Rebuttal: Ditching The 401k Is A Favor To The Taxman, But It Ruins Your Returns

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Includes: SPY
by: Colorado Wealth Management Fund

Summary

The value of pretax savings was not compounded throughout the original article.

The assumed tax rate was absurdly low for the income level of Seeking Alpha’s audience.

There are several benefits to the retirement account that are difficult to quantify.

This article is a rebuttal to a piece on ditching the 401k. While I enjoyed reading through the article, I found some significant issues that were not addressed that substantially weaken the argument that was presented. In the interest of ensuring readers see both sides of the issue from proponents, rather than from a straw man, I will be providing the argument for utilizing the 401k.

The match has a catch is true

Frequently employers do have a vesting schedule that significantly weakens the value of the employer match. While it would be nice for employees to avoid that kind of a situation, it isn't reasonable for employees to have to turn down jobs on the basis of a vesting schedule. My wife was lucky and found a great job that vested the employer match immediately. That was great because we were getting the heck out of there and moving to Colorado. For many employees, that isn't an option. In my opinion, advisors treating the employer match (with a vesting schedule) as free money are out of touch with the employment market. I'll grant that the original author got this right.

Pretax savings - the savings that were misunderstood

The original piece used this chart:

Following the logic, he then proposed that a $300 increase in take home pay was slightly more than a 1% increase in effective pay. That is true, but it is also very misleading. The value of the pretax nature of plans should not be shortened to being an increase in take home pay.

It also drops to a 15% tax rate, which I would use if the audience was actually facing a 15% tax rate. If you're still working and you are only paying 15% (counting state taxes), please call me out in the comments. I doubt more than a couple of people reading this article are working and only paying 15% on their marginal income. It might be possible for a few residents in the states that don't charge income tax, but I expect this is pretty rare among the people that read Seeking Alpha.

Actual value of delaying taxation

I put together a chart that I believe is much more applicable to the general readership of SA. I believe 25% is a more reasonable expectation for taxation levels for the readership, so I used 25% in my example. Remember that a traditional retirement account still has taxes applied on distribution. There are a few "issues" with the assumptions that make it impossible for any example to apply to all readers; I'll tackle those issues in a bit. I assumed that the portfolio could face short-term gains, interest income taxes, or REIT income taxes, so I treated all gains at the 25% tax rate.

Here is the chart showing the value of one year of contributions, made 25 years before retirement, of either 10,000 pretax into a 401k or 7,500 post tax into an individual asset management account.

The original logic would just see a difference in take home pay, but I see an improvement in the value of compounding every single year because the dividends, interest, and capital gains are not being taxed. The difficulty here is that if the investor was investing in individual stocks that did not pay any dividends and never sold his positions, then those gains would all be unrealized capital gains, and in theory, they would also compound without taxation issues. In my opinion, the reality is probably somewhere in between. Investing in individual stocks with only 7,500 in assets under management, in my opinion, is a terrible strategy that would expose an investor to a much higher standard deviation of returns and possibly trading costs (depending on the number of stocks) compared to simply buying the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and being done with it.

Issues

I'd like to address several of the other benefits or weaknesses that are more difficult to quantify.

The 401k prevents bad investor behavior

The retail investor has a tendency to sell low and buy high. When an investor simply sets their paycheck to be automatically invested in SPY every month and then forgets about it, the investor will benefit from DCA (dollar cost averaging). By having a natural dollar cost averaging impact and making it much more difficult for investors to sell at the wrong time, human behavior is dramatically improved.

The tax rate I selected is too high or too low

Even if I applied charts with every federal tax rate, they would still be wrong for most investors because of state tax rates. Therefore, investors wanting exact numbers would need to run their own numbers.

Long-term holders gain growth in share value without taxation

That's true. However, if they are buying into any entity that is buying and selling shares, they may be exposed to capital gains at either short-term or long-term rates.

Some 401k plans have terrible options

That's a fair critique and it is one that isn't mentioned enough. Some plans do have options that are simply bad. Over the long haul, I don't want a mutual fund charging a high expense ratio to attempt to duplicate SPY; I'd rather just have SPY and get rid of the highly compensated "manager".

However, if an employee leaves their job, they can transfer the 401k into their IRA, which means they'll be able to invest in the securities offered to them in that plan.

Taxation rates change

When employees invest in a 401k, the actual taxation rates they will pay are unknown. To be fair, employees buying stocks in any company also face unknown taxation rates. We can only create estimates. However, I believe in planning for the worst case scenario. If the U.S. tax code does not change, then an investor in the U.S. who is facing a 25% tax rate in retirement is doing pretty darn great. If the investor failed to save and prepare for retirement, they may face a lower taxation rate on distributions in retirement than the rate they avoided when they made the contributions many years ago. Again, I am not providing tax advice.

Conclusion

The benefits of the 401k specifically, such as employer matching, may be oversold. However, the benefits of passive investing and compounding without taxation are dramatic and frequently undersold. While the benefits of having the money invested "before the employee sees it" are fairly substantial for the population in general, the readership of Seeking Alpha is not characterized by a failure to put away money for investing. The bigger risk would be selling in panic or buying in euphoria. Those events can substantially reduce returns over the long term, while dollar cost averaging can significantly improve performance.

Based on my knowledge of finance, I opened a solo 401k with Schwab. In that way, I'm backing up my assessment of the benefits of tax-free compounding by putting in the maximum allowed each year. Also in my personal finances, my wife continues to use the 401k provided by her employer and donates enough to receive the entire match. We do not max out the account each year because after the match is reached I believe it is more important to max out our IRA accounts each year.

Disclaimer: I am not a CPA or other licensed tax professional. I am referring to general situations, not to your individual situation. Consult a tax professional if you want help planning for taxes.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.