Tax advantages of maxing out 401(k) may be too good to pass up
Q: Since 401(k) withdrawals are taxed as regular income, is it better to only contribute enough to get the company match instead of maxing out contributions? You could invest the money after taxes in stocks, where dividends and capital gains are taxed at a lower rate.
- G.R., via e-mail
A: Roger Gorham, a certified financial planner in Hillsborough, N.J., says that it's generally a good idea to maximize 401(k) contributions.
Because a 401(k) contribution is not subject to ordinary income taxes immediately, you have more money to invest, he says. For example, Mr. Gorham says if a $1,000 contribution generates a $100 gain (assuming a 10 percent return), the 401(k) would hold $1,100 after one year. Assuming you retire next year in the 28 percent tax bracket and withdraw the money, you would pay $308 in income taxes, leaving you with $792.
If that $1,000 was not put into a 401(k) and immediately taxed at 28 percent, the initial investment would only be $720. A 10 percent capital gain over one year yields $72, and subjects you to $11 in capital gains taxes (at 15 percent), leaving you with $781, or $11 less than if that money was put in the 401(k).
Gorham says you might not maximize your contribution if you expect your ordinary tax rate to be higher at retirement than it is now.
Q: I'm reallocating my Roth and have invested 75 percent in three stock funds. I'm looking to put the rest in a tax-efficient index fund or exchange-traded fund (ETF), but I'm not making any progress in locating websites that will help me. I want to compare the performance of about 12 ETFs.
S.N., via e-mail
A: Bryan Lee, a certified financial planner in Plano, Texas, says that you should visit the websites of the mutual funds or ETFs that you're considering.
In his opinion, Barclays Global Investors, which offers iShares (they're like mutual funds that invest in indexes of stock rather than actual companies), has a great website (www.ishares.com) that should provide information that you want. Likewise, the State Street Global website (www.ssga.com) offers information on its proprietary ETFs, such as Spiders (SPY) and QQQ (the NASDAQ 100 Trust) as well as other ETFs.
Though you're going it alone, Mr. Lee suggests that if you're not confident in your overall allocation or have never had your risk tolerance assessed, you should consider talking to an independent certified financial planner.