When you take these myths and realities together, you’ll see that unless you have an employee match on your 401k, you may be better off exploring alternative retirement accounts such as IRAs and Roth IRAs because they also shield you from capital gains taxes. And despite common misperceptions, there are ways to invest in non-401k retirement accounts regardless of your income level. If you have a match, you might put every penny up to it that you are able, but not a single penny more. And if it’s available, you might use a broker-linked account that enables you to invest in a market-tracking vehicle and avoid wasting money on management fees. Alternatives will be discussed in coming posts.
Did you know? 401k refers to section 401(k) of a 1978 piece of legislation that spawned the growth of the mutual fund industry.
Myth #1 versus Reality #1: Tax-advantaged compounding is a myth, but there are capital gains benefits
Myth #1: By putting my pre-tax dollars to work in a 401k, I am putting my money to work earlier and letting it compound so I have more in retirement.
Busting myth #1: This is a very common misconception, and I’m shocked sometimes at how many sophisticated people fall into this trap. Putting your money aside in pre-tax dollar form does not enable you to tax-free compound and end at a higher amount. Let’s illustrate with an example:
Scenario where you put pre-tax money aside:
Suppose you put $100 away pre-tax into a retirement account. Over time, it doubles. So you now have $200. When you go to withdraw these funds, you will have to pay taxes. Let’s say your tax rate is 30%, then you will have $140 net dollars (taking 30% off $200).
Scenario where you put post-tax money aside:
Suppose you take that $100 from your paycheck and pay your taxes now ($30 at 30% tax rate). Then you have $70 to invest. Over time, again, it doubles. You now have $140. This is exactly the same amount you have in the pre-tax example above.
There is no such thing as pre-tax compounding. Conceptually, in the end, your money, including accrued gains, will be taxed, putting you into the same situation. Mathematically, you’re just distributing the tax rate (if static) to a later part in the equation. There are arguments, such as a view that your own personal tax rate will fall, but that is beyond the scope of this post and a future subject. Also note, I did not incorporate capital gains taxes for simplicity in the above, but they would not change the conclusion if static. Main thing I want to dispel is the notion that there is such a thing as a pre-tax compounding advantage.
Reality #1: There are still tax savings in the form of capital gains shields utilizing retirement accounts.
You will pay income tax, one way or the other (pre-tax or post-tax), when investing in retirement account. But there is another tax to worry about – the capital gains tax. And that is one benefit of most retirement accounts, including 401k’s. Capital gains taxes are “extra” taxes you incur on any gains on investments. Shielded retirement accounts (401’ks, 529 accounts, IRAs, Roth IRAs) avoid those gains. In contrast, if your money is not in a shielded retirement account, you will pay those gains. Here’s an illustration:
Scenario where you invest in an account without a tax shield
So let’s say you put $100 after income taxes (money from your take-home pay) in an account (not a tax-shielded retirement account but a regular old account). Suppose it doubles to $200, then you have a capital gain of $100. That $100 is subject to the $100 capital gains tax. It depends on your income level, but for most people this is going to be around 15%. That means, you have to pay $15 in capital gains taxes. So, in the end, you’ll have $185.
Scenario where you invest in a retirement account with a tax shield
Let’s say you put the after-tax $100 in a tax-shielded retirement account. Suppose it doubles to $200. You then have $200 as the gains are not subject to capital gains taxes.
Myth #2 versus Reality #2: Access to superior investments is a myth; higher fees is a reality
Myth #2: With my 401k, I am investing in a professional who will manage my money better than I could or a passive investment could.
Busting myth #2: It has been widely established that mutual funds may chronically underperform the broader market, even on a risk-adjusted basis. Here’s one example from UPenn discussing this topic. Over the past 15 years, for example, the average mutual fund has returned about 6% on average versus about 9% for the S&P 500. That’s 3 percentage-points lower per year. That means if you put in a dollar at the beginning of the 15 year period, you’d have $3.64 if you invested in the market versus $2.40 if invested in the average mutual fund. And that doesn’t even include excessive fees from mutual funds that would drop this to about $2.15. It’s not really about finding the “right” manager; most underperform the market and charge excessive fees.
Reality #2: Investing in a mutual fund product costs you more in fees than alternative investments
Mutual funds (those who manage your 401k) can charge you up to 3% for a product that tends not to outperform the market. On average, they charge you 0.82% per year and may deliver subpar performance. 0.82% may seem like a reasonable or small fee, but it adds up. For example, if you put aside $1,000 every year for the next 30 years, and your investments went up 7% per year, you’d have almost $100,000 if you parked your money in a low-cost ETF alternative. However, you’d only have $87,500 if you invested in a 401k. Their fees would add up to over $14,000! If you are investing in a 401k, you might see if your plan has a brokerage link option, which enables you to freely invest in lower cost market-tracking alternatives without paying excessive fees.
Myth #3 versus Reality #3: Need to invest in 401k because over income limit for other products is a myth, but there is a valuable benefit from employer matching
Myth #3: I need to put my money in a 401k because I am over the qualified income limit.
Busting myth #3:
The income limit for contributing with deductions to an IRA ($103,000 adjusted gross income for married/joint or $64,000 for single). However, there is nothing stopping your from making a non-deductible contribution to your IRA and rolling those funds into a Roth IRA (like an IRA but taxes paid upfront). For example, suppose you make $200,000. You put $6,000 into an IRA. Now, you likely can’t just leave it there because you’ll be paying income taxes on any gains that come of it, and you likely still want to take advantage of the capital gains shield (discussed in Reality #1).
So you take that $6,000; you “roll” it into a Roth IRA. You will owe the income taxes on that amount (which is fine, you would have paid them if not investing in a retirement account anyways). Let’s say you have a 30% tax rate, then you have $4,200 for your Roth IRA. Any growth in the investments when you retire will not be taxed further. This is known as a “backdoor Roth IRA.”
We already established when busting Myth #1 that there is no real income tax savings from an IRA (it’s only the capital gains savings in Reality #1).
You’re actually free to contribute to your IRA no matter what your income level is. You’ll just pay the taxes upfront. So unless you have a view that taxes will fall from present rates, which realistically is anyone’s guess, you might go ahead and just fund your IRA and roll it into a Roth IRA. The standard limit is $6,000 ($7,000 if you’re age 50 or older), but there is such a thing as a mega backdoor IRA that enables you to put away $56,000 per year in total between your 401k and Roth IRA. That will be the subject of another post. There are also alternatives, such as 529 accounts, which I would suggest only investing in if you are putting away more than $56,000 because they do not offer real benefits beyond that of an IRA (which can be used for education expenses). Subject of a future post as well.
Reality #3: Only real reason to not use alternatives is employer matching The primary reason to invest in a 401k is employer matching. To the extent your employer provides matching, you likely can’t really beat that option. It’s essentially “free” money (technically it’s not free because without this retirement benefit your pay would likely be higher, but it is what it is). It’s true your mutual fund may underperform the market and charge excessive fees, but you can’t beat free money. Let’s say your employer matches up to $6,000 and you take advantage of that option. You would basically need your 401k to fall and the market to rise in order to lose. As subpar as returns for mutual funds can be, that would be pretty atrocious investing and not likely something you’ll experience. So the bottom line is if you have a match option, you should take advantage of it; it trumps all other points. But you should likely not put a single penny in above your match amount.
Hope you enjoyed the post, which is the first in a series of retirement planning posts. If you have a topic you’d like me to add to the pipeline, please suggest in the comments below.
Did you know? Japan adopted the 401k system and refers to it as a 401k even though there is no section 401(k) in Japanese legislation.