There are several reasons for getting a 401(k). 401(k) tax breaks isn’t one of them. Over the last 3 years I have not had to pay federal taxes. This, because all my income is derived from capital gains and seeing as these barely put me past the 10% tax bracket, I owe 0% federal tax on these. This year preparing for taxes (2017) things look different. I started the Roth IRA conversion ladder, in the amount of $40,000. It’s a measure I have to take because my after-tax investment accounts will run dry, prior to my 401(k) withdrawal age of 59 (and a half).
Rolling over from a 401(k) to a Roth IRA implies that all money converted is subject to regular income tax. So for 2017 I owe at least income tax over $40,000.
I realized something, I really should have known
The often touted reason of, paying less taxes when contributing to a 401(k), is a myth!
For the Rollover I sold 175 shares of VIIIX. Based on First in/First out, these shares were bought in 2002 at an average of about $90.
Back in 2002, by contributing to the 401(k), I did not have to pay federal tax over $10,000 (the rest of the $15,750, paid for these shares, was from corporate matching). Today, I have to pay tax over $40,000. Whilst in the 30% tax bracket back in 2002, I delayed paying $3,000 so today, being in the 15% tax bracket, I can pay $4,500 ($1,500 more).
The other argument of paying into the 401(k) you hear all the time is: “When I retire, I will be in a lower tax bracket”. So what? By the time you retire your money will have tripled if not quadrupled, so even at a lower tax bracket you’ll end up paying more. Keep in mind; I’m selling 12 years prior to retirement age. Based on 8% growth that $40,000 I pay tax over today would have been worth $93,265 at age 59.5.
Yeah but..
That $10,000 plus corporate matching turned into $40,000, what’s your problem? Well, the “problem” I have is that, had I simply invested that money in the after-tax stock market, I would currently owe 0% in taxes. My main investments in my 401(k) are in the Vanguard index fund and my investments in my after tax accounts are in SPY. The investment is the same.
it would have seen identical growth, with the following differences:
Had I invested in after-tax accounts instead of a 401(k), I wouldn’t have to liquidate/convert today.
Had I invested in after-tax accounts instead of a 401(k), I wouldn’t have to pay taxes (as long as I stay withing the new 12% tax bracket).
There is a big but. On the flip side of the coin:
Had I invested in after-tax accounts instead of a 401(k), I would not have received the corporate matching….Hmmm
So what does this mean
First of all; for the government the 401(k) is awesome. It’s a win-win for them. They will collect way more tax dollars from you, if you contribute to the 401(k). If today, you’re 24 and choose to defer paying taxes over $200 you’ll save $24.00 in the 12% bracket. By saving that $24 today, you get to pay to pay $354.00 over that same $200.00 after it’s grown to $2,957.00 at early retirement at 59.5 (based on gains of 8% annually). Maybe the government isn’t so ineffective after all. They don’t mind, you not paying $24 today, knowing they’ll get 15 times that, 35 years later. Dirty little secret, they’re lending you that $24 today at a mere 8 percent interest (or whatever the market return is), to collect 30 years later.
A 401(k) ONLY makes sense, if there is corporate matching dollars. If there is no corporate matching you’re only signing up for paying way more taxes in the long run. There’s nothing in that 401(k) you can’t achieve by investing it yourself in an after-tax investment account.
401(k) distributions are subject to regular income tax. Capital gains however, has its own rules, which currently means 0% if you’re within the 12% tax bracket (that’s an income of $77,400 when Married filing jointly).
if you buy one share in VIIIX at $249 today in your 401(k) you save $29.88 in taxes. When you distribute that share of VIIIX in 30 years for $2,320 you’ll pay $278 in taxes. (based 12% bracket and 8% annual growth). There is no tax-break, just deferral with a high price-tag.
Update: based on comments by fulltimefinance.com I have to point out; All of this applies only if your long term capital gains fall within the 12% tax bracket (today $77,400.00). Once your capital gains exceeds that amount you’ll be dropping in similar tax brackets as the 401(k) distribution. I do like to point out as well, that should you need more than 77K as a married couple in retirement, you better have a hefty retirement balance (million+).
Running the numbers
For my own sanity, I resorted to building a spreadsheet and comparing the scenarios of using after-tax accounts versus 401(k). Following is the setup of this scenario.
