Don't Max Out Your 401(k): Part 2

When I wrote "Don't Max Out Your 401(k)" in July, reaction was swift... and informative. Readers emailed and Fool Community members discussed, pointing out many of the factors to be considered when deciding where an investor's retirement money should reside.

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By Robert Brokamp (TMF Bro)
October 1, 2002

There's nothing like a boisterous debate about retirement accounts. (A smackdown over lawn-mowing techniques is a close second.) On July 15, I wrote a Motley Fool Take entitled Don't Max Out Your 401(k). The article inspired more than a few readers to send some thoughts via email, and prompted an enlightening conversation on the Bonds & Fixed Income Investments discussion board. These Fools raised so many good points that I thought it would be worthwhile to take a closer look at the question of how much of your retirement savings should go into your employer-sponsored retirement plan.

First, permit me to reprint the first few paragraphs of the original article:

When it comes to saving for retirement, many Americans first turn to their employer-sponsored plan (401(k), 403(b), 457, etc.). However, in a recent BusinessWeek article, economists Laurence J. Kotlikoff of Boston University and Jagadeesh Gokhale of the Federal Reserve Bank of Cleveland claim that many investors would have more money in retirement if they contributed to accounts other than 401(k)s.

Their primary reason: Withdrawals from 401(k) accounts are taxed as ordinary income, instead of at the lower rates of long-term capital gains. Not only does this reduce the after-tax benefit of a 401(k), but it might push retirees into a higher tax bracket and thus subject more Social Security benefits to taxes.

If your employer matches your contributions to your retirement plan, you should contribute at least as much to take full advantage of that free money, according to Kotlikoff and Gokhale. After that, you're probably better off putting your money elsewhere, preferably a Roth IRA if you're eligible.

Implicit in this argument is that, if your employer doesn't offer a match, you should contribute the maximum amount to a Roth IRA before even considering another option.

Thanks to the miracle of modern technology, many readers were able to take time out of their workday to provide instant feedback, via email and discussion boards. Some of the comments I received were about my article, some were about the BusinessWeek article. Most of them could be summed up by the following statements.

"You didn't mention that contributions to 401(k)s are made with pre-tax money!"
True enough. Being a responsible adult who believes in personal accountability, I place the blame firmly on Reggie, Jackie, and Bob, our editors, for making me keep the article to 400 words and leave out this important point. (None of the notorious triumvirates -- Marc Antony, Octavian, and Lepidus or Moe, Larry, and Curly -- could hold a candle to our editors.) But the fact that the IRS doesn't consider 401(k) contributions as wages is too important to ignore.

When money is transferred directly from your paycheck to your 401(k), Uncle Sam doesn't take any income taxes (though the Social Security Administration still snatches its share). This can result in some sweet savings. For example, a worker who is in the 27% tax bracket will pay $270 less in income taxes for every $1,000 contributed to her 401(k).

This is a significant factor to take into account when determining whether your retirement savings should go into a 401(k), traditional IRA, Roth IRA, or elsewhere. To help with that determination, you can fiddle with a Roth vs. traditional IRA calculator. (It also can be used to compare a Roth to a 401(k), though it can't take an employer match into account. Choose "Option 1" and compare the results of a Roth IRA to those of a Deductible IRA.)

Believe it or not, the BusinessWeek article found a drawback to the income-tax-free status of 401(k) contributions: Less taxable income could drop you down a tax bracket, which would devalue the benefits of other tax deductions such as mortgage interest.

"Putting retirement money in a taxable account when you have a tax-advantaged option is bunk!"
Kotlikoff and Gokhale argue that a good portion of savings should go into regular taxable accounts. In fact, according to their study, some people shouldn't contribute to a 401(k) at all, such as a couple who are both 45, have a combined income of less than $250,000, and have been contributing 13.5% of their incomes to a 401(k) for 20 years.

It is presumed that, besides contributing to a Roth (if eligible), such investors should buy the stocks of high-quality companies that don't pay significant dividends. Just hold on to these companies for years and years, then pay the 10% or 20% capital gains rate when you sell in retirement, instead of the ordinary income rates that retirees will have to pay on withdrawals from 401(k)s and traditional IRAs.

Well, this got a few pots a-stewin'. Here's what Fool Community member Lokicious had to say:

Let me say again, these "experts" are working from untenable assumptions. They assume that portfolios should be grossly stock heavy, they assume no one will ever sell or rebalance, and they assume people will gradually drip money out of stocks during retirement. Where have they been the last two years?

That about sums it up. If you will be in a higher tax bracket in retirement, and you won't incur many taxes along the way to retirement (because you won't sell your holdings or invest in income-producing securities), it's possible that buying and holding a stock for 20 years will work out better than investing in your 401(k)'s mutual funds. But are those realistic assumptions? Hardly.

"My biggest complaint about my 401(k) is the lack of flexibility. My only investment choices are a bunch of lousy mutual funds."
Yes, 401(k) investors are held captive to their fund choices. We're vigorous proponents of index funds, but they're not very exciting if you have the talent to beat the market. If you think you've got what it takes, Hot Shot, then definitely lean toward an IRA since you can buy individual stocks. But keep your active trading out of regular accounts; the taxes will kill ya.

Fool Community member reallyalldone brought up a couple of other restrictive characteristics of 401(k)s: You have to start taking the money at age 70 1/2 whether you need it or not, and you can't pass the capital gains to your heirs untaxed. Those are worth keeping in mind -- and laws worth monitoring. Estate tax law changes constantly, and some congressfolks have proposed doing away with required distributions.

"Take a look at these sexy pictures!"
That email probably wasn't prompted by my article, but we sure get a lot of porn spam at the Fool. I fear for when my children are of email age. If some of that smut turns up in my daughter's inbox, I'm going to find the guy who sent it, go to his house, and squat naked in front of his TV during the Super Bowl. It won't be a pretty sight.

"Finally someone speaks the truth! People who contribute to 401(k)s lose the ability to deduct capital losses!"
I got an email from an accountant who said that 401(k)s and IRAs are a bad idea because if you sell a security for less than you paid for it, you can't deduct the loss. That seems awfully defeatist to me: Invest for growth, but choose the account that will provide the most benefit in case of a loss. If you find that, over the long term (i.e., longer than the last few years), you're seeing so many losses that it would be better for you to be in a taxable account, perhaps you should evaluate your investment strategy.

"You never call me!"
That one came from my mother.

The moral of this story (and you've heard it before) is that everyone's situation is different; there are few maxims of money management that apply to everyone. That said, all workers should decide the 401(k) vs. Roth dilemma for unmatched contributions. If you don't want to go solo, visit the Retirement Investing discussion board, or enroll in TMF Money Advisor (which comes with a membership to the Fool Community).

Robert Brokamp contributes enough energy to his job to get the full employer match, then puts the rest into large, sweaty, smelly men whom he's never met yet still influence his well-being (i.e., fantasy football).  The Motley Fool is investors writing for investors.