401K a scam?

I am doing pretty much exactly what you are(and have a similarly chintzy 401k match). You may be better off opening a traditional IRA once you max out your Roth, as the tax benefits are the same as a 401k. If you aren't going to stick around for your employer's match (which will probably step-vest over the 6 year period so you will still get something), then there really is no reason to do a 401k until you max your traditional and roth.

Also- are you sure that your company will match 3,000 per year? The way I interpret that match is: 6%*60,000*20% per year. Which is 600. You may want to start by investigating that before you severely over contribute.

It sounds like you have your mind made up already, and with the crappy company match, I pretty much agree with you.

Fill your Roth, then go up to the company match if you can afford it. Remember that your choices in your current 401k is only temporary. Once you quit, you can roll to a 401k and then you can choose whatever you want.

Also, I didn't mean to imply you haven't already "investigated" the match amount. Double-check might be a better choice of words, as you obviously have done your homework already.

It just depends on your company match. Is it worth it? That decision is up to you. Forecasting tax rates 30 years into the future is a total crap shoot. What if we are using a national sales tax by then and have eliminated the income tax? You get off tax free. Scenarios of higher and lower taxes on 401k withdrawals are probably equally likely. So, I wouldn't gamble too much on that variable.

If you want to assume that you'll be in a higher tax bracket after retirement, then you're right that much of the benefit of 401k is out the window. I'm surprised how many people I work with make this same assumption about being in a higher tax bracket later.

I think it's more likely to be true for those people who want to work until they have WAY more set aside than they need to retire. You know, the kind of people who are making $80k at retirement and then take $100k out of an income-producing account after retirement.

To those people I say, geez, you should've retired earlier. I plan to be the other way around, and retire as you as I can possibly get by, which means that my income in retirement will be lower than before retirement and my tax bracket will likely be much lower.

Another upside to the 401k (not relative to the Roth, but relative to nothing at all, which is what lots of people do when they talk themselves out of 401k withholding) is the basic savings account concept. People tend to blow they money they have, so if you set some aside and never see it, you won't spend as much. Then you'll suddenly have a ton of money invested some day and live happily ever after.

1. I'm pretty sure the earlier post correcting your calculations (about company match) are correct. "20%" of your first 5% contribution, is almost surely calculated as follows: your contribution: 5% of $60,000 = $3,000. They match 20% of that $3,000, or $600. Basically, if you max the company match, you get 1% of your salary (20% of 5%) in company match.

Better than nothing unless your 401k fund choices are truly horribly expensive. Is there at least one index fund? If not, and they are all over 1% expense ratio, I wouldn't put anything in the 401k. I figure you're paying the expense ratio every year until you leave the company and can roll it over into some good options. Just make sure you save as much (or more) into your "mock 401k" and don't touch it.

One thing I would definitely check into is a self-directed 401k option (not sure if that's exactly what it's called, but you should be able to find it with some research). Some plans offer this (but NEVER advertise it). Even if you don't currently have the option, research it and then go to whoever in your company manages the plan and try to get it added. It basically allows you to fill out a form and put your 401k money into a different investment provider with good options.

Another thing you might try is to put together some true numbers (Vanguard probably has some examples) about how expensive in the long term (30-40 years) your current 401k funds are. Then, go talk to your company's 401k manager and see if you can convince them to revamp the 401k plan to a good company with better options. The person may have no idea how bad the options are - don't assume they have done any research beyond meeting with the salesman (umm, I mean "financial advisor") and signing on the dotted line.

1. You don't know what the tax will be in 50 years - you can't. It could be lower - for all you know, we could have a consumption tax and not an income tax. So why pre-pay taxes with a Roth?

I don't pre-pay anything, especially 30% of my income.

And who is say that the gov't can't grab some of your Roth?

Point is, with 50 years of tax policy ahead of us, it doesn't make sense to think 2012 will be the absolutely best time to pay tax.

2. One of the best features of a 401k is that it is automatic - you don't have to remember to write the $5000 check to your Roth. Many people will make excuses to not contribute, or forget. You will never save much unless you save regularly.

3. You can take money out of a Roth, penalty free. Not always a good thing.

the plan design is crap, yes. and that vesting stinks. And expensive funds hurt.

But generally, the problems with a Roth outweigh their benefits.

Thanks everyone for the great comments and insights. Keep the great posts coming.

