Tuesday, April 28, 2009

Investing in a 401k may not be a good idea


Posted by Stephen Mills; Group 1a
  • Tax Rates Will Rise - A tax break today doesn’t seem like such a good deal anymore if you end up having to pay a much higher rate upon withdrawal. With a $10 trillion national debt, continuing budget deficits, and staggeringly large entitlement obligations for Social Security and Medicare, many if not most observers predict the U.S. government will have no choice but to raise taxes significantly in the future. After all, we can only live off borrowed money for so long. If taxes are raised significantly in the future, the scales tip more in favor of paying taxes now rather than later. A Roth IRA would be the most obvious alternative.
  • You Owe Income Tax On All Gains - In a 401k, there is no such thing as a capital gain: it is all considered regular income by the IRS and thus taxed at the highest possible rates. For some asset classes that throw off a lot of taxable income such as corporate bonds or REITs, this is fine since relatively little of their long-term return comes from capital gains. For low-cost index funds, growth stock mutual funds, and other low-turnover, equity-based investment strategies, however, this is a significant disadvantage. Since practically all of an index fund’s return comes in the form of long-term capital gains, the value of the tax deferral is minimized: these funds would be very tax-efficient anyway. “But you still start with more money in the beginning because you save on taxes,” you might say. This is true, but that isn’t necessarily enough to overcome the twin disadvantages of high-cost, low-quality investment choices prevalent in most 401k plans. Lazy Man And Money does the math here.
  • 401ks Have Expensive, Sub-par Investment Options - On average, I have found this to be true. Sure, some larger companies administer their 401k plans through Vanguard or one of the other top mutual fund companies and offer low-cost, high-quality investment options to their employees but in my experience, this is rare. I have never in my life had a decent 401k plan, in fact. Many contend it’s better to forgo the tax deferral in favor of superior investment options, and this is certainly sometimes the case.
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