Are you a sucker to invest in a 401(k)?

One theory making the rounds these days holds that 401(k)s are tax traps. Here's why that's wrong.

Money Magazine) -- As a Money reader, you're likely well aware of the wonders of a 401(k). You don't pay up-front taxes on the money you contribute, and you don't owe taxes on your investment earnings until you withdraw the cash in retirement.

But some financial advisers (and a couple of books) have begun to voice a dissenting view: If you invest in your 401(k), they say, you'll end up paying more in taxes than you have to.

On the face of it, this argument looks plausible. If you buy stocks or stock mutual funds in a regular brokerage account, you will pay a 15% long-term capital-gains rate when you eventually sell. But you'll have to pay ordinary income tax rates of 28% or even 35% on your 401(k) withdrawals. Could the 401(k) skeptics be right?

Strictly by the numbers
Let's say you put $10,000 in your 401(k) and invest in a stock-index fund that earns an average of 8% a year. After 20 years it will be worth $46,610. Withdraw the money all at once and you'll pay $13,051 in taxes, assuming you're in the 28% bracket, leaving you $33,559 to spend.

But what if instead you had bought that tax-efficient stock fund outside your plan? Wouldn't your tax bill be lower?

Yes, but that's the wrong way to look at it.

If you skip your 401(k) in favor of a taxable account, you must first shell out taxes on that $10,000, which leaves you with just $7,200 to invest (assuming the same 28% bracket).

Plus, over the next 20 years, you'll have taxes on any dividends and gains the fund pays out. Even though you will get a lower 15% rate on your gains when you sell, you end up with $28,950, or about $4,600 less than with the 401(k).

A tinier final tax bill can't make up for having to pay taxes all along.

But wait...
What if you find yourself in a higher tax bracket later on? Well, in this example, you'd have to be in a 38% tax bracket 20 years from now to have made the wrong decision.

While Congress may (okay, will) have raised taxes by then, your bracket might not increase if your income drops in retirement. And the longer you wait to take the money, the more you stand to gain by keeping the money in your 401(k).

Plus, comparing a 401(k) with a stock-index fund is the toughest test, since index funds generate little in the way of tax bills before you sell. If you buy a bond fund, where income is taxed at your ordinary rate, or an actively managed stock fund that distributes more gains than an index fund and triggers a far bigger tax bill for you every year, the difference in favor of the 401(k) account will be even greater.

...and furthermore
This math ignores an employer match in your 401(k), which you are likely to get on at least part of your contribution. Add that in and the 401(k) looks better still.

You do the math
With the 401(k) savings calculator at dinkytown.net, you can compare investing in and out of a 401(k), including the effect of having an employer match in your plan.

The bottom line
Rest assured that deferred investing yields more after-tax dollars.

Prepare For Retirement

Here is an article I found on CNNMoney.com tonight. I think it is very imporant to start investing as soon as possible in order to secure a safe and comfortable retirement. You don't have to be making $100,000 a year to save enough in 20 or 30 years. All you have to do is put away as much as possible aside every month and pretend like it doesn't exist. Here is a calculator which I personally love - http://personal.fidelity.com/toolbox/growth/growth.shtml

Question: I’ve been out of college two years and contribute enough to my 401(k) to get the full employer match. Currently, I’ve got 50% of my 401(k) money in large-cap funds, 20% in small- and mid-caps and 30% in international funds. I’m also planning to start saving an additional $200 a month in a Roth IRA. I’m considering going with a target-date fund but I’m leery of taking a cookie-cutter approach. What do you suggest? —A. B., Pennsylvania

Answer: First, let me congratulate you for getting off to such a great start with your retirement planning. By starting to save so early in your career, you’re dramatically increasing the odds that you’ll have a nest egg large enough to support you in comfort when you’re ready to call it a career.

But don’t just take my word for it. Go to our What You Need To Save calculator, plug in your age, salary and the amount you’ve already set aside for retirement, and you’ll get an estimate of what percentage of your salary you should be saving to be able to retire at 65. You can then compare that figure to what you’re actually doing to see if you’re on track.

You also appear to be doing a good job on the investment front. You’ve spread your money among foreign, large- and small-cap stock funds, which shows that, if nothing else, you’re avoiding the three costly investment errors I’ve written about previously that can undermine the growth of your 401(k).

That said, I notice that you don’t have any money in bond funds. You can certainly argue that an all-equity 401(k) is just fine for someone your age. After all, your retirement stash is going to be invested for decades. So why concern yourself with market drops that may seem scary now but will appear like tiny dips in retrospect? You might as well go for all the gusto you can, right?

Well, at the risk of sounding overly cautious, I think even youngsters like yourself should hedge your bets a bit by holding some bond funds. Although I expect stocks to deliver far higher returns than bonds over the next 40 or so years, there’s always the chance they won’t. And having even a small cushion in bonds may provide enough emotional comfort to prevent you from bailing out of stocks if the market takes a nosedive.

So I’d recommend you consider shaving a bit off your holdings in international, small- and mid-cap funds and building a stake of 10% to 15% of your assets in bonds.

Now, about that Roth IRA.

I could see you going either way with that account. You could create something very similar to your 401(k) portfolio in your Roth by investing in individual funds. Of course, you would have to do a bit of research into the funds before buying them, although you can make that task a lot easier by using our Money 70 list of recommended funds as a starting point. And you would also have to rebalance your portfolio each year so that the varying returns different funds earn don’t push your overall asset mix too far out of whack.

On the other hand, if you don’t feel like evaluating specific funds and doing the annual maintenance in your Roth, you could make things easy on yourself and just buy a target-retirement fund. You would get a ready-made mix of stocks and bonds appropriate for your age, and that mix would morph a bit more toward bonds as you near retirement. In short, you wouldn’t have to do any rebalancing with the Roth; the fund would do it for you. I’m sure you could do just fine with any number of the different target funds out there, but I’m partial to the very reasonably priced ones that made our Money 70 roster.

As for your concern about target funds being a cookie-cutter solution, well, they are in the sense that you’re not getting a blend of stocks and bonds tailored to your specific financial circumstances. Everyone in the fund gets the same asset mix.

But I don’t see that as a major shortcoming. For one thing, left to their own devices many people won’t come close to an appropriate asset allocation on their own. So if a target fund gets you a decent asset mix and a coherent long-term investment strategy, that’s for the good.

You may be able to get a better portfolio by going to an adviser, but on the other hand you may not - and either way you’ll pay an extra expense that many people, especially those just starting out, can’t afford.

Finally, I think going with a target fund can protect us from our worse impulses - namely, the urge to dart in and out of different sectors of the market, move from stocks into cash or bonds, buy into the hot fund du jour, etc. By putting your portfolio strategy on autopilot, I think you’re less likely to engage in self-defeating behavior.

Bottom line: if the ease of putting your Roth IRA money into a target fund appeals to you, I wouldn’t let the cookie-cutter criticism stop you. If you don’t think you’ll rebalance your 401(k) portfolio every year (and most people don’t), you might want to consider a target fund there too, if your plan offers one.

Target funds aren’t perfect. But for people who aren’t likely to do better on their own or don’t want to put in the effort, and people who can’t afford to pay an adviser or just don’t want to, target funds can be an excellent choice.

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