Is it best to put money into 401K and pay taxes at earned income rates or pay taxes up front and pay capital gains and dividend rates?

Answer 1

There are a few different ways to answer this question.

* First, it matters whether or not your employer matches any of your 401(k) contributions. Ninety percent of employers do; if yours does too, you'll want to begin by putting at least as much money into the 401(k) that your company will match. For example, let's say your company will match 25 cents for every dollar you contribute up to 6% of your income. You make $100000 per year; 6% of your income is $6000. So, you contribute $6000 to your 401(k) and your company kicks in $1500 (25 cents for every dollar you put in, up to 6% of your income). You can certainly contribute more than 6% of your income (although no more than 35% of your income or, for 2007, $15500), but you want to give enough to get the company match; otherwise, you're leaving free money on the table.

* Second, regardless of whether or not your company matches your 401(k) contributions, you should consider opening a Roth IRA (individual retirement account). Unlike the 401(k), in which your contributions are pre-tax (meaning that you make your contributions out of your salary and then pay taxes on the amount that's left; that leads to fewer taxes now, but then you pay taxes when you withdraw the money in retirement), Roth IRA contributions are after-tax: you pay taxes now but then you can withdraw the money for free in retirement. This is wonderful for several reasons:

1) Tax rates are at historic lows right now, so the odds are good that we'll all pay significantly more taxes in the future; that makes both the 401(k) option and your idea of investing in the market outside of a retirement account not quite so good. You don't know what the future tax rates will be, and the odds are that they'll be higher; the Roth IRA takes away that problem. Pay (relatively low) taxes now, and take the money out for free later.

2) Since you can't save a significant sum per year in Roth IRAs ($4000 in 2007 if you're under 50), you'll still need to save for retirement in your 401(k) plan (or elsewhere), and so having a 401(k) where you will pay taxes and a Roth IRA where you won't pay taxes gives you what the experts like to call "tax diversification." When you retire, you'll then have some options about which account to pull money from so that, depending on several factors (such as what your income bracket is that year, whether you sold your house or stocks, etc.), you'll be able to decide whether you want to take out money from an account where you'll owe taxes or where you won't.

3) Lastly, since you contribute to a Roth IRA with after-tax dollars, those dollars count for more: you get to keep every single dollar you pull out in retirement. In a 401(k), you'll have to use some of those dollars to pay taxes, so not all of those dollars that you put in the 401(k) are really for you--you're putting away some of them for the IRS.

So--long answer short--your best bet is to invest in your 401(k) first if there is any company match. Don't leave free money on the table--it's like you're forfeiting part of your salary. Invest only up to the match, and then put the rest of your money in a Roth IRA (such as a Vanguard Total Stock Market index fund). Contribute the full $4000/year to a Roth IRA. If you have money leftover you could consider investing it in the market, as the long-term capital gains and dividend rates are likely lower than your tax rate--but that's not a good plan if you're investing this money for retirement, as these rates expire in 2010 and there's no guarantee they'll stay low. So a safer strategy would be to invest the extra money (after you've made a full $4000 contribution to your Roth IRA) back into your 401(k).

AnswerWhile I was typing my contribution someone else submitted one, which actually points out some different takes I hope I address.

This is certainly a question that every financial type has an opinion on. I find it is frequently shaded by where they earn their fees, and which items they weigh more heavily than others. I believe they all would agree that your personal financial situation, age, expected needs, and more, etc., all enter the equation.

Unquestionably, the comparison is really more in line with deciding on contributing to a before tax IRA or an after tax one, called a Roth IRA. I believe that in a 401(k) situation, the fact that there is normally a matching of at least some part of the contribution, by the employer, (frequently 50% of the first 6% of your salary) contribution, would mean virtually everybody would agree that is a "must" take advantage of at least. (You contribute 6% and get credit for 9%). Contributions above that (to the allowed 15% of salary) would be the question.

First most planners would say you need to have some after tax money as an emergency fund…3 to 6 months needs is the amount you commonly hear. Again, more or less depending on your personal situation. But that seems logical and indisputable.

So, once you've done the basic "musts", got an emergency account, taken advantage of matching benefits, paid off credit cards, etc., should you IRA or Roth (or 401k or not) with the additional funds you are saving for long term or retirement?

Personally, I go with some steadfast ideas: Especially as Tax rates are now historically decreasing, the main new tax revenue ideas revolve around making a National sales tax and changing what income is taxable or expenses dedcutible (like eliminating home mortgage interest deduction) or such.. all these things would still effect you if you paid income tax on the current investment funds, yet get you no benefit.

I am a tax expert...(more degrees than a thermometer as the saying goes)…and a tax planning ruke that is virtually ALWAYS true says: …Don't pay taxes now that you can otherwise pay later…

I vote for the before tax investment. (And consider, it isn't just held to retirement, however many years that may be, but may well be finally withdrawn and taxed 20 -30 or more years after retirement).

Some thoughts on that same line: What if the tax ideas we're seeing actually eliminate (or really start to replace) the income tax….do you think the Feds will give you a refund? Unlikely. You'll have paid a tax you don't have to. (Rates, while low , are political suicide to increase, is considered economically regressive, and again, holding rates but increasing the tax base works fine....or going to a new program altogether).

What if your life takes a change....you end up in Europe...or someplace. US ain't sending you a refund.

Pay today means pay the State today. Then retire to Florida ot Nevada, etc. So I would pay NJ (or NY, or Calif, etc.) 9+% now, and like so many, retire where there is no income tax? Bad investment.

Paying with future dollars are deflated dollars.

The more assets you have, the better. Taxes paid are not an asset. Investment accounts are.

Something many seem to ignore: The money in IRA/401k is generally treated specially in many life situations; exempt from bankruptcy/seizure; lawsuit, etc. Your other assets are just an attraction to the vultures.

Very Importantly -- Inherited without tax - giving a new stepped up basis to your beneficiaries (so if you die and paid tax on your invested funds, that is money your family won't get. If you didn't pay the tax, that money will pass to them and essentially NEVER be taxed). And unless you spend all your returement funds (which is uncommon), this may well become a big part of your estate.

While intended for long term and retirement, (a real and big need), it is still available under many programs for housing/education, etc.

Presumably, when your withdrawing from the account your no longer working (even true if a hardship period). Your income is low, your income tax rate is lower. (Your other expenses may be too).

What you withdraw is rateably taxable.

In a taxed account, the gains and dividend taxes really cut into what your realizing on the investments as you go along..agreeably you MAY have to pay them in the future.

However, if you expect to lose money on your investments, do it in a taxable account. (Losses in a taxable account may well be used to offset current income…but not in a non taxable one.)

Finally - Just the idea that the governments solution to fears of social security, economy, etc., and people wanting to save more for retirement is to override years of promoting tax deferring plans, and say essentially, the way to do it is to pay them more taxes now...seems fishy and I'm sort of leary about!