Starting age: 30
Starting income: $60,000
Annual raise: 3%
Return on investments: 8%
Early retirement at 59.5 (gotta dream)
Requirement budget after retirement: $70,000 (we’re all gonna live on less when we retire, right?)
Income includes funds needed, to pay taxes.
Tax brackets for Married, filed jointly, starting 2018 (the new tax ones)
The standard deduction $24,000 is taken each year
inflation after retirement 2.5%
Scenario 1: Contribute 8% to 401(k) without corporate matching versus investing in after-tax account
Based on the numbers above you will:
401(k):
by age 59.5 have invested: $228,362.00
Have an account balance of: $791,637.69
Paid: $173,463.37 in federal income tax
After tax account:
by age 59.5 have invested: $228,362.00
Have an account balance of: $791,637.69
Paid: $193.246.81 in federal income tax
Having paid into 401(k) as opposed to After-tax would have yielded the exact same investment balances but, you would have paid less taxes. $19,783.44 LESS taxes paid. That great right? Yes, you saved on taxes while you were contributing to your 401(k) during your career. Only if life ended there.
It doesn’t though. You’re only 59.5 and will now start taking money from your investments. $70,000 based on the budget stated above.
When you take money from your 401(k) its all taxable as regular income. All $70,000 are subject to the 12% tax bracket. if you sell/distribute $70,000 from your 401(k) you have to pay 12% in taxes that year and each year following. Based on inflation, you will live within the 12% tax bracket until age 73 (not accounting for SSN), after which inflation will have put your budget need back in the 22% income bracket. Due to inflation adjusted Tax brackets and Standard deductions, you’ll likely stay within 12%.
When you take money from your After-tax account all distribution is subject to capital gains tax, which will effectively always leave you in the 12% tax bracket. Meaning you pay 0% in taxes. It also means you can take out less of your after-tax accounts as you don’t need to account for having to pay taxes.
from age 59.5 on until money runs out of the accounts (at age 77) you will pay federal taxes as follows:
401(k): $45,953.68
After tax Accounts: $0
Having a 401(k) without corporate matching results in paying $26,170 MORE over the lifetime of your investment. compared to investing it in after-tax accounts. you do not save on taxes with a 401(k), it’s a myth.
In this scenario, on top of all, your after-tax accounts will last a few more years as you can withdraw less. The assumption was that the $70,000 starting budget after retirement included funds for paying taxes.
Scenario 2: Corporate matching.
One cannot argue with power if the corporate match. If your company offers a Roth 401(k) with similar matching, great. If your company does not offer such a plan that’s unfortunate but consider walking away from the 401(k) and corporate matching. Instead, build up the self discipline to award yourself that 3% dollar match in invest the 11% of your salary into after tax accounts yourself.
The numbers will look at follows:
401(k):
by age 59.5 have invested: $313,997.74
Have an account balance of: $1,088,501.83
Paid: $173,463.37 in federal income tax
After tax account:
by age 59.5 have invested: $313,997.74
Have an account balance of: $1,088,501.83
Paid: $193.246.81 in federal income tax
You will have seen a tax break of $19,783.44
from age 59.5 on until money runs out of the accounts (at age 90) you will pay federal taxes as follows:
401(k): $121,426.66
After tax Accounts: $0
So over you’re lifetime (until age 90) you pay over a $101,000 less in taxes going with either a Roth 401(K) or other after-tax accounts.
One might argue that walking away from 3% matching and trying to make up for that yourself is nuts (I believe with a some effort and self discipline you can find 3% in your budget).
It does get you two important benefits the 401(k) doesn’t offer:
-You will pay a lot less taxes (contributing 11%, about $101,000 less till the age of 90).
-You get the freedom to do with your investments what you want and when you want it (and within bounds, without paying taxes).
Personally I don’t mind paying my fair share of taxes and would probably still opt for corporate matching, but I know, that doesn’t apply to all. Furthermore, that Freedom certainly has a nice ring to it.
Of course, there is the argument that without having it automatically put in a 401(k) it would get spend. I worry about that attitude. If you don’t have the self discipline today, to manage your money AND you’re deferring any effort in building that self discipline (by tricking yourself with automating), How well will you fair in retirement when you do have to manage it.
