Too cool for a 401(k)? Do the math
A reader thinks he can do better on his own. Money's Walter Updegrave says the numbers don't add up.
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (Money) -- QUESTION: Everyone says you should invest in a 401(k). But if my employer doesn't match my contributions and I don't expect to be in a lower tax bracket after I retire, I don't see the point. Wouldn't I be better off just paying taxes and putting my money in a mutual fund that generates little in the way of ongoing taxable distributions, such as an index fund? I don't see how a 401(k) helps me. -- Mark C., Wilmington, Delaware

Granted, a company match makes a 401(k) a better deal. But I wouldn't be so quick to dismiss a 401(k) without the match. The long-term tax-deferred compounding of gains you get in a 401(k) alone may be enough to make it a better bet than the alternative you're suggesting.

It really comes down to how big a jump in tax brackets you're likely to make and how tax efficiently you can invest outside the 401(k).

Let's run a few numbers.

Going with the 401(k) You don't say what your current tax bracket is or how much you can contribute to your 401(k), but let's assume you're in the 25% tax bracket and that you can sock away $10,000 in your 401(k).

If you earn 8% a year on that ten grand, it will be worth $46,610 after 20 years. In this case, the money grows tax free, but you have to pay taxes when you pull it out.

If you're still in the 25% tax bracket at that time, that $46,610 would be worth $34,958. If you've moved into the 28% bracket, it would be worth $33,559. If you've moved into the 33% bracket, it would be worth less still, or $31,229. And if you are in the 35% bracket, your 401(k)'s after-tax value would be $30,297.

Going on your own But what if instead of doing the 401(k) you invest in a tax-efficient mutual fund? In fact, to really give the 401(k) tough competition, let's assume that you invest in a fund that's so efficient that all your gains remain untaxed until you withdraw them, and let's also figure that all your gains are taxed at the long-term capital gains rate, which maxes out at 15%.

Unlike the 401(k), however, where you get to invest pre-tax dollars, you've first got to pay tax on the dollars you invest.

So if you're in the 25% tax bracket, you fork over $2,500 in taxes and invest $7,500. Assuming the same 8% return, over 20 years that $7,500 would grow to $34,957. At the capital gains rate, you'd owe $4,119 in taxes, leaving you with $30,838.

Bottom Line Looking at the first example, the 401(k) leaves you with more in each case unless you end up jumping to the 35 percent bracket.

Keep in mind that I've also been making the assumption that all of your tax-efficient fund's return will come in the form of long-term capital gains and that you won't pay tax on any of that gain for 20 years. Those are generous assumptions. In real life, the fund might not be that tax-efficient. And if you sell the shares to reinvest somewhere else, you'll pay taxes earlier and not gain the full benefit of deferring taxes for 20 years.

When you consider that the 401(k) is such a simple way to save - I mean, all you've got to do is sign up and the money is deducted from your paycheck before you get your greedy little lunch hooks on it - I think it would be a mistake to forego the 401(k) just because you might end up in a higher tax bracket.

Now consider a Roth

That said, however, I think it would also be wise for you to contribute to a Roth IRA. Why? Well, with a Roth you pay tax on your contribution, but you get to withdraw the money from your account tax-free later on (assuming you meet certain conditions, which you can read about here).

That's a big advantage if you end up in a higher tax bracket because you're effectively arbitraging the tax system in your favor - that is, paying taxes today when you're at a lower rate and avoiding them in the future when you would be in a higher tax bracket.

Actually, if you invest the max in a Roth it's a better deal if you stay in the same tax bracket and possibly even if you fall into a slightly lower one because doing the max in a Roth effectively allows you to earn a tax-free return on more dollars. (For details on why this is the case, check out my Long View column in the August issue of MONEY Magazine.)

There are a couple of other benefits to doing the Roth. You'll have a pot of money in retirement that isn't subject to income tax, giving you a benefit I call "tax diversification," which is a fancy way of saying your entire retirement stash isn't at the mercy of wherever income tax rates happen to be after you retire. (For more on the concept of tax diversification, click here.)

And you can also leave your money in the Roth the rest of your life if you wish. With a 401(k) or traditional IRA, you've eventually got to start making required withdrawals, which means some of your money is no longer sheltered from taxes.

So max out on the Roth, then put as much as you can in your 401(k) and if you still have savings left over, then go ahead with your tax-efficient investing plan. This three-pronged approach would really make you a model of tax diversification.

You would have one pot of money taxed at ordinary income tax rates (the 401(k)), another pot not taxed at all (the Roth) and a third pot (the tax-efficient fund) taxed at long-term capital gains rates, which, for now at least max out at a relatively comfortable 15%.

All in all, that's not a bad retirement scenario, whatever tax bracket you eventually end up in.


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