FOOLISH FOUR PORTFOLIO

<THE FOOLISH FOUR>

401(k) Comments
by Robert Sheard

LEXINGTON, KY. (August 19, 1998) -- A couple of readers noticed an article in the Houston Chronicle recently that quoted my views on 401(k) plans, and I'd like to expand on the partial information in that article.

It was a local newspaper article done several months ago that apparently got picked up on the Knight Ridder newswire, but it didn't include the complete context of my statements. In the interview I said that investors who have employer-matched contributions to their 401(k) contributions are in a good position and should take advantage of that match. But beyond the point where your employer stops matching your contributions, it may not be in your best interest to continue contributing to the plan.

Let me give you an example of a case where this may not be your best option. A reader wrote me this morning who's in the 31% tax bracket. If he has an additional $5,000 to invest in his 401(k) plan after his match stops, should he do it? It depends. Most 401(k) plans offer a limited range of mutual funds as investment choices, and as I've written many times, over 80% of all stock mutual funds don't even keep pace with the Standard & Poor's 500 Index over time.

But let's say he can use an index fund. If he invests the $5,000 today and the fund earns the rate of return for the S&P 500 for the last 13 years (17.2%) for the next fifteen years, his investment grows to $54,061. Keep in mind that this entire amount is subject to ordinary income tax since it's pre-tax money. If when he retires he's in the 15% tax bracket, his tax burden on that amount is $8,109. That leaves the real value of his account at $45,952.

As an alternative, he can pay the 31% income tax now on that $5,000, leaving $3,450 to invest, and set it up in a taxable portfolio, managing the investments in a good stock strategy. Let's compare it to the Keystone returns over the same period as our test. Since 1986, the Keystone 10 has earned 26.3%. Investing the $3,450 that's left after income taxes and then paying the 20% capital gains taxes each year, his investment still climbs to $60,500 after fifteen years.

So even after paying the income tax up front at 31% and then paying 20% tax each year on the growth, he's still better off than in the alternative where he deferred taxes until the 15 years ended and was only able to choose an index fund.

Obviously, these return rates can vary and no one knows what the next fifteen years will bring. But my essential point was that if one's 401(k) options are mediocre (or worse) mutual funds, the option to pay the taxes up front and manage the money in a good stock portfolio can often generate a better ultimate portfolio value. You simply have to compare your current and expected tax rates, the alternatives in your retirement plan you can choose among, and the length of time you expect to be investing.

For those of you who asked, then, that's the fuller story behind the abbreviated comments of mine quoted in the news piece in the Houston Chronicle (and perhaps other Knight Ridder papers).

Current Dow Order | 1998 Dow Returns

[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]


08/19/98 Close
Stock  Change   Last 
 -------------------- 
 UK   +   1/16  46.56 
 IP   ---       42.81 
 MO   -   7/16  42.69 
 EK   ---       86.88 
  
 
 
                    Day   Month    Year 
         FOOL-4   -0.18%  -1.11%  12.71% 
         DJIA     -0.25%  -2.14%   9.93% 
         S&P 500  -0.29%  -2.02%  13.15% 
         NASDAQ   -0.67%  -1.59%  17.34% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  206 Eastman Ko    60.56     86.88    43.45% 
  12/31/97  291 Union Carb    42.94     46.56     8.44% 
  12/31/97  289 Int'l Pape    43.13     42.81    -0.72% 
  12/31/97  276 Philip Mor    45.25     42.69    -5.66% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  206 Eastman Ko 12475.88  17896.25  $5420.38 
  12/31/97  291 Union Carb 12494.81  13549.69  $1054.88 
  12/31/97  289 Int'l Pape 12463.13  12372.81   -$90.31 
  12/31/97  276 Philip Mor 12489.00  11781.75  -$707.25 
  
  
                              CASH    $754.73 
                             TOTAL  $56355.23