Update: Commenter JB correctly pointed out that my calculations did not account for inflation adjusted tax brackets. In my calculations at some point both income and retirement income flipped over to 22%. Based on inflation adjusted brackets both salary and retirement income will remain in the 12% bracket. I have adjust the numbers accordingly. It led to another flaw which is the lack of inflation adjustment for the standard deduction. I’ve also adjusted the number for this.
Feel free to (in a constructive and non-condescending way) point out other flaws, I’ll be happy to argue/learn and adjust.
Good luck reaching your financial goals.
My employer matches 6%, but i contribute the max allowed to 401(k). May be I should contribute only 6% to 401(k), and invest the rest after tax?
I wish I had. I for a long time maxed out my 401(k). Had I invested the non-matched funds in after tax account, I’d be in better position today and pay less taxes going forward. I would definitely put whatever in the 401(k) to get the 6% match. That’s a good matching program
Okay, I need to think about this. Still learning everything. Why is every single personal finance blog out there talking about maximizing 401(k)?
Will spend some time with a spreadsheet and google this weekend and report back!
I think most blogs talk about maxing out 401(k)s because it is assumed most people don’t have to discipline or knowledge to invest it themselves. Inherently there is nothing wrong with maxing out the 401(k) as long as you don’t mind paying the taxes in retirement.
Under current tax law the 401(k) distribution is taxed as regular income (10%/12%/22%/22%/32%/35)
Under current tax law stock gains result in long term capital gains (0%/15%/20%). If you can budget within the 12% tax bracket (i.e all I need $77,400 a year) you will pay 0% long term capital gains. If all your money will come from stock sales you’ll pay $0 in federal tax (barring any tax on dividends).
The difference over the lifetime of your retirement can mean thousands if not hundreds of thousands in taxes.
I see what you meant, but don’t you start off with a smaller amount if it is an after tax investment? Suppose I am in a high tax bracket, say 32%. If I put that in 401(k), I have $100. For other investments, I would start off with $68. When will I recover that? That is the what I don’t get.
The premise of this article is the choice of putting 10% of your salary in pre or 10% in your post tax accounts. You can think of it at a 401(k) or Roth 401(k). You contribute the same percentage, with different tax consequences.
Naturally, if you choose to invest less in your after tax account (68 instead of 100), you’ll have less by the time you retire.
But if, for argument’s sake, we run the numbers: In the following scenario: Starting age 30, Starting Salary $60,000.00, annual raise 3%, death at 90
-401(k) contribution 11%,
At age 59, you’ll have $1,088,501.00.
-After tax contribution 11% minus the tax-break you pass up
At age 59 you’ll have $954,460.45
You will have $134,041 LESS at time of retirement.
with the 401(k) account, you will pay a total of $492,645.00 in taxes till the age of 90
With an after tax account, you will pay $296,964.00 in taxes till the age of 90
You will pay $195,681 more taxes with a 401(k), so in a sense, yes even by choosing to contribute less in your after tax (68 instead of 100).
It doesn’t change the tax payment narrative after retirement. With an after tax-account, You’ll pay 0% (if you stay in the 12% bracket). With the 401(k) distributions you’ll pay taxes till the day you die, vastly out-costing the tax-break you enjoyed pre-retirement.
The bigger question becomes, if you choose/are-only-able to invest the remaining dollars (the 68, instead of 100), will there be enough at retirement age to last till death. In the case of an 11% contribution, yes, anything less than 10%; ehhh, it would depend on other factors (like SSN)
(all of this applies to federal tax, and assumes starting retirement in 12% bracket)
Thank you for doing all the math for me!
This is right in my wheelhouse, but I’m struggling to understand where the math is coming from. I’ve read through this several times and something isn’t clicking for me. Is it possible that you’re not taking into consideration the yearly taxation of the growth of the non-retirement account? For example: Year 1, $1000 grows to $1100 but you pay $20 in taxes so you end up with $1080. Now instead of $1100 growing it’s $1080, and so on. I know the taxation of capital gains vs IRA distributions is different, but I still can’t see the massive gap you’re referring to. If anything, invest it into a Roth 401k (if available) and you overcome any benefits from investing outside a 401k.
