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The Cost of Not Saving for Retirement

Contributed by mm | July 23, 2004 11:43 AM PST

Robert Brokamp from Fool.com summarized the major reasons why one should save in 401(k) accounts:

- Immediate income tax break
- Employer match
- Deferred income tax from capital appreciation

Of course this is no new stuff to people who have some basic knowledge about how 401(k) works, and Robert's math is shabby at best by concluding the benefit of contributing $6,000 is a net worth increase of $4,780 without mentioning that 401(k) balance, no matter it is from employee contribution, employer match or capital appreciation, will be taxed by the retirement time.

To this end, I built a model to showcase the real cost of not saving in 401(k). As there is no argument that one should always contribute to the point to get maximal employer match (you cannot beat instant free money), the model only focuses on any additional contribution above that point.

The following assumptions have been made:

#1 $6,000/year before-tax income will be available for saving purpose, either for 401(k) or after-tax account (if the latter, income tax will apply immediately)

#2 Annual Rate of Return in both options will be 6%

#3 Marginal income rate of 25% will be applied to all contributions to after-tax account, or withdrawal from 401(k) account (this is to assume other income will push the tax bracket to 25% first), and this rate is unchanged across 30 years

#4 A blended capital gain tax rate of 17% applies to all appreciation in the after-tax account. It suggests that most appreciation will be taxed as long-term capital gain or dividend income (both taxed at 15% now) and a small amount will be taxed as short-term capital gains at ordinary income tax bracket (25%)

#5 35% of capital appreciation that will be taxed in the same year. This is to suggest a portfolio with low turnover so that 65% of the capital gains will not be taxed until the portfolio is liquidated at retirement time. This assumption gives the benefit of doubt to the after-tax option.

The results are revealing:

- by the end of the 10th year, 401(k) strategy is 4.1%, or $2,408 ahead of the after-tax option;
- by the end of the 20th year, 401(k) strategy is 8.2%, or 13,613 ahead
- by the end of the 30th year, 401(k) strategy is 12.0%, or $42,839 ahead

  To Save In 401(k)  To Save In After-Tax Brokerage Account   Variance 
Column [1] [2] [3]  [4]   [5]   [6]   [7]   [8]   [9]   [10]   [11]   [12]   [13] 
Year Contribution Investment Income Balance  Net Proceeds   Contribution   Investment Income   Capital Gain Tax   Balance   Cost Basis   Liquidation Tax   Net Proceeds   Variance   Variance % 
0      $                -    $                -          $                -    $                -    $                -    $                -    $                -    
1  $           6,000  $                -    $           6,000  $           4,500  $           4,500  $                -    $                -    $           4,500  $           4,500  $                -    $           4,500  $                -   0.0%
2  $           6,000  $              360  $         12,360  $           9,270  $           4,500  $              270  $               16  $           9,254  $           9,095  $               27  $           9,227  $               43 0.5%
3  $           6,000  $              742  $         19,102  $         14,326  $           4,500  $              555  $               33  $         14,276  $         13,789  $               83  $         14,193  $              133 0.9%
4  $           6,000  $           1,146  $         26,248  $         19,686  $           4,500  $              857  $               51  $         19,582  $         18,589  $              169  $         19,413  $              273 1.4%
5  $           6,000  $           1,575  $         33,823  $         25,367  $           4,500  $           1,175  $               70  $         25,187  $         23,500  $              287  $         24,900  $              467 1.8%
6  $           6,000  $           2,029  $         41,852  $         31,389  $           4,500  $           1,511  $               90  $         31,108  $         28,529  $              438  $         30,670  $              719 2.3%
7  $           6,000  $           2,511  $         50,363  $         37,772  $           4,500  $           1,866  $              111  $         37,363  $         33,682  $              626  $         36,738  $           1,035 2.7%
8  $           6,000  $           3,022  $         59,385  $         44,539  $           4,500  $           2,242  $              133  $         43,972  $         38,967  $              851  $         43,121  $           1,418 3.2%
9  $           6,000  $           3,563  $         68,948  $         51,711  $           4,500  $           2,638  $              157  $         50,953  $         44,390  $           1,116  $         49,837  $           1,873 3.6%
10  $           6,000  $           4,137  $         79,085  $         59,314  $           4,500  $           3,057  $              182  $         58,328  $         49,960  $           1,423  $         56,906  $           2,408 4.1%
20  $           6,000  $         12,154  $       220,714  $       165,535  $           4,500  $           8,793  $              523  $       159,321  $       115,797  $           7,399  $       151,922  $         13,613 8.2%
30  $           6,000  $         26,510  $       474,349  $       355,762  $           4,500  $         18,724  $           1,114  $       334,183  $       209,124  $         21,260  $       312,923  $         42,839 12.0%
[1] Annual Contribution to 401(k) Account, Assumption #1
[2] Investment Income = Last Year's Balance * Annual Rate of Return (Column [3] * Assumption #2)
[3] Balance = This Year's Contribution + Last Year's Balance + Investment Income = [1] + [3] + [2]
[4] Net Proceeds If Cash Out = Balance * (1 - Income Tax Rate) = Column [3] * Assumption #3 (Early Withdrawal Penalty Not Included)
 
[5] Annual Contribution to After-Tax Account, Assumption #1
[6] Investment Income = Last Year's Balance * Annual Rate of Return (Column [8] * Assumption #2)
[7] Capital Gain Tax = Investment Income * % Subject to Immedate Tax * Capital Tax Tax Rate = Column [6] * Assumption $3 * Assumption #5
[8] Balance = This Year's Contribution + Investment Income - Capital Gain Tax + Last Year's Balance = [5] + [6] - [7] + [8]
[9] Cost Basis = Amount That Has Been Taxed = Last Year's Cost Basis + This Year's Contribution + Investment Income * % Subject to Immediate Tax = [10] + [5] + [6] * Assumption #5
[10] Liquidation Tax = Tax if Cash Out All Positions = (Balance - Cost Basis) * Capital Gain Tax
[11] Net Proceeds = Balance - Liquidation Tax
 
[12] Variance = [4] - [1]
[13] Variance % = [12] / [4]

This implies that while the 401(k) strategy certainly beats the after-tax option, the difference is not as much as most people perceived. Laxing some of the assumptions do not change the landscape by much. For example, changing assumption #5 from 35% to 85% will only widen the gap after 30 years a bit more to 14.1%, or $50,055.

So is there a reason why, in witness of the absolute gap, should some people consider a balance between saving in 401(k) and saving in after-tax accounts? The answer is liquidity: the 401(k) balance is not readily available before 59 1/2 years old without an early withdrawal penalty (unless one deploys some strategies to bypass the penalty -- that's not without consequences). If making the maximal 401(k) contribution will leave a hole in your after-tax accounts like keeping a balance in high-interest credit cards, one'd better divert less money to 401(k) account. After all, having a sizable balance in 401(k) and a comparable balance in credit card accounts is not a good way to manage money.

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