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You might do better without tax deferral [ClearOnMoney]
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You might do better without tax deferral

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Commentary

You might do better without tax deferral

10 Jan 2011 by Jim Fickett.

Investments outside of a 401(k) might perform well enough to more than make up for the loss of tax deferral.

Most investors consider it axiomatic that one should take advantage of any tax deferral available. I.e., the advice often given, and taken at face value, is that one should contribute as much as possible to any available 401(k) plan. Tax deferral is a good thing in and of itself, of course, but there are trade-offs, mainly in the lousy selection of funds usually offered. So it is worth looking at the whole matter quantitatively.

I only want to challenge tax deferral per se. It is important to note that there are other reasons, besides tax deferral, to contribute to a 401(k).

  1. If you receive a company match to some part of your savings, this is a huge benefit. Say the company matches 1-to-1 the first 3% you contribute to a 401(k). That is an immediate 100% return on that portion of your savings - a benefit that should not be refused.
  2. Some find it easier to save with payroll deductions, so you never see the money and are not tempted to spend it. Everyone is different, and perhaps the most important thing you do as an investor is to understand your own strengths and weaknesses, and discover a style that works for you. Saving well is even more important than investing well so, if using automatic contributions to a tax-deferred savings plan helps you save, that is a major consideration.

It is also worth noting that it takes a lot of work to invest well. Not everyone has, or wants to spend, that time. If you don't, then by all means go with some of the basic choices in a 401(k) and have done with it.

Caveats aside, suppose that for some chunk of your savings it is a real choice to save inside a 401(k) or outside. How much difference does it make?

The short answer is less than you might think. A typical professional facing the choice at mid-career would probably see a difference of less than 1% in annualized returns, making the same investments with or without tax deferral.

Let's look at some realistic scenarios. Most of the impact of tax deferral is in one's later working years, given that by then significant savings have accumulated and tax rates are higher. So let's look at the case of someone who is going to work for 20 more years and then, in retirement, have a tax rate that is one-third lower. We'll look at annual yields ranging from 2% to 12%. These are nominal yields, since that is what is taxed, and they represent only the taxable portion of yields, for the same reason. Given that long-term stock returns are about 7% nominal (4% real) but, for the long term investor, much of that is already sheltered until the stock is sold, probably the 4% and 6% values would be most typical. Finally we'll look at overall (not marginal) tax rates of 10%, 20%, or 30%. A typical professional would probably be somewhere around the 20% overall tax rate.

In each cell of the following table are two yields. Each is a compound_annual_growth_rate (CAGR). The first is the CAGR without tax deferral, and the second is the CAGR with tax deferral. The numbers are in bold if the difference is more than one percentage point.

20 years, 1/3 lower tax Tax rate
10% 20% 30%
Yield 2% 1.80%/1.89% 1.60%/1.78% 1.40%/1.66%
4% 3.60%/3.81% 3.20%/3.61% 2.80%/3.41%
6% 5.40%/5.76% 4.80%/5.50% 4.20%/5.23%
8% 7.20%/7.71% 6.40%/7.41% 5.60%/7.09%
10% 9.00%/9.68% 8.00%/9.35% 7.00%/8.99%
12% 10.80%/11.66% 9.60%/11.30% 8.40%/10.91%

For 4% and 6% yields, and a 20% tax rate, the difference in annualized yield between tax-deferred investing and non-tax-deferred investing is less than 1%. Even in the most extreme scenario listed here, 12% nominal yields for someone subject to 30% tax rates, the difference is 2.5%.

My main point, then, is that if you have the time and are willing to work on investing, you may very well do better outside the 401(k). It is not as easy as some people think to add even 1% to annualized returns (though getting rid of excessive fund management fees can be a good start). But it is certainly reasonable to hope to do 2-3% better than the vanilla choices available in many 401(k)'s. In particular, currently, with bonds facing a likely world of rising yields and falling values, and the stock market greatly overvalued, the standard array of stock and bond funds is rather unattractive. In contrast, some of the better managed bond funds, and many individual stocks, remain reasonably valued.

I am not recommending against the usage of 401(k)'s. What I am saying is that the matter deserves some thought, and for some people a mixed strategy will be appropriate.