401k question

I'd start with 10% of gross income to 401ks. The most important factors to saving are setting money aside and making sure the money grows moderately. The 401k takes some guesswork out of this. Getting the tax deferral on the gains is also a good thing. You could do much worse than just invest in 401k... you MIGHT be able to do better, but many options would be "worse".

You don't know about future taxes, so using tax diversification might be in order.

I might suggest contributing some money to a taxable account and/or traditional IRA. In 2010 the income restrictions on Roth conversions are removed, so you could contribute to a traditional now, convert it in 3 years and have some money in a Roth flavored account.

Generally the options suggested are

1) contribute to 401k up to match 2) max out Roth 3) max out 401k 4) taxable accounts

with some discussion of possibly reordering 3 and 4 in some situations.

You can do 1)- but no match. You cannot do 2) (income) You can do 3) You can do 4)

A mix of 401k and taxable accounts is acceptable. Saving 10% of income is a good step to financial independance. 2k "after tax" might be closer to 2300 "pre tax", so the 401k allows you to put more money to work in your favor now, and get a tax break as well.

A quick back-of-the-envelope computation shows that tax-deferral overwhelms lower rates over time: Assumptions: investment grows at 10%/yr, taxable account taxed at 25%/yr ever year on that 10% deferred acct taxed at 40% when liquidated current marginal rate of 25% (ie. invest $10k in 401k or $7.5k in taxableacct): For the first 9 years, you have more spendable money in the taxable account after year 1: $8062 vs. $6600 ($11000 * 0.6 for taxes) after year 9: $14379 vs. $14147

After that, compounding at the higher rate totally trounces it: after year 20: $31858 vs. $40364 ($67274 * 0.6 for taxes)

Now there are a lot of bad assumptions here - the taxable account is *perfectly* taxable, for example, whereas it could have been stuck into a tax-efficient index fund and be effectively tax-deferred for the most part as well as ultimately taxable at long-term-cap-gains rates. A *lot* of basically crappy assumptions (rate of return, tax rates, etc. etc.) But the basic point stands - tax deferral may generate exponentially better long-term results - literally.

Moreover, a tax-deferred account gives you lots more flexibility to do things like rebalance without having to worry about taxes. Very helpful if you want to make the portfolio more conservative later on.

Lastly, you may ultimately get an opportunity to roll it into a Roth at some point (perhaps stopping in a regular IRA on the way). If you do that at a point when your marginal rates are low (ie. if you take year off of work for some reason) you may come out way ahead.

I drone on about when to reverse 3 and 4 at

base it on any extra expenses within the 401(k) compared to the external post-tax account. JOE

Thanks to everyone for the advice. It is much appreciated.

So the general consensus seems to be:

Max out the 401k assuming the fees aren't too high (which they seem not to be). Taxes would have to go up quite a bit to overcome the deferral advantages and the potential increase in capital gains taxes seems just as likely.

Sound right?

Side questions:

1. Personally, how much more would you have to earn in a 401k vs. a taxable account to feel it was worth having your money tied up for that long?
2. How do you think the tax situation will change by 2045 considering the state of Social Security? Does this change the strategy?

Thanks again,

Seth

My comment would be to "max" 401k as a good place to start and learn. After a certain period of time, you may see value to changing your tax strategy- maybe the amount you set aside projects you to retire in the

33% tax bracket, maybe it will project you to 25% tax bracket. Each of this situations might suggest a different strategy. Early retirement may even suggest a third (different) strategy.

Side questions

1) depends on when you withdraw (what age) and the tax bracket you are in. Because you are starting your 401k first, it will be "bigger"- a larger part of your picture. Adding other pieces (taxable investments, Roth accounts, other holdings) you will see them differently. Generally 10k ina 401k is worth less than 10k in a taxable account which is worth less than 10k in a Roth account. Maybe a 5-10% factor between each. The higher the tax bracket, the more the Roth is favored.

2) No idea- so use "tax diversification"- hold different assets which will be taxed in different ways. Roth, taxable accounts, 401k accounts, other.

The important thing is to save 15% or so, then look for the tax-advantaged savings methods first. IRS tax-deferred accounts are designed for the middle class and top out at AGIs of $100K thereabouts. Then you have to saving like rich people- capital gains you dont have to sell for a long time. Index stock funds are fairly well diversified (safe-ish) and defer most of their capital gains until you sell them. Real estate is another deferred gain investment that some people swear by.

The 'downside' if any, of a 401 is first, the fees, which you've addressed, that your's were low. Second, is the conversion of long term cap gains (now 15% tops) to ordinary income (35% or higher). Third (last) is the risk of saving your way to a higher tax bracket, in general, this should be the least of your worries, just something to keep in the back of your mind as time goes on. Again, in general, I believe the risk is that rates will rise, both income tax, and capital gains rates. (Rising income tax suggests throttling back the 401 if the balance grows too high, but higher cap gains favors the 401). So, in the end a mix of pre and post tax savings is indicated. JOE