maximize 401k contributions?

Question

I have been contributing the maximum to my 401k account, including the catch-up contribution for those over age 50. My contribution far exceeds that needed to get the maximum company match.

I wondered if this was the best idea, so modeled how the account would grow in two cases:
	1 - Continuing to contribute the maximum ($23,000 per year currently)
	2. Contribute the minimum needed to get the full company match (5% contribution in my case ($7,500)).
	The model uses these assumptions:
	$400,000 current balance
	$150,000 annual salary, paid monthly.
	25% federal tax bracket
	6% state (CA) tax bracket
	12 years until retirement
	stock investments earning 6% annual returns (very conservative)

As the chart below indicates, option 1 accumulates $271,514 more dollars. Not surprising, huh? But wait, there's more-

How much of that difference stems from the larger contribution?
	$85,466, leaving $186,048 due to growth.

What's the yield on $186,048 growing to $271,514 in 12 years?
	3.15% APR.

So, if my thinking and my math are correct, if I can find another investment exceeding 3.15% APR, I should be better off, right?

There's one other detail - the loss of pre-tax savings. According to the calculator on my 401k fund manager's website, I'm going to lose $401 per month in tax savings. But I will still be getting $891 more per month which I could save and devote to other investment activities.

Please share your thoughts and affirm or refute my thinking.

Chris Soignier · Answer

A few more things to think about:

1) all future (non-Roth) 401K distributions will be taxed as ordinary income, regardless of how you grew your balance

2) Limited control over investments - you usually can't do stocks, can't do options, can't do ETF's, can't use leverage, can't short, just a handful over crappy 401k's w/ excess expenses.

3) can't take advantage of the many tax advantages of investing in real estate in a 401K

I just recently saw the light.   I'm 48, and am going to at a minimum start an SEPP distribution arrangement.   I may withdraw in excess of that, but will be careful to control my tax burden.    I won't be contributing to a 401K again ex. perhaps to meet my employee match.

Bruce W. · Answer

David that's great wisdom there. There are two short-term concerns: 1. Another debt ceiling debate in February and 2. Possible Fed tapering in late January.

I no longer understand the debt ceiling issue at all. If they're just going to keep raising it, why not extend it to infinity and avoid the periodic turmoil? As for tapering, I see it as necessary to avoid higher inflation and further devaluation of our currency, but it will really shake things up, especially in housing.

These two items don't include a generic correction like what you describe. Bubbles are inevitable these days, because there's just so much money being invested. We may be seeing a bull market bubble about to pop!

Having said all that, I think 12 more years is long enough to recoup any short-term losses, although no one likes to lose money. Our housing market is experiencing a mini-correction right now due to reduced demand, so it seems nothing is safe.

David Beard · Answer

Bruce, that makes sense, but I personally would exercise great caution regarding stock market exposure going forward.  Looking at annual returns of the Wilshire 5000 (broadest measure of US equity market), you can see that a major correction is likely on the horizon.  I would run very tight trailing stops on your equities.  Many pro's sell at any 8% pullback (IBD advocates this approach) as a basic capital preservation measure.  I would strongly recommend that you do the same.  Good luck with your saving plan!

Bruce W. · Answer

After reviewing my math, I realized that $85,466 growing to $271,514 in 12 years is actually 9.67%, not 3.15%. I now plan to continue contributing the max to my 401k account and will just have to wait a little longer for my savings to reach critical mass before I make my next RE investment.

David Beard · Answer

Well, there's no right or wrong answer.  This is just a mathematical exercise that hinges on a whole bunch of assumptions:

• risk tolerance
• ability to attain x% when investing outside of the shackles of your company retirement plan
• amount of time available to spend pursuing those returns
• return assumption inside your company plan
• federal and state marginal tax rates in the future
• range of options in your company 401k.  Do you have a brokerage window giving you the full supermarket of mutual funds ETFs, REITs, etc.?

As an active FT RE investor, I have no difficulty earning 15-20% completely passively (secured lending), or 30%+ with more involvement.  Since you're working a corporate job, you may need to remain very passive in terms of your time allotment.

Yes, compounding pre-tax money and paying tax at the end is a much better answer than compounding after-tax money, assuming equivalent returns and equivalent tax rates throughout the entire period.

I sure can't say if you can produce non-401k returns that will beat your 401k returns by a wide enough margin to overcome the loss from losing pre-tax compounding.  There is an indifference return that you can compute.  The 3.15% you're mentioning doesn't sound like a number that could possibly make any sense.  The indifference return would have to be above 6% (assuming you can reliably generate 6% in a 401k plan).