11

My employer does not match 401k contributions at all.

Currently, I do not make any contributions to a 401k or an IRA due to a need for liquidity.

Aside from the obvious gains incurring no tax liability, is there any benefit for me to contribute to a 401k compared to a relatively high-yield savings account? I'm a 25-year-old married father and homeowner, paying off student loans for myself and my wife, so I'm not earning a large amount in either situation.

Assume monthly/yearly budgeting isn't an issue.

EDIT 1: Clarification - I do plan on eventually getting a 401k account and an IRA account, and am aware of the advantages and limitations of each. However, for the next 58 months, I'm accelerating my loan payments (highest interest first) so that I can eventually have some money to invest in long-term funds.

This question is more specific to the context of being young, fairly new to the workplace, and heavily in student loan debt (negative net worth, by tens of thousands of dollars).

I am currently a young entry-level software developer in the 15% marginal tax bracket (effective rate significantly lower due to student loan and mortgage deductions and child credit).

EDIT 2: Alternative - The "alternative" to 401k contributions is my current course of action: Paying down my existing loan debt and slowly building up a small savings for medium-sized one-off purchases (mostly house-related fixings, since we just bought our house 18 months ago).

  • 8
    Don't invest yet, you should pay off the debt as quickly as you can. – AbraCadaver Oct 16 '14 at 19:47
  • @AbraCadaver That's my current course of action, and it was my suspicion that it was the best approach for now – Noah Oct 16 '14 at 19:51
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    @AbraCadaver: Paying off the debt as quickly as you can is an investment. As long as you don't end up defaulting on the loan, it is 100% guaranteed to yield exactly the APR of your loan, compounded exactly as your loan is compounded, for the full duration of the loan, by reducing the amount of interest you end up paying. And considering that most bank loans have far higher APRs than other safe investments like bonds, yield-wise this is literally one of the best and safest investments you can possibly make, especially early on in the loan. – Mason Wheeler Oct 17 '14 at 0:07
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    @Noah: Don't play the math. It tells you that if your investment yields 6% and car loan is only 2.5% then you make 3.5% by having the loan, which is somewhat true in a perfect situation. However, if you lose your job or some other circumstance, you still owe debt payments. With debt gone you have little to no risk and can live and invest freely however you want. – AbraCadaver Oct 17 '14 at 3:00
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    Is the alternative use of the money a high yield savings account, or is it paying off the student loans? You mention both, and it is not clear what the true alternative is. – jjanes Oct 17 '14 at 4:05
18

The main reasons are that investment are deducted from your gross income and earnings are not taxed until withdrawal. This applies to both traditional IRAs and 401Ks. Roth accounts have different rules but valuable benefits.

Income tax deferral on contributions

My effective income tax rate is around 35%. This means that for every $1000 I earn in wage I only get to keep $650. Since my 401K contributions are deferred reductions from my income I can invest 35% more money into my 401K than I would be able to invest in a non-tax-advantaged account. Where I can invest $1000 into my 401K I would only be able to invest $650 into a non-advantaged account with the same wages.

If I put $650 into an account yielding 10% then my one-year return on my income is $65

The 10% return on my $1000 is $100. Compared to what I would have been able to take home in the first place this makes my ROI $100/$650 = 15.3%

Tax deferral on earnings

Interest earned in non-advantaged accounts incurs taxes every year. Interest earned in advantaged accounts does not incur taxes until withdrawn.

Compounding 10% annually for 20 years is significantly more than 6.5% compounded annually for 20 years.

Imagine 10% on a 1000 investment with no additional cash flows over 20 year. The result is $6727, or 672%. Imagine your income tax rate does not reduce below 35%, your after-tax return is 4372, or %437 return.

Now imagine you pay taxes every year on 10% take, so your take annually is only 6.5%... Now over 20 years you have $3523 (but you've already paid all taxes on this) and your return is %352

You have earned 24% more money because taxes were deferred until withdrawal!