The way the match is described in company materials is Acme Corp. "will match 20% of your contribution up to a maximum of 5% of your salary." So I do think that my $60k salary equates to a max annual company match of $3k. You guys are probably right though, it is probably a poorly written phrase by my company's HR department. (A separate topic, are HR departments good for anything?...Sorry, I digress )But I would have to contribute $3k/.20=$15k to get that. And yes, the expense ratios are high. >1% for most of the fund offerings.

That combined with the the piss-poor vesting schedule, the lack of control, and lack of long term "job security", I have decided not to contribute a cent more. When I switch jobs/employers...something that is definitely possible within the next 24 months, I will roll the money I currently have the 401k into something else of my choosing.

You are all good to point out that I shouldn't be trying to prognosticate when it comes to tax rates down the road. I should focus on what I know now and simply try to save as much as possible.

My new strategy will be maxing out my Roth IRA (as I have already been doing for the past few years), and probably open and contribute some to a traditional IRA as well. Outside of that I will keep a good chunk of my money in liquid non-retirement accounts. All of this will be done at Vanguard because they have an excellent range of fund offerings and their fees/expense overheads are low. Maybe I am buying into the marketing, but I feel Vanguard takes a more measured approach to business and investing, and has more a social conscience than some of the other financial companies. Basically, unlike the rest of Wall Street, it doesn't feel like like a trying to screw me over.

In the end, it seems like the key is living below ones means (easy for me to do as a single dude with no kids or expensive cars, boats, houses, etc.) and saving the money somewhere where it gets a healthy return long term. At any point in time this could be a mix of stocks, bonds, and other types of funds.

Sounds like a good plan to me.

Glad you are aware of Vanguard. Agree that they are hard to beat.

Don't give up on trying to get your HR dept to improve the 401k offerings or the plan. It's worth a try at least. I believe Vanguard has some info material for company plans on their website.

It sounds like saving regularly won't be a problem for you, but I would suggest splitting up your paycheck with multiple direct deposits (if available), and setting up a regular fund purchase in your Vanguard accounts (basically mimic what would be happening in an automatic 401k). One, it keeps you honest; two, you'll benefit from dollar-cost averaging and not make the psychological mistakes that all of us are susceptible to; and three, it will simplify your life & thinking so you don't have to think about making transfers/purchases every paycheck or every month.

Best of all, keep up your critical thinking and questioning the conventional wisdom. Too many people follow advice like "401k is a great deal" without digging a little deeper and making sure that it actually is. This trait will serve you well in all aspects of life.

Have a good one.

Are you sure you can contribute to a regular IRA if you are eligible for a company 401K? I know you used to NOT be able to(even if you didn't take advantage of the company 401K), maybe that changed.

What's your marginal tax rate? 15% or 25%? If 15% I'd go with the Roth and pay my taxes now because it's highly unlikely you'll be in a lower tax bracket than 15% at retirement. Any higher than 15% I'd go with the 401K no matter how crappy the company match or even with 1% fees by the 401K administrators. At 25% tax savings you are better off with the 401K.

oh my holy god the information on this thread is woefully and shockingly inaccurate.

a) you cannot contribute to a traditional IRA after you have maxed out a Roth IRA. No, no, a thousand times no.

b) the primary tax benefit to a traditional IRA/401(k) is emphatically NOT that you are likely to be in a lower tax bracket at retirement than during your working years. the primary tax benefit is complete exemption from capital gains/dividends/interest taxation - in other words, complete exemption from taxation on the return on investment.

c) i am so, so, so incredibly sad that none of you are aware of this. but at the same time, i guess i can't be surprised because slate.com's economics blogger made the same mistake a month or so ago. see:

http://www.slate.com/blogs/moneybox/2012/01/19/does_mitt_romney_have_over_20_million_in_his_individual_retirement_account.html

and for those who doubt point (b), see the following example (taken from the comment thread on the above linked slate post) (and if you search this message board's archives using my name and something like roth IRA, you'll find 2-3 other times that i've posted similar examples demonstrating this point):

Mitt makes $100,000 of salary in 1990. His marginal tax rate is 30%. For the sake of the example, say he has $50k of non-tax expenses in the year. $100k of income, $30k of tax, $50k of expenses leaves $20k left. If he invests that $20k in a Bain fund and does very well, say a 300x return over 20 years, he ends up with $6,000,000. If somehow none of this income passed through to him annually and was thus subject to tax in each year (which it would of course in the real world), he would face in 2010 (at the end of my hypothetical 20 year period) a 15% tax on the gain, or 15% of $5,980,000, or $897,000, leaving him with $5,083,000.

