Should I cut my 401(k) and diversify?

By Walter Updegrave, senior editor

(Money Magazine) -- Question: I'm 50 years old and contribute 20% of salary to my 401(k), of which my employer matches 6%. The choices in my 401(k) plan are limited, however, so I want to branch out. I already max out a Roth IRA, so I can't invest more there.

So I'm considering cutting my 401(k) contribution to 6% and investing the rest in low-cost ETFs in a taxable account with a discount broker. This way I'll be able to diversify into things like REITS, emerging markets, commodities, infrastructure, etc. Do you think this plan is a good idea? -- J.B., Carmel, Indiana

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Answer: I'm all for diversification. Intuitively, though, giving up a good portion of your 401(k)'s tax break in return for more investment options doesn't strike me as a very good trade off.

But why don't we crunch a few numbers to see how things might work out.

Let's say, just for the purposes of this example, that you earn $80,000 a year. So you have two choices: contribute $16,000 (20% of $80,000) to your 401(k); or, put just $4,800 (6% of $80,000) into your 401(k) and then invest the remaining $11,200 that would have gone into your 401(k) in ETFs instead. (I'm leaving your 401(k) match out of this, since you'll get that in both scenarios.)

Although I have no idea what returns the markets will deliver over the next 15 years, let's assume for argument's sake that you earn 7% a year on your investments. That would mean that the $16,000 you contribute to your 401(k) at age 50 would be worth $44,145 when you hit 65. If you're in the 25% tax bracket when you pull that money out, you would have $33,109 after taxes.

Now let's see how you might do splitting your dough between your 401(k) and ETFs in a taxable account.

The $4,800 you put in the 401(k) would be worth $13,243 before taxes in 15 years and, again assuming a 25% tax rate, $9,933 after tax.

As for the ETFs, remember: unlike with a 401(k), you don't get to invest pre-tax dollars in a taxable account.

So after paying tax at a 25% rate on the $11,200 that would have gone into your 401(k), you're left with $8,400 to invest in the ETFs. At a 7% annual return, that amount would grow to $23,176 in 15 years.

If we stopped there and added the $23,176 from the ETFs to the $9,933 from the 401(k), you'd have $33,109 the same as putting all $16,000 into the 401(k).

But we can't stop there. We've also got to deduct taxes from the gain in your ETF investment. Even assuming we're incredibly generous and tax your entire ETF gain of $14,776 ($23,176 minus $8,400) at a long-term capital gains tax rate of 15%, you'd shell out $2,216 in taxes, leaving you with $20,960. Add that to the $9,933 in your 401(k), and you've got a combined $30,893.

So that's $30,893 by splitting your money between the 401(k) and ETFs in a taxable account vs. $33,109 just sticking with the 401(k). So for all your trouble, you would be behind by $2,216, which, not coincidentally, is the amount of the tax you had to pay on your ETF gain.

Or, to put it another way, you ended up with about 7% less over 15 years on one year's worth of savings by shifting some of your money to a taxable account rather than sticking to the 401(k).

Now, are there ways that you could have come out ahead by going outside your 401(k)?

Sure. If, instead of paying tax at a 25% rate when you pull the money out of the 401(k), you paid at a higher rate, then the 401(k)-ETF combo could come out ahead. It would have to be a substantial bump in tax rates, though, up to 33% or so in this example.

And even if you believed that were possible, I'd note two things. First, the tax tab on your ETFs in reality would very likely be higher than the rock-bottom 15% rate I used in the example.

That's especially true in the case of commodity ETFs, which don't always qualify for the most advantageous long-term capital gains tax rate.

So for the 401(k)-ETF combo to win out, you would probably have to pay taxes at a rate of even higher than 33% on your 401(k) at withdrawal.

I'd also point out that if facing a higher tax rate down the road is really a concern for you, you're already hedging against that possibility by contributing to a Roth account.

Your ETF plan could also come out on top if you assume the ETFs you pick will earn higher after-tax returns than the investments your money would have gone into within your 401(k).

Is that likely? Hard to say not knowing what you're the choices are within your plan. But given the original scenario I laid out above, you would need something like an extra full percentage point of return per year for 15 years for higher returns to make up the difference.

I certainly wouldn't count on getting that big an edge over that long a stretch. As for going ahead with your plan for diversification reasons alone, I'm sympathetic, with a caveat.

A lot of investors these days use diversification as a rationale for buying whatever is new or hot. We saw that occur with real estate in the mid-2000s and we've seen it happen with gold recently.

And whether it's because investors have gotten religion about diversification or they're enamored by the high returns some emerging markets generated last year and the year to date, the appetite for emerging markets ETFs has bordered on insatiable, with assets climbing from $72 billion in 2008 to nearly $194 billion earlier this year, according to a recent BlackRock report.

I'm not saying you're one of these "faux" diversifiers. But it certainly doesn't hurt for all of us to examine our true reasons when making investment moves.

And if you decide that diversification is what's really motivating you, you might consider whether you can achieve that goal using the Roth account you already have.

To sum up, I think you need a pretty compelling alternative to give up the tax breaks and convenience of a 401(k). So unless you're in a clearly subpar 401(k) plan with choices that are extremely limited, obviously inferior and weighed down by high expenses -- which you may be able to evaluate by clicking here -- I'd be wary about shifting my contributions to a taxable account. To top of page

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