On a side note, planning for tax considerations in 10+ years is super difficult due to things changing. Of course, I don’t recommend NOT planning either 🙂
Roth IRA would indeed be better, but has more limited funding possibilities (unless it’s a Roth 401(k), which I’m not sure all employers provide).
There are no taxes on yearly growth (unrealized gains) in an after-tax investment account (other than dividends). You only pay capital gains taxes when you sell your shares. If you can live within the 12% tax bracket (That is, if after retirement your majority of income is capital gains and remains below 77K) you will pay 0% tax.
As far as planning based on taxation for the long-term should it’s not gauranteed but its the best we have. The tax code is changing for 2018 but that’s the first overhaul was 31 years ago.
Ahhhh! My head is swimming with these numbers but I get the theory. Holy crap, young people need to see this post. And that’s an excellent point about deferring self-discipline and automation.
I know, there is a lot of math there. The way it drove home for me was when I converted 40K from my 401(k) to my Roth IRA. I’ve been retired almost 4 years and basically have paid no federal tax based on stock sales because I live within the current 15% tax bracket (taxes incurred by dividends, were offset by deductibles).
I touch my 401(k) and suddenly I’m taxed again (as you would if you took out money from your 401(k) after 59.5). Made me think, and subsequently draw some conclusions.
The only scenario where your arguement is true is the one where the after market withdrawals pay 0 percent capital gains. Otherwise the 401k comes out ahead. Paying the ordinary income tax on the investment or the ordinary Income tax on the result is a wash at the same tax rate. Why, because you get the return on the taxable amount of the after tax which nets them out. The 401k benefit is it avoids the additional cap gains while after tax except tax advantaged does not. Given cap gains start at 77k a year at 15 percent it depends on what you expect in 401k output. It also depends on your inputs and future tax law. If your currently in the bracket over 77k then your current tax rate is greater then it will be if it’s under 77 k in retirement, giving you tax relief based on a bracket reduction. If your over 77 k in retirement cap gains kicks in and you save 15 percent. Now if you start under 77 k and stay there you might have a point.
Keep in mind this assumes you invest the portion of the 401k that would otherwise be taxed going into an after tax account, which adds to your investing principal. If you invest in a 401k to have more cash to party then all bets are off.
Absolutely, one should be disciplined to invest the remainder. Which is probably why 401(k)s (despite their taxation) are still the best option for most people. I do worry about those that don’t have that discipline. Once their 401(k) becomes available for distribution there is no-one or nothing in place to stop them partying on.
I think I agree (mostly) on your first comment. Although, I still have the feeling you you may be better off even if you need more than 77K a year.
After retirement you pay regular income on the entire distribution from your 401(k). So if you withdraw 90K from your 401(k) because that is what you need you will fall within the higher than 12% bracket (new 2018 bracket).
If you withdraw 90K from your after-tax account, chances are you are still within the 12% bracket as your income is only the capital gains. If your investments quadrupled over time, only 67,500 would be capital gains/income. I’m pretty sure you would still pay 0%
Once you’re financial annual needs do exceed capital gains of 77K you would fall in pretty much the same tax brackets.
This is kind of where the second part of the story around 401(k) bugs me. The other line your fed is, you’ll live on less when in retirement and therefor will most likely be in a lower tax bracket.
“The often touted reason of, paying less taxes when contributing to a 401(k), is a myth!”
Say it ain’t so! Sadly, I’m afraid you’re right, my friend. I ran an experiment a few years ago to see which was better, the Roth or the 401(k). Turns out, at least in my shoddy experiment, that there was no tax advantage to the 401(k). Anyway, before I even conducted this experiment, I put more money into my brokerage account than my Roth and 401(k). It was only later in my investing career that I stopped putting money into our brokerage account and started to max out my 401(k). I can’t tell you why I did this, I just did. And thank God I did. Half of my portfolio is now in my brokerage account. And now I have access to a lot of tax-free capital gains if I need them. Great freakin’ post, Maarten. Thank you.
Thx, good thing you went half the other way. I did too but just not enough, hence the Roth IRA conversion ladder today.
Sadly it seems like another example of “I want it now. I’ll take some credit (tax break) today” and pay it off later. Not being fully aware of how much that later may cost you.