But if, instead, he is able to contribute a portion of his salary, pre-tax, to a 401(k) plan, he'll face the following math:

in order to still pay his $50k of expenses post-tax, he'll need to preserve about $71,430 of his pre-tax money. so $71,430 of pre-tax money turns into $50k post tax after payment of the 30% tax. the remaining $28,570 can be invested (as compared to only $20k above with no deduction).

now he gets the same 300x return over 20 years, leaving him with $8,571,000. (note that in this version he would not face annual taxation on partnership income as opposed to above where we had to falsely assume that the partnership made no income until the end of the 20 years).

$8,571,000 would then face a 30% tax rate (i'm using 30% rather than 35% because i used 30% in the year of contribution in this example), leaving him with $5,999,700. even with a 35% rate, it would be $5,571,150.

in either case, he is better off paying the higher ordinary income tax rate in the later year because he was able to invest more in year one. and this example didn't even take into account the very real benefit of no taxation of annual distributions.

to make a long story short, the ability to deduct a contribution to a 401(k) or IRA is the exact equivalent of not taxing the return on investment. because of this, it is clearly better to pay the 35% tax on an IRA distribution (which, again, is equivalent to a 0% capital gains tax because of the deduction at the time of contribution to the IRA) than to pay a 15% long term capital gains rate.

You have valid points. The only thing you are off base on is the cynical view that you will pay higher taxes when you retire. Its good to build up savings in a ROTH but generally its best to take a tax deduction now, not 30 years from now. Don't worry about inflation in the long run either. Historically, the sustained inflation America has had for 40 + years is very abnormal and can't last. Even now the problem is deflation. The Fed is doing radical stuff just to get inflation back to where it was. But yes, basically you are screwed over for reasons you stated. You make a decent paycheck and you don't own a home, have kids, and you are out of school. You are being taxed at a higher rate than Romney. Your only recourse to lower your taxes is the 401K If you have paid off debts or at least have them in control and paying a low interest rates, then I would contribute some to a 401K. But I recommend that in the way that I recommend accepting the prison food that your jailor serves you.

You are correct here. Point taken. For whatever reason I was under the impression that a traditional IRA was its own deal. But no, the max is 5k annually between both the Roth and traditional IRA.

I don't 100% agree with you here. You make it sound like it is a no brainer. Actually, one of the key benefits of the 401k *is* tax deferral and the hope of being a lower bracket. And sure, there are no cap gains taxes, but one, that assumes my crappy 401k fund options increase in value anyway (not a given these days), and two, that I don't need *any* of the money until retirement. What if I want to use some of my returns to start a business, pay a big medical bill, or reinvest it into a start-up I like. In a 401k I can't touch *my* money. If I have to pay a little tax to have access to some of my money and returns, so be it. Not a dealbreaker by any means.

You make a nice point, and I am aware that 401k contributions can lower my taxable income, but this example doesn't really apply in my situation. I make $60k a year. Since I am single, this puts me in the 25% federal tax rate. To get down to the 15% bracket, I'd need to put about 25,000 into my 401k this year. That is simply unrealistic. That means my take home pay after taxes, 5k roth ira contribution, heath insurance, etc. drops to well below 20,000 a year. Again, even with my crappy 1BR apartment here in one of the highest cost of living areas in the country, I'm not sure that would leave enough for everyday living expenses. And God forbid I want to take a week-long vacation while I am still able to walk without a cane? I agree with you, the 401k vehicle can be used to reduce tax burden, but the simple fact is that I don't have as much "play" money as Mitt. I have to think about all my financial needs and wishes and not just retirement (and believe me, I live *well* below my means). Must be nice being Mitt though.

I don't disagree, just wish there wasn't a $5k limit on the on the IRA, because in my situation the vanguard options there are much better than the crap 401k my company offers.

Thanks for posting your comments. I will search around for some of your other advice because you have clearly thought this out.

ryan foreman wrote:

But yes, basically you are screwed over for reasons you stated. You make a decent paycheck and you don't own a home, have kids, and you are out of school. You are being taxed at a higher rate than Romney. Your only recourse to lower your taxes is the 401K

If you have paid off debts or at least have them in control and paying a low interest rates, then I would contribute some to a 401K. But I recommend that in the way that I recommend accepting the prison food that your jailor serves you.