EDIT: Some tabular info for the commenters

+-------------+-------------+-------------+
|      P      |      G      | N(LESS 35%) |
+-------------+-------------+-------------+
|             |             |             |
| 1000        | 1100        | 1065        |
|             |             |             |
| 1065        | 1171.5      | 1134.225    |
|             |             |             |
| 1134.225    | 1247.6475   | 1207.949625 |
|             |             |             |
| 1207.949625 | 1328.744588 | 1286.466351 |
|             |             |             |
| 1286.466351 | 1415.112986 | 1370.086663 |
|             |             |             |
| 1370.086663 | 1507.09533  | 1459.142297 |
|             |             |             |
| 1459.142297 | 1605.056526 | 1553.986546 |
|             |             |             |
| 1553.986546 | 1709.3852   | 1654.995671 |
|             |             |             |
| 1654.995671 | 1820.495238 | 1762.57039  |
|             |             |             |
| 1762.57039  | 1938.827429 | 1877.137465 |
|             |             |             |
| 1877.137465 | 2064.851212 | 1999.151401 |
|             |             |             |
| 1999.151401 | 2199.066541 | 2129.096242 |
|             |             |             |
| 2129.096242 | 2342.005866 | 2267.487497 |
|             |             |             |
| 2267.487497 | 2494.236247 | 2414.874185 |
|             |             |             |
| 2414.874185 | 2656.361603 | 2571.841007 |
|             |             |             |
| 2571.841007 | 2829.025107 | 2739.010672 |
|             |             |             |
| 2739.010672 | 3012.911739 | 2917.046366 |
|             |             |             |
| 2917.046366 | 3208.751002 | 3106.654379 |
|             |             |             |
| 3106.654379 | 3417.319817 | 3308.586914 |
|             |             |             |
| 3308.586914 | 3639.445606 | 3523.645064 |
|             |             |             |
| 3523.645064 | 3876.00957  | 3752.681993 |
+-------------+-------------+-------------+

Your take home from the investment is $3752 because you have diligently paid your taxes every year on the earnings.

Now, with the tax deferred until withdrawal!

+-------------+-------------+-------------+
|      P      |      G      |  N(NO TAX)  |
+-------------+-------------+-------------+
|             |             |             |
| 1000        | 1100        | 1100        |
|             |             |             |
| 1100        | 1210        | 1210        |
|             |             |             |
| 1210        | 1331        | 1331        |
|             |             |             |
| 1331        | 1464.1      | 1464.1      |
|             |             |             |
| 1464.1      | 1610.51     | 1610.51     |
|             |             |             |
| 1610.51     | 1771.561    | 1771.561    |
|             |             |             |
| 1771.561    | 1948.7171   | 1948.7171   |
|             |             |             |
| 1948.7171   | 2143.58881  | 2143.58881  |
|             |             |             |
| 2143.58881  | 2357.947691 | 2357.947691 |
|             |             |             |
| 2357.947691 | 2593.74246  | 2593.74246  |
|             |             |             |
| 2593.74246  | 2853.116706 | 2853.116706 |
|             |             |             |
| 2853.116706 | 3138.428377 | 3138.428377 |
|             |             |             |
| 3138.428377 | 3452.271214 | 3452.271214 |
|             |             |             |
| 3452.271214 | 3797.498336 | 3797.498336 |
|             |             |             |
| 3797.498336 | 4177.248169 | 4177.248169 |
|             |             |             |
| 4177.248169 | 4594.972986 | 4594.972986 |
|             |             |             |
| 4594.972986 | 5054.470285 | 5054.470285 |
|             |             |             |
| 5054.470285 | 5559.917313 | 5559.917313 |
|             |             |             |
| 5559.917313 | 6115.909045 | 6115.909045 |
|             |             |             |
| 6115.909045 | 6727.499949 | 6727.499949 |
|             |             |             |
| 6727.499949 | 7400.249944 | 7400.249944 |
+-------------+-------------+-------------+

You then owe 35% tax on the withdrawal so you keep 7400 * .65 = $4810

$4810 versus $3750 means you have made an additional $1060, or 28%, from the compounding against tax-advantaged earnings.

