<THE FOOLISH FOUR>
by Robert Sheard
LEXINGTON, KY. (July 21, 1998) -- I've recently been asked about where investors should place their savings each year and because of the proposed changes in tax laws, I'd like to go over the options most of us have again.
Most investors have three options: a regular taxable portfolio, an employer's retirement plan (a 401(k), for example), and an IRA of some kind. Since 401(k) plans and IRAs offer tax advantages, it makes sense to examine them first.
The advantage to a 401(k) is that your money goes in before taxes and the growth is tax-deferred. Also, some employers match at least a portion of your contributions. But a huge downside to most 401(k) plans is that the investment choices are limited to mutual funds.
So, heretical as it may sound, I believe one should only invest in a 401(k) plan if the employer is matching the contributions. If there's no employer matching, and the best you can do is an index fund's long-term return, you may well be able to open a taxable account and get better after-tax returns buying stocks directly.
The decision is a simple one for a Roth IRA vs. a 401(k) with no matching. Let's suppose you're in the 28% tax bracket. You have to earn roughly $2,775 to have the $2,000 you may invest (after-tax money) in a Roth IRA. Let's take that $2,775 and compound it at 15.7% a year for 20 years. That's the lifetime return of the Vanguard Index 500 Fund, which is just over 20 years old. At the end of 20 years, you'd have $51,278.
Don't forget, however, that you still owe ordinary income taxes on that entire amount. If you're in the 15% tax bracket at retirement, your total would be reduced to $43,586. If you're in the 28% bracket (where a lot of retirees find themselves), you've only got $36,920.
As an alternative, let's pay the 28% taxes on the original $2,775 of income, deposit the $2,000 into a Roth IRA and invest it Foolishly. The return on the Unemotional Value portfolio, for example, for the past two decades has been 21.2%. That $2,000 would grow to $93,558, completely tax free. That smokes the index fund alternative in the 401(k), even though more money went to work in the 401(k) right away.
Once again, trying to avoid taxes up front costs the investor a fortune in the end if by doing so he has to pass up on decent investment alternatives. The Roth IRA is a far better alternative than a 401(k) plan that doesn't match your contributions.
In fact, a taxable stock portfolio under these same conditions beats a 401(k) plan. Let's take the same $2,775 in earnings, pay the income tax, and invest the remaining $2,000 into the Unemotional Value Four account, paying the full 20% capital gains tax each year. (I realize that dividends would be taxed at his ordinary income tax rate of 28%, but I'm already stacking the deck assuming a complete turnover of the portfolio each year, so you're going to have to give me this one.)
The annual after-tax return would be 17.0%. So even in the taxable account, you'd end up with $46,211 after 20 years, better than the amount from the 401(k) after taxes (from $36,920 to $43,586 depending on the tax rate at retirement).
Of course, this entire exercise is based on assumed rates of return that may be completely wrong for the future, but at historical rates over equivalent periods, the 401(k), with its limitations on investment alternatives, just doesn't stack up against either the Roth IRA or a regular taxable portfolio. So unless your employer is matching your contributions to your 401(k) plan (and giving you a healthy gain from day one), look to your IRA first and your taxable stock portfolio second.
Current Dow Order | 1998 Dow Returns
[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]
07/21/98 Close
Stock Change Last -------------------- UK --- 51.31 IP - 1/16 45.38 MO + 1/16 40.13 EK -1 7/16 86.75 |
Day Month Year
FOOL-4 -0.51% 6.36% 15.49%
DJIA -1.14% 2.66% 16.21%
S&P 500 -1.61% 2.75% 20.06%
NASDAQ -1.74% 4.45% 26.03%
Rec'd # Security In At Now Change
12/31/97 206 Eastman Ko 60.56 86.75 43.24%
12/31/97 291 Union Carb 42.94 51.31 19.51%
12/31/97 289 Int'l Pape 43.13 45.38 5.22%
12/31/97 276 Philip Mor 45.25 40.13 -11.33%
Rec'd # Security In At Value Change
12/31/97 206 Eastman Ko 12475.88 17870.50 $5394.63
12/31/97 291 Union Carb 12494.81 14931.94 $2437.13
12/31/97 289 Int'l Pape 12463.13 13113.38 $650.25
12/31/97 276 Philip Mor 12489.00 11074.50 -$1414.50
CASH $754.73
TOTAL $57745.04
|