Haha the jailor metaphor was great. Sums up the situation quite nicely. and I always appreciate some comic relief. thank you sir.

Saving in a Roth or a Traditional IRA (or 401k) will yield the same after-tax income if your contributions today are taxed (for the Roth) at the same rate as your distributions would be taxed (for the Traditional) in the future. That's where the "if the tax rate in the future is lower" thing comes into play. If the comparison is between a Traditional IRA and saving outside an IRA, your example is exactly right. You come out ahead with the IRA, even if your future tax rate is the same.

One thing you have to keep in mind with any comparison though, is that they call them marginal tax rates for a reason. If your marginal tax rate is 25%, that's what you will be paying on the entire contribution you don't make to your 401k. If you do make the contribution, and then at retirement your entire income is from your IRA distributions, only a portion of your distributions will be taxed at 25%. Much of it will be taxed at lower rates. This makes Kaitainen's example even more compelling.

To the OP, if you contribute 15k to your 401k you won't be paying anywhere close to 20k in taxes. After subtracting your exemption, standard deduction, and 401k contribution, your taxable income will be only 35k, and the income tax on that is less than 5k. Adding in SS and state taxes will still probably put you at less than 10k.

Quick math, say your taxes are 25%.

Every dollar you decide to not put in the 401K gives you 75 cents to spend. Or to put in the Roth.

Every dollar you do put in the 401K (if you stay till the match) becomes $1.20 post match.

Seems like a pretty easy decision to me.

That is not entirely true. You are not factoring in the time value of money and that a tax deduction now is more valuable than a tax deduction 30 years from now. All things being equal lets say he has $5,000 to either invest in the 401K/Traditional IRA or a ROTH. At a 25% marginal tax rate contributing to a traditional IRA gives him $1,250 in his pocket NOW. He can reinvest that tax savings and have it grow for 30 years along side the full $5,000 he contributed. 30 years from now he pays a tax on withdrawals but he is still ahead. Or for that matter he could blow the $1,250 in Vegas and have some extra good memories when he retires. There are two good reasons to invest in a ROTH. 1. It serves as a good short term emergency savings account because any withdrawals before retirement age are considered tax free withdrawal of basis. 2. There is always a risk that the OP is right and in fact tax rates are higher when he retires. A ROTH serves as a hedge against that risk. Investing some money in a ROTH is definitely a good thing. But the large majority of retirement savings should be in a tax deferred account.

dukerdog wrote:

Saving in a Roth or a Traditional IRA (or 401k) will yield the same after-tax income if your contributions today are taxed (for the Roth) at the same rate as your distributions would be taxed (for the Traditional) in the future. That's where the "if the tax rate in the future is lower" thing comes into play. If the comparison is between a Traditional IRA and saving outside an IRA, your example is exactly right. You come out ahead with the IRA, even if your future tax rate is the same.

It's a simple calculation. Let's say you have $1000 of income to invest today, and then you'll retire in 10 years and withdraw it all. Assume that in that 10 years your investment doubles.

If you invest in a Traditional IRA or 401k, you'll be able to invest the whole $1000 since it is before taxes. After it doubles in value in 10 years you withdraw the entire $2000 and pay 25% taxes, so you are left with $1500.

If instead you invest in a Roth you get to invest only $750 since you have to pay 25% on that $1000 of income first. After 10 years it doubles in value and you withdraw the $1500 tax free.

If taxes are the same when you retire as they are when you invest, you end up with the same amount of money regardless of which path you take, Roth or Traditional.

dukerdog wrote:

If taxes are the same when you retire as they are when you invest, you end up with the same amount of money regardless of which path you take, Roth or Traditional.

i'm constantly amazed by how few people understand this.

the one slightly more complicated factor to add in is that the roth contribution limit is effectively a higher limit than the traditional limit.

they are both $5,000 for IRAs, or $17,000 (i believe) for 401(k)'s, but because roth contributions are after tax money, it is as if the limit is $5000 (or $17000) + tax owed on the money contributed. versus simply $5000 (or $17000) for the traditional.

so if you are in a position to max out your contributions, the roth option might get a leg up for this reason.