the full ordinary income rate. Because you pay as much as 35 percent on interest outside a 401(k), you're usually better off keeping such investments inside, where you can defer the IRS reckoning.

According to Poterba, it pays to put retirement money in a taxable account only if you're investing just in stocks and are close to retirement--say, 10 years away--and your tax rate will be higher in your golden years. A higher bracket in retirement may sound unlikely, but disappearing deductions or changes in the tax code could have that result. After all, today's low rates are in effect only until 2008. And you'd need more than a Ph.D. in economics to know what Congress will do after that. -- DANIEL ALTMAN