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Comment by mrb | Hacker News Reader

With no employer match, a 401k has ZERO tax advantages. Because it merely delays when your income is taxed: after withdrawing it from the 401k. Mathematically you end up with the same capital whether your pay income taxes today and invest post-tax money, or whether you invest in a pre-tax 401k and pay taxes later.

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> With no employer match, a 401k has ZERO tax advantages. Because it merely delays when your income is taxed: after withdrawing it from the 401k. Mathematically you end up with the same capital whether your pay income taxes today and invest post-tax money, or whether you invest in a pre-tax 401k and pay taxes later.

If you are paying a higher marginal income tax rate now than you will be when you retire (before considering the income from withdrawing retirement investments), you are better off with a tax deferred retirement account.

If you are paying a lower marginal income tax rate now than you will be when you retire (before considering the income from withdrawing retirement investments), you are better off without a tax-deferred retirement account.

For most people, the former is more likely than the latter.

That's not true: the capital gains you accumulate are pre-tax, so your entire investment is taxed once, upon withdrawal, as income. With up-front taxation you still end up paying additional capital gains taxes at the end of the day on your total capital gain.

There are conceivable situations where you end up paying more in taxes, if your retirement income tax rate is higher than your current income tax rate plus your capital gains rate multiplied by the ratio of capital gains to the total capital.

I've spreadsheeted it out and using a 30 year timeline and what I most would consider an extremely conservative rate of return, you end up with about 15% total advantage. This can go up to 20 to 25% if you assume more aggressive returns.

Despite that, I hate the fact that your money is locked up and there is a severe penalty if you pull it out (except in a few situations, and even then the amount you can pull is limited.)

Is it worth 15% of your money for it to be truly your money? It is to me, but that's a subjective call.

401(k)s are also generally protected from creditors in bankruptcy cases and from being subject to seizure from an adverse lawsuit settlement.

Hopefully few people will come to need such protections, but that's an additional way to keep it "truly your money".

> With up-front taxation you still end up paying additional capital gains taxes at the end of the day on your total capital gain.

Not true if it is a Roth IRA, which is post-tax contribution but tax free on withdrawal.

Of course.

A Roth IRA almost always makes sense, which is why they are so limited.

> A Roth IRA almost always makes sense, which is why they are so limited.

A Roth IRA makes sense in two circumstances:

1) You have maxed out contributions to tax-deferred retirement accounts, such that the only options for additional retirement savings are Roth IRA or regular investments with no special tax benefits (i.e., post-tax contribution and capital gains tax on withdrawals.), or

2) you expect to be at a retirement-savings-excluded income esuch that the average tax on withdrawals from your retirement savings would, if taxed as income, be greater than the taxes you pay on current-year income. (Otherwise, your better off with a tax-deferred vehicle than a Roth IRA.)

That's not how it works. You pay last-dollar taxes on the money that would otherwise go into the 401k. You pay first-dollar taxes it when you withdraw at retirement. The first-dollar taxes are lower up to the tax bracket you'd otherwise be in if you didn't contribute to the 401k, unless you have additional sources of retirement income.

Even without an employer match, the 401k has the advantage that interest is not taxed. This makes a big difference over the course of a career.

Mathematically you end up with the same capital whether your pay income taxes today and invest post-tax money

No.

___

Put $100 in an IRA.

    [$100]

Quadruple your money by keeping it in an index fund for a couple decades.

    [$400]

Pay 25% income tax on the money.

    [$300]

Spend $300 in retirement.

---

Or,

___

Earn $100.

    [$100]

Pay 25% income tax on the money today.

    [$75]

Quadruple your money by keeping it in an index fund for a couple decades.

    [$300]

Pay 15% capital gains tax on the $225 gain.

    [$266.25]

Spend $266.25 in retirement.

---

But you could also tell this story:

___

Put $100 in an IRA.

    [$100]

Double your money in some garbage high-fee actively managed fund your boss's boss picked out based on the quality of strippers the investment advisor hired when he sold your company the plan. Your awful 401k offered limited investment options and the rest were even worse.

    [$200]

Pay 25% income tax on the money.

    [$150]

Spend $150 in retirement.

---

But lobbying your boss to get low-fee index funds into the 401k plan doesn't fit on a card. It's still the kind of thing a wise planner needs to do sometimes.

Oh my. I did not know capital gains tax did not apply to 401(k) plans!

Let's try with some numbers. First, let's invest $1000 post-tax, for a number of years, where we end up doubling (getting 200%) return on investment after a number of years.. Assume tax is 25%. So you are investing $750. Your return on investment is $1500, but that get's taxed at 25%, so you actually are getting $1125. Add that to your original $750 investment, and you have a total of $1875.

Now let's do this pre-tax money (401k). $1000 invested, with 200% return, gives you $2000 profit, or $3000 with the initial investment. Now take 25% tax out of that 3000, you end up with $2250 at the end. So you get a total of $375 advantage with the 401k route.

Oh, and during retirement, you will most likely live on a reduced gross income (you aren't paying FICA, your house is paid for already, and you also [might] get social security income). Which means, with our graduated tax system, your overall tax rate is less then, for an even better tax savings (you only pay taxes on the amount of 401k that you withdraw each year).

That's not true if your tax rate changes over time, which it probably will. Specifically, when you withdraw during retirement it is likely you will not be earning much and your tax rate will be much lower than when you were working full time.

If it is the case that you are going to move money around between funds then would the 401K would provide a benefit?Because you wouldn't have to pay capital gains tax every time you switch and have made money?

That's only true if you expect to earn the same amount (or more specifically, to be at the same tax rate) while putting money in as you will while taking money out.

you could be even worse off, if the income is taxed later at a higher rate.

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