Arohan’s investing life

Let me start by saying that for average employees investing in a 401k plan makes absolute sense. A typical American worker is not a savvy investor, neither is a disciplined saver. A 401K plan offers discipline and a conservative selection of investment options that may not offer spectacular returns, but are also less likely to result in significant losses (as long as the investments are diversified). And on top of this, if the employer offers a matching contribution, it would be downright financially irresponsible to not take advantage of it.

Earlier this year I embarked on an entrepreneurial journey and one question has kept bugging me. Should I create a 401K plan that I as an owner will participate in. Offering 401K plans for my employees is a business decision but for me to participate in the plan is just a question of figuring out whether it makes financial sense. I prepared a simple model to aid me in my decision and have come to realize that for me personally (and possibly for many others who meet the criteria laid out in the rest of the article) a 401K plan is NOT the best way to save and invest.

From a business perspective, any dollars that my business puts in my 401K account is an expense. But so are any dollars that my business decides to pay me as salary. I can use the dollars that my business would have contributed to my 401K plan (including whatever company match is established for the plan) and just pay those dollars to me as (an increase in my) salary. Therefore, for the business it is a moot point (actually the business can save some money in 401K plan maintenance costs if you are the only employee).

So the question that I need to tackle now is whether it makes sense on a personal level.

Here are the following assumptions that I consider to be true in my situation and which is possibly true for many of my readers:

a. I consider myself to be an above average investor that can generate annual returns atleast 2% above what an average 401k plan funds would generate over long term (which can be approximated to the market return minus the average fund expense ratio)
b. My investments are reasonably tax efficient. This is not hard to do with a value style of investing where one tends to hold the investments for atleast a year or more (qualifying for a lower capital gains tax)
c. My intent is to generate significant personal wealth through investments and my businesses and I want my investments to be liquid and available if I choose to start enjoying the fruits of my labor earlier than the government prescribed retirement age
d. I expect to be in a significantly higher tax bracket in the future than where I am now, and
e. Part of my investments will be in private businesses and assets

The following numeric assumptions were made in my model:
1. long term market returns = 10% average per year
2. Average dividend yield = 2%
3. My personal overperformance over the market = 2%
4. Personal income tax rate = 30%
5. Dividend tax rate = 15% (in the taxable account)
6. Capital gains tax rate = 15% (in the taxable account)
7. Early withdrawal penalty = 10% (for a 401k account withdrawal)

To set up the model, I assumed the two scenarios

Scenario 1: Invest $100 per month in a 401K account, investments yield 2%, capital growth = 10% for an effective growth rate of 12%

Scenario 2: Pay $100 per month in income to me, pay 30% tax on the income, invest the remaining $70 per month in a taxable account, investments yield 2%, capital growth 12%, Dividend tax paid = 15% on the 2% yield for an effective growth rate of 13.7%

With these scenarios:

- at the end of 10 years, my 401K balance was (in future dollars) $23,004 and my taxable account balance was $17,811

Assuming both accounts were liquidated for cash at the end of 10 years, my 401k proceeds were $13,802 (after 30% income tax on the entire balance and 10% early withdrawal penalty) and my taxable account proceeds were $16,533 (after 15% capital gains tax, tax on dividend is assumed to be paid from the dividend yield as we go)

- at the end of 25 years, my 401K balance was $187,885 and my taxable account balance was $178,621

Assuming both accounts were liquidated for cash at the end of 25 years (and still before the retirement age), my 401K proceeds were $112,731 and my taxable account proceeds were $155,911

Assuming 25 years took me past the retirement age and so I did not have to pay early withdrawal penalty, then my 401K balance was $131,519

Conclusion: It appears that under certain conditions it is better to invest in a taxable account compared to investing in a 401K account. Of course, for one to achieve this, the person has to be financially disciplined and a savvy investor, and be willