Wednesday, February 27, 2008

Sucker to invest in 401k?

Recently an article in Money Magazine poses the question about whether it is foolish to invest in a 401k? The article states that some advisors are saying that it will cost you more to invest in a 401k than a regular taxable account. The reason is that when you start drawing on a 401k, it is at regular income tax rates. However in a taxable account, you might only pay 15% to long term capital gains.

The article goes on to explain why not investing in a 401k is a bad idea. That you will end up with less money because the initial investment is less due to taxes. Hence, the amount saved grows slower.

But there is the argument what if tax rates go up and you find yourself in a higher bracket? Right now are the lowest tax brackets in a long time, and it can only go up from here. So what happens if you pay 40% instead of 28% now?

I think these are valid concerns and points. However, by deferring the taxes on your investments in a 401k, you have an opportunity for the money to grow faster. Also you aren't paying taxes twice, just once. In a regular account you will pay taxes as you put it in (25%, and when you have gains 15%), so there is a double taxation. In a 401k, even if the rate is higher in 30 years, you'll only pay it once.

Another more pressing factor is the ease of saving directly from a paycheck. It is a lot easier to save when it's on automatic investment. How many people would actually save money if they had to set up an investment account, direct deposit, etc? If people find saving into a 401k difficult, I can only imagine how much fewer people would save into a taxable account. I would hazard less than 75% would even do it.

So maybe, there is a valid concern to investing in a 401k could cost you more in the long run. However if it means not saving for retirement versus saving, I'd rather gamble on paying higher taxes rather than not saving at all for retirement.

2 comments:

Master Your Card said...

Hey great post! I've always heard maxing out your 401k is the best way to keep up your standard of living when you retire - good to know it's accurate!

Jonathan

Anonymous said...

Any question regarding retirement and the future will depend on what they will be doing with the tax rates. There simply isn't a good answer.

However, wouldn't one who is worried about this then invest in a Roth rather than an account that doesn't get some sort of tax preference?

CJ