Sunday, July 22, 2012

Thoughts on IRAs and 401k's for high income individuals, Part 2

In the last blog post, I discussed some of the features and limitations of both IRA and Roth IRA plans, and came to the conclusion that for young high-incoming individuals, jumping through the hoops in order to achieve a "backdoor Roth" is probably the best option. Now let's see what are our options for 401k plans.

The main advantage of 401k over IRA is the contribution limit. For 2012, an individual is allowed to contribute up to 17k per year. That is quite a bit of money! It may not sound like too much, but the tax-deferred status of 401k really makes a difference. Let's imagine a hypothetical situation where you max out your 401k on some steady investment that returns 5%. Note, 5% is a very conservative number, most other sources assume that you get 8%. Over 30 years, assuming annual compouding, your total in your 401k account would be 1129460 dollars, of which only 510k is your principal! Of course, the 1.1M in 30 years may not buy you as much, but even if you take into consideration of inflation, assuming it will be at 2% per year(Fed has been trying to achieve that number), we'll still end up with  808k.

Now keep in mind this number is achieved using a very modest earning estimate. If we use the standard 50/50 asset allocation, according to Vanguard, for the period of 1926 to 2011, the annual return is 8.2%! Even though past performance is no guarantee for the future, we have reasonable confidence that the performance of the markets will not stray too far from this number given a long enough time frame. So that 17k per year, i.e. 510k principal, in 30 years time will end up as 1.9M after inflation!

Without the tax benefit from 401k, you basically reduce your earning by whatever percentage your highest tax bracket is. Assuming a 28% federal tax (which is potentially going to rise), and 2% state tax (probably an underestimate), our glorious 1.9M will be reduced to 1.25M, a 35% reduction in final value, and a 47% reduction in profit! So the tax deferral really makes a difference. Bear in mind though, this tax calculation method is a very simplified approximation, as it does not take into account the difference in tax treatment between long-term and short-term capital gains or the portfolio turn-over rate.

Employers are also able to "match" employee contribution, essentially doubling your 401k's, *if* they so choose to. In that case, by all means maximize your 401k, because the "matching" part is almost like a salary raise!

The bad thing for 401k though, is that you have a limited choice of investment options. Basically companies choose a custodian for you. Usually, companies choose decent financial institutions, but they can still be limiting. For example, the company I work for chooses Fidelity as our 401k custodian. Even though by no means is Fidelity a bad choice, we only have a limited sub-set of fidelity funds to invest in, and can not invest in some potentially more lucrative investment, e.g. P2P lending. This is not the end of the world though, since you can always rollover your 401k plans to IRA, which then gives you unlimited freedom :)

401k's, just like IRAs, come in two flavors. Roth and non-Roth. The non-Roth one are almost identical to IRA apart from the advantage and disadvantage I mentioned above. But the Roth one is slightly worse than the Roth IRA when it comes to distribution. Roth IRAs allow you to withdraw your principal after 5 years tax-free, but Roth 401k applies a "pro-rata" rule. E.g. Imagine you have 10k in Roth IRAs and Roth 401k's respectively, the newest contribution in both were made more than 5 years ago, and 5k from each type of accounts are earnings ( I know, super earning rate) . Now you want to withdraw 5k from each type. On the Roth IRA side, you pay no tax, but on the Roth 401k side, you have to pay tax on 2.5k of the distributions if you are younger than 59.5. Not too good huh? Of course, you can always wait for a job change and do a rollover from Roth 401k to Roth IRA, which then entitles you to tax-free principal withdrawals even before 59.5.

In fact, I'd argue that anyone with Roth 401k's should rollover all their assets into a Roth IRA whenever possible, for greater flexibility in both investment and withdrawal.

I'll be make some little tools for estimating growth, maybe I can do better than most of the tools on the internet :)

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