Reply to Anyone NOT maxing out your 401(k) even though you're making decent money?

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[quote=Anonymous][quote=Anonymous][quote=Anonymous][quote=Anonymous]You should both be maxing out your 401ks. It isn't taxed. It's silly not to do this. It's like a 35% return on your money. 
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This badly misunderstands the tax advantages of a 401(k).  There are two such advantages.  1-The possibility that your marginal tax rate will be lower in retirement than it is now, and 2-Avoiding the need to pay annual taxes on dividends and realized capital gains (e.g. from rebalancing).

For #1, if you believe that you will be in the same tax bracket at retirement as you are now, there is no tax advantage from investing with pre-tax money instead of post-tax money.  If you believe (say) that you will pay 28% of your marginal income dollar in taxes when retired, versus 35% now, then the tax advantage from using pre-tax money to invest is 7%.

For #2, if you were to buy and hold index funds in a non-retirement account, you would pay little or no capital gains taxes, but you would still pay taxes on dividends annually.  Say that you expect a return of 8% from your portfolio, and that you will have to pay taxes equal to 5% of the gains each year.  In this case, holding the funds in a non-retirement account is equivalent to a reduction in annual return from 8% to 7.6%.  This reduction will be greater if your dividend tax rate is higher, you invest in funds that pay relatively more dividends, or if you have more realized capital gains each year (say because of rebalancing).

For most people, the savings from #2 will be greater than those from #1.

NP here.  Isn't #2 basically a wash?  Say you gain $100 dollars from rebalancing.  You're either paying tax on the gain now or later right?  To make the math easier assume #1 is the same now as in retirement (unlikely but this will make the point easier for me to understand).

[/quote][/quote]

You just earned $1000 .  You want to invest it, and withdraw after 30 years, in retirement.  Continuing with my examples, suppose your current tax rate is 35%, your tax rate in 30 years will be 28%, your expected annual return is 8%, and in a non-retirement account you would expect to pay .4% a year in taxes on capital gains and dividends.

If you put the $1000 in a 401(k), in 30 years it is worth:  (1-.28)*1000*1.08^30=$7,245.11
If you pay current taxes on the $1000 and put it in a non-retirement account, in 20 years it is worth: (1-.35)*1000*1.076^30=$5,851.69.

To isolate the effect of #2, now assume that your tax rate both now and in 30 years will be 35%.  Then, the $1000 would be worth (1-.35)*1000*1.08^30=$6,540.73 after 30 years in a 401(k), versus (1-.35)*1000*1.076^30=$5,851.69 after 30 years in a non-retirement account.

You are missing that there is a compounding effect from not having to pay the tax on gains every year.[/quote]

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