While researching this, I learned about the Roth 401(k). Never heard of it before but it seems more attractive to me.
I had this same conversation with a friend about a year ago. He was putting all of his retirement income into Roth accounts (Roth 401k w/ employer) and I was doing the traditional, pre-tax route. The basis of the conversation was the same – pay the taxes now and live tax free in retirement.
But there was something missing – the ability to have more money right now and put it to work. By contributing pre-tax dollars, your take home pay is higher (because you avoid tax). This becomes more significant as you rise up the income tax brackets.
The kicker is that you must take that additional take-home pay and invest it (Roth, then taxable). By reducing your taxes with pre-tax contributions, you are able to save more of that money now, allowing it to grow over a longer period of time. Instead of $18,000 into a Roth 401(k) right now, you could save $18,000 in a traditional 401(k) and $5,000 in a Roth IRA with the tax savings.
You could also use the tax savings to invest in a business or real estate or any other way to earn income for yourself.
That, in my opinion, is why the tax break be so beneficial.
I don’t think there is a wrong way to go about it. Rather, a preference for more money now and the ability to invest more, but taxes later or less money now and no taxes later.
See the your “kicker” is where I see it fall apart. Remember that fidelity rep that came to your company to explain the 401(k). I don’t think his/her sales pitch was “get a tax break today, so you can invest what you save on taxes”. It was probably “So you can save for that trip to Disney”.
Only rational VERY PF-aware individuals would take your approach. That Rollover I did last year was from my very first 401(k) 20 years ago. Even I, at that time I had other things on my mind to do with that tax “break”.
You are right, it does take discipline to save the additional cash versus spend it. That trip to Disney does sound like more fun! So, I agree with you there.
Either way is a fair option, and a Roth can benefit folks in low income tax brackets the most, especially when they are young. All depends on how you plan to use the money if saving with pre-tax dollars.
Enjoyed the viewpoint presented in this post!
I certainly do not want to dismiss the 401(k) and like I stated in the article, the common matching makes up for much of my grievance. Also a premise to this article is an expect tax bracket of 12% in retirement. I Do wish I had heard of the Roth 401(k) earlier than I did.
I’m sorry but this is just a ridiculous article. The math is terribly flawed.
In the examples at the bottom, the 401k yields the same contributions and investment amount as the taxable account. And of course the taxes paid are less with the 401k (although I’m not quite clear on what these taxes respresent since the 401k contribution is fully tax deductible and there would be zero taxes associated with the 401k amount contributed). At that point the author seems to assume you take the 401k tax savings, put it in a vault and bury it in the back yard. Most normal people instead would take that tax savings and invest it. Either by increasing the 401k, or in a Roth IRA, or in a taxable account, and of course that savings will grow. But the author doesn’t do that. He compares the tax avoided at the beginning, decades before and not compounded, to the tax taken out at the end, which of course is bigger, because the 401k grew, a lot!
Then he says that due to “inflation” at 73 years old the 401k investor goes from 12% to 22%. I’m assuming the author is not aware that tax brackets are adjusted for inflation. But somehow the after tax account magically stays in the 0% rate from here to eternity.
Then in his example 2 the author is seemingly befuddled by the fact that the larger 401k account due to the matching has even HIGHER taxes. God forbid you accumulate more money which results in higher taxes.
Example 3 compares a hypothetical 3% “self match” that magically comes from somewhere.
Finally, if one really believed after tax was better than pre tax then go with Roth 401ks and Roth IRAs which will always do better than a taxable account.
Thank you. You are correct. The math is flawed (no need to call it ridiculous, I did ask for someone to point out where I screwed up).
Your remark about me not adjusting tax brackets for inflation was correct. It in itself didn’t make the huge difference. I also did not adjust the standard deductible for inflation. Due to it, at age 90 it was still at 24,000 and not the 105,000 it would be when adjusted for inflation.
I’ve changed the numbers to reflect.
Scenario 2:
This scenario is a flawed comparison as your after-tax accounts will run out 13 year prior to the 401(k) option. I will remove that scenario (no befuddlement, I did point out the flaw, but you’re correct it doesn’t add anything).
Example 3 compares a hypothetical 3% “self-match” that magically comes from somewhere.
