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).