401K TAX TRAP

What the government gives the government takes away!

Be careful you do not fall too deeply into the 401-K tax trap!

A long term friend and regular reader wrote the following:

This weekend I was reading an article in Smart Money, the Sept 2006 issue, regarding this pension reform bill in Congress. According to this article, if passed, Employers would be able to enroll employees into their 401K program. This article went on to discuss that over the next 10 years the hundreds of billions of dollars in new money that would be flowing into the stock market. This article went on to discuss target-date funds and expense fees but the bottom line to me seemed to be the tidal wave of money that would be infused into the market.

This would seem to be fantastic for the market. What are your thoughts?


The article is correct; by allowing and encouraging companies to automatically sign employees up for payroll deductions into 401-K accounts, the participation rate is expected to soar. The mutual fund companies spent millions to "show Congress the wisdom of this law" and they are licking their chops! It is long term great news for solving the deficit as accumulated tax liabilities well eventually soar to the stratosphere.

An simple example is the best way to show why. Lets say a young fellow goes to work at the age of 22 and deposits $1,000 per month year after year for 40 years. Let's say he allocates his account well and earns an average of 12% return. At the age of 62, his account would be worth about $11,880,000. His principle investment would be $480,000. Now the big question; what will the tax be on ordinary income in 40 years?

Had these funds been invested outside a 401-K account, it is likely that the gains would be long term capital gains which are taxed at one half the ordinary rate. Furthermore, upon death, the inheritance would pass to the heirs and they would receive a stepped up basis, which means there would be no income taxes due! If you assume the marginal ordinary income tax rate (for the wealthy) is 50%, the taxes owed on this 401-K would be $5,940,000.

There is a lot more bad news. If we assume the average expense ratio of the average fund where the money was invested was an even 1% of assets, then the balance of this account was reduced by approximately $4,450,000.

There are many other considerations. Had he not invested in the 401-K, he would not have received matching funds from the company if any and he would have had to pay the ordinary income tax on the $480,000 up front instead of in arrears.

By using leverage to buy real estate, the 401-K investor could probably have boosted his total after tax return by a couple of percentage points or more. This investor could easily be looking at $30 or even $60 million dollars of equity in real estate. It is usually difficult for us mere mortals to comprehend the power of compound interest. Einstein said something like it is the most powerful mathematical formula on earth.

The investment industry is a high powered industry. Those who own the news media are powerful indeed. To convert my simple example to a detailed situation would take much work. Few folks are going to be swayed by my arguments. The matching money in combination with the upfront tax break is a deal that everyone should accept on 3 to 5% of ones pay. My children follow my advice and only deposit the amounts that are matched. They invest the bulk of their funds in taxable accounts but they use management techniques to reduce the taxes due (primarily they take losses short term and let winners go long term).

If you put all your money in 401-K accounts 529 education accounts, Roth IRA accounts and medical savings accounts, you are hand-cuffing your money. I don't have the figures handy but an astoundingly high percentage of these funds are drawn out early. Fees and penalties are paid on the withdrawals in addition to ordinary income tax rates. It does not matter that the investments in the account were held long term; double the tax rate plus the penalties are still due.

I am a believer in cash flow. Businesses can and often do lose money year after year and yet they still survive because they have enough cash available. Locking up all ones assets in accounts means that the funds cannot be used for other investments. Businesses typically avoid funding projects that offer less than a 15% rate of return. When a business finds a project that offers such a return, it borrows as much as it needs to fund the project while still keeping liquid cash available. Americans should manage their investments like a business. Just for fun, let me tell you that $1,000 per month invested for 40 years at 15% compounds to $31 Million Bucks.

In our example, the snow ball has really started to roll. The account has reached $11,880,000 at the age of 62. Chances are good that this fellow does not want to pay the tax on withdrawals and uses other funds for the next 6 years until he is 68. At 12% return, which is not unreasonable in a combination of large and small stocks, the account value will have doubled again. The fellows tax liability will have jumped by another $5,940,000.

If nothing else, this email should help diffuse the pessimism in the market place today. We hear a lot of gloom and doom about who is going to pay taxes after all the baby boomers have retired. The answer is that the baby boomers will. The government is not about to go broke. Our country has a low debt to asset ratio. It makes no sense to the man on the street who hears the "horror news nightly" but the USA has run a trade deficit for something like 96 of the last 100 years (the few years when we did not were in the middle of the depression or a very tough recession). The USA still receives more investment income from foreigners than we pay out. The growing amount of dollars being withdrawn from 401-K accounts is producing higher and higher tax revenues and erroneous negative savings statistics that frighten the public into investing more into 401-K accounts. The government will have the ability to tax these accounts heavily if needed.

High taxes and high fees run hand in hand. In our example, the 68 year old man would be paying an annual fee of $220,000. The same money using a dart board approach would do just as well while avoiding the $220,000 in fees. Those who have 401-K accounts of $15,000 or more should push hard for greater investment flexibility. In a self managed account, one could buy individual stocks and avoid the "holding" fees.

The bottom line is that one must be careful not to substantially increase the amounts of management fees and taxes one must eventually pay. Please do not say that I have recommended against investing in 401-K accounts. Again, the first few percent of matched income is a compelling offer. After the first few percent, there are reasons to consider other alternative investments.

Please recall that investing and writing emails about investing are just hobbies for me. I write what I think for the education and entertainment of readers. Readers are responsible for their own actions. Feel free to write me and I'd be glad to discuss your investment specifics