The 3% does appear magically but from self-discipline by lowering your budget. Somehow, in your world everyone is smart enough to re-invest the tax break they get from their 401(k) but too stupid to lower their expenses (hmm, I’ll take the high road here).
The reason I did not want to bring up Roth IRA is because it’s limited to $5,500 annually and the reason I did not bring up the Roth 401(k) is because I don’t think it is offered widely (it wasn’t in my company).
But for the sake of argument let’s change the after-tax account with a Roth 401(k). You’ll contribute 8% like the 401(k) and your company matches 3% (no need to conjure up the 3%).
In that case
401(k)
Taxes paid over lifetime (until money runs out at 90): $294,926
Roth 401(k)
Taxes paid over lifetime (until money runs out at 77): $193,246 (still 0 taxes after retirement)
Taxes paid less over your lifetime: $101,679.22
So, one might argue the myth of 401(k) tax breaks is a little left standing.
I will update with the newly added inflation adjusted tax bracket and inflation adjusted standard deductibles.
Some constructive criticism in return; next time you need to comment, leave out words like ridiculous and befuddled. I blog for the fun of it, I spend a lot of time doing this and like everyone else I make mistakes. Don’t spoil the fun.
Maarten,
Respectfully, your analyses are not fair comparisons. They are comparing apples and oranges. If you’re attempting to compare the tax break of a tax-deferred account to a taxable account, you have to account for taxes properly, or your analysis won’t be valid. In this post, it seems you are not accounting for the fact that $1 pre-tax is not equivalent to $1 after-tax. This is a huge flaw*.
The concept of the enormous tax break offered by traditional tax-advantaged accounts used to confuse me, also. A gracious financial journalist finally cleared things up for me with this response to my query:
“think of a tax-deductible retirement account as a partnership between you and uncle sam. presume you’re in the 25% tax bracket. when you put in $1, it’s really like you’re putting 75 cents of after-tax income and uncle sam is kicking in 25 cents. ten years later, the account has doubled to $2 and you’re still in the 25% tax bracket. you pull out your $2, paying 25% or 50 cents to uncle sam, leaving you with $1.50. in effect, you got 100% tax-free growth on your initial 75 cent after-tax investment.
“by contrast, suppose you had skipped the retirement account, stuck the 75 cents in a taxable and bought the same investment, so that your money again doubled to $1.50. all even? no, because when you sell the investment in the taxable account, you’ll have to pay capital-gains taxes–and thus you would have done better with the tax-deductible retirement account.”
And that’s not all: In a taxable account you’ll also be paying taxes on dividends and capital gains distributions (in the case of actively managed mutual funds) every year.
But the big revelation was this part: Assuming a constant tax rate, the tax-deferred account provides TAX-FREE GROWTH. (If taxes are lower in retirement than they were at the time of contribution, you make out even better!) It’s easy to see that a Roth account offers tax-free growth. It’s a little trickier to see that a traditional account offers exactly the same tax-free growth, under a constant tax rate assumption.
One point of confusion is the absolute dollar value of the taxes paid under the two different types of tax-advantaged accounts. But if your objective is to maximize after-tax spendable dollars, as it should be, the amount of taxes paid becomes irrelevant. It’s not what you pay in taxes, it’s how much you get to keep.
There is an example written up here, with a valid comparison of traditional and Roth accounts. You can easily extend the comparison to a taxable account to see that a taxable account leaves you with the least spendable dollars of all, due to annual taxation on dividends and other taxable distributions, and the final taxation on realized capital gains.
https://www.bogleheads.org/wiki/Traditional_versus_Roth#Taxes
* If, for some reason, you aren’t convinced it’s appropriate to compare equivalent dollars, then how would you propose accounting for the higher standard of living you get to enjoy if you assume you’ll be spending the initial tax break you get with a tax-deferred account?
Yes, what you say applies to the 25% tax bracket. What you miss here is that all examples assume the 12% tax bracket (most Americans don’t enjoy the 25% bracket). My point is that at 12% you pay NO taxes on on the after tax account. Long term capital gains for 12% tax bracket is 0%.
I like the single dollar examples but here’s the reality: I’m a 47 year old in retirement that pays $0 in federal taxes because I live within the 12% bracket (and intend to stay there). I got a $3,000 tax break (back in 2001) on the shares I sold last year and paid $4,500 in taxes on it last year. The Tax man is the winner here.
