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Why You Should Always Run the Numbers

We interrupt our normal (very) irregular postings on Web, Tech, Music, and Politics to talk about the exciting world of Personal Finance!

Having spent my years at USC faithfully saving into my 403b, I wasn't planning to put anything more into "retirement" - based on my calculations I'd already reached my >60 goals (such is the power of a 2:1 to 10% match and the power of compound interest).

Boy am I glad I stopped and ran the numbers on what the difference is for contributing to a 401k vs regular investment. Here are some notes on calculating benefit even if you plan on withdrawing before retirement (basically, using the 401k as an investment vehicle):

  • Because the 401k is invested pre-tax and is treated as regular income on withdrawal, even after the 10% early withdrawal penalty, you'll start off with a 1-2% bonus (the exact number depends on your marginal tax rate vs your capital gains)
  • If you further assume a drop in tax bracket, say from the maximum 35% at time of investment to a more reasonable 28% or 25% for when you cash out, you're looking at an instant bump in returns of 12.2% or 17.65%, respectively.
  • Figure in a modest employer match, say 1:4, vested at 67% (16.75% at the point of investment), and you're up to a 37.5% returns difference. That's not too shabby!

So far, all of this has been time-invariant (because the numbers are lopped off the bottom and top and not affecting the rate of return). However, if you're investing in mutual funds, your difference of returns after taxes on distributions (always taxed as income) can be anywhere from about 0.5% for tax-managed and index funds, to 2% or more (my highest fund, Vanguard's Energy Fund is there; Vanguard rates it as 50% tax efficient, so I'm assuming there are worse out there).

Now, here's where we apply the power of compound interest. Assuming a 1% difference in tax load, even over 2 years, there will be a 2.5% difference. Over 10 years, this becomes a 12.75% difference, and over 20 years, we're talking about almost a 27% difference. (that's added on top of top of the existing 37.5% returns difference)

And remember, this is *with* the 10% early withdrawal penalty and paying full income taxes (vs capital gains). And that's why you should always run the numbers.

NOTE: I've seen one document online that seems to imply that in addition to the withdrawal penalty, you'll need to retroactively pay capital gains, but that seems to contradict what the IRS has to say on distributions, but it's probably a wise idea to consult a certified tax professional for the final say on the matter (-CPA has confirmed my reading, although noted an additional 2.5% state penalty). Besides early disbursement, you can also take a 72(t) or by taking a loan out against the 401k (this only works while you're employed).

2006-06-03 16:54:07