I've read some contrarian opinions that point out the following flaws in the "max out your 401k" philosophy:
- If your tax rate is higher when you retire than when you contribute (because you make more or because the govt raises income tax rates), then you are actually paying more tax.
- You cannot tax-deduct capital losses that occur in your 401k account.
- You only pay capital gains tax on capital gains in a regular brokerage account, whereas you pay income tax (higher) on capital gains in a 401k
These are all good points. However, I think they work better theoretically than in practice. Let's take each one in turn:
Tax rate might be higher when you retire:
I don't really buy this one. There are two possibilities here:
- Tax bracket: This is likely to be lower because you are retired, hence there is a good chance you are not pulling in big income since you are no long salaried.
- Overall tax rates: Unpredictable. If taxes overall increase, chances are that being in a lower tax bracket will counteract this. If push comes to shove and taxes are just way too high when you want to withdraw, you can always suck it up, move to a no-income-tax-state for one year, and withdraw there to further push the odds in your favor. Also make sure to bring in no other income in that one year.
With careful planning, I do not see how the probability of taxes being higher at retirement than at contribution is likely. The one exception is if you are so rich that you can't help but be taxed highly and perhaps pay an estate tax when you are at retirement age. But this thread does not apply to people who have to worry about estate taxes, so let's ignore that possibility. This thread is for the everyman.
Cannot tax-deduct capital losses
This is a fair argument. However, if one's strategy is long-term investing in funds rather than individual stocks, it is unlikely that this would be a major concern over a 30-40 year period.
Paying capital gains vs. income tax at withdrawal
I did the math, and even assuming that the capital gains tax is only 5% when you withdraw and your income tax remained steady at 35% throughout, you will come out ahead using the 401k rather than the brokerage account. This assumes no exorbitant realized capital losses throughout the investment period.
Okay, so there is a basic review of the issues. Can anyone help me find some holes in my own argument? I am trying to think about this rationally but all roads point to "max out 401k". Also, for the sake of simplicity, let's assume a Roth account is not an option.