Here is my story to counter the journalist:
“think of a tax-deductible retirement account as a loan from uncle Sam. Presume you’re in the 12% tax bracket. when you put in $1, it’s really like you’re putting $1 of after-tax income and uncle Sam lending you 12 cents. thirty years later, the account has ten folded to $10 and you’re still in the 12% tax bracket. you pull out your $10, paying 12% or $1.20 cents to uncle sam, leaving you with $8.80.
“by contrast, suppose you had skipped the government loan of 12 cents, but paid it up front, stuck the full $1 in a taxable and bought the same investment, so that your money again ten fold to $10.
all even? no, because when you sell the investment in the taxable account, you’ll have to pay 0% capital-gains taxes–and thus you’re left with $10 (instead of the $8.80 from your retirement account). you would have done better with the after tax account.”
You argue that you would have paid taxes over the dividends in the after tax account. You are correct, I would have paid 12% over 2% dividends on SPY totaling $0.27 for the full 10 years, which would leave me with $9.73 (still better than the $8.80 from my pre-tax account).
* I very much disagree with the notion that having more dollars to spend makes for a higher standard of life (especially citing 25% bracket examples). Clearly we define standard of life in very different ways.
Maarten,
In effect, part of your argument is that a taxable account will function like a Roth account, as long as you don’t have to pay any taxes on the capital gains. Okay. So there are two important points to consider. First, you still pay taxes on dividends every year, so there is one difference. Second, tax rates can change on a dime, as we’ve just witnessed. There are no guarantees an investor paying zero capital gains taxes today will still be paying zero capital gains taxes in the future.
More importantly, the most seriously flawed part or your argument is that you are still refusing to compare equivalent dollars!
If you “suppose you had skipped the government loan of 12 cents,” then, sorry, you no longer have the full $1 to deposit in a taxable account. For every dollar you earn at a job, you have the choice of putting the full dollar in a tax-deferred account, or you can pay taxes on it, and use whatever is left over as you see fit, including invest it. But it takes you more than $1 pre-tax to invest each $1 after-tax. They are simply not equivalent dollars! You just admitted that you didn’t get the 12 cent loan from the government, so where did the extra 12 cents come from for deposit in the taxable account?
You seem very committed to your perspective. But without accounting for the initial tax of your income for any after-tax accounts, your logic is flawed. I’ve tried to help you to see that. If you chose to ignore the flaw in your logic, after it is pointed out, that is completely your choice.
There are far worse mistakes an investor can make than favoring a taxable account over a tax-advantaged account based on flawed logic. (And I know this from experience, having both used the same flawed logic you are stuck in, and having made worse mistakes.)
I wish you well.
This to me is the core of the issue with all of this: You make the presumption that one cannot conjure up the 12 cents if the government doesn’t give it to you. if you you don’t get the tax break you can only invest 88 cents. This is where the flaw lies. Not the math. You’re math is solid when you say investing a dollar yields more than investing 88 cents.
it takes you more than $1 pre-tax to invest each $1 after-tax: It does, and I prefer paying 12c tax over that dollar today than $1.20 years later.
Your argument is all about absolute math and ignores the fact that though a little life change you can get the same returns and be less beholden to government.
I’m saying, don’t look at the government for that extra 12 cents (and owe then 1.20 30 years later) but instead spend a little less and use the 12 cents saved to invest (be it via a Roth 401(k) or after tax investment). To show it’s not that hard to find that extra 12 cents I just published a new post Ways to Save $2,220 a Year
You’ll owe the government much less over the next 30 years and beyond even with the negligent dividend taxes included.
People just love to take money (that they don’t really have) like loans to buy a boat or loans to build a kitchen or like 12 cents from the government today to invest. All of them to be paid back later in life with interest.
If you opted for a Roth 401(k) and muster the strength to find that extra 12c elsewhere, you’ll get the exact same returns with less taxes.
As for not knowing what rates look like tomorrow, weak tea (especially, considering in your last comment you assumed taxes would the same or lower in retirement. You math can make assumptions but I can’t?);
Thank you for trying to make me see the light but I think I’ll go back to enjoying early retirement. The one I reached at 43 by doing everything people told me was wrong.