But Matthew! you say... Annual proceeds from your investments are not taxed at your income tax rate. This is true for now but the political winds are pushing this direction. However, even if you use a reduced rate in the first situation (let's say 30% instead of 35%, if you're a California resident) then the effect is $4140 rather than $3750. Less of a gain, but still a gain. In fact your capital-gains rate would have to be as low as 22% to even this difference out (versus a 35% income tax rate).... And remember that this assumes you're in the same bracket at retirement (which more people are not)

You may also note that I used $1000 as the principle in both calculations. This was intentional to show the effects of compounding the taxable earnings alone. If you replace the taxable principle with $650 instead of $1000 then the effect is even more pronounced and only balanced out if your capital gains rate is actually zero!

  • If your marginal rate is the same at deposit time as it is at withdrawal time, the net effect is identical returns. 1000 * .65 * 4 is the same as 1000 * 4 * .65. (Say a 300% return over time, thus *4) – JoeTaxpayer Oct 16 '14 at 18:54
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    @JoeTaxpayer Compounded interest is non commutative. Even if your tax rate is the same at the point of contribution and withdrawal your earnings over time are absolutely not the same. – Matthew Oct 16 '14 at 19:00
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    @Noah then in your case you might consider a roth account, in which your contributions are taxed but your earnings are tax-exempt. – Matthew Oct 16 '14 at 19:01
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    @Matthew - nice work. +1. I had a senior moment. The math I suggested is correct for Roth vs Pre-Tax, but not for regular growth. – JoeTaxpayer Oct 16 '14 at 20:30
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    @JoeTaxpayer that's correct. If your income tax rate is identical in retirement as it is now then the Roth and Traditional options are equal but they are both still superior to the non-advantaged account – Matthew Oct 17 '14 at 3:30
4

If you are working for a small company, the expense ratios on the funds in the 401k account are likely much higher than you can get with a similar IRA. Depending on your income, whether you are married and want to contribute to a spouse's IRA, your limit on what can be contributed to an IRA may vary, but the compelling reason to contribute to a 401k is that the contribution limit is higher ($17,500 vs $5,500 for people on the lower end of the income scale) so you may need to contribute to a 401k to meet your retirement savings goals.

2

It's tough to avoid the discussion of taxes. Matthew's answer was excellent but of course, tax was part of the discussion.

In an article I wrote a while back, The 15% solution, I described how one can optimize taxes paid by using Roth (401 or IRA) while at a marginal 15%, and carefully transition to pretax to avoid the 25% bracket. It's possible to effectively save money from a 25% rate and withdraw it at 0%. (Zero is what one pays for the first $20K of a couple's income, this is the combined standard deduction and personal exemptions.) It would take $500K at retirement to produce the $20,000 withdrawal at a 4% rate. Keep in mind, this is a moving target as the numbers edge up each year.

With no match, I'd consider the Roth IRA. But I also agree, paying higher interest debt first is a wise priority.

  • I read this one a while back, but it's good to brush up on it. Thanks! – Noah Oct 17 '14 at 1:27
0

Do you have an emergency fund?

If so, one idea is to put money into a Roth IRA, and invest it conservatively (short term government bonds, or a IRA savings account). Since you can withdraw your contributions from a Roth at any time, this could serve as most of your emergency fund, which means you could then use your existing non-tax-sheltered emergency fund to pay down the loans.

This way if an emergency does come up, you have access to the money. And if an emergency doesn't come up, you have some tax-sheltered funds that you would not otherwise have.

  • Do you know if the contribution limit Roth IRA Savings Accounts is the net (contributions - distributions) or sum of all contributions? – Noah Oct 17 '14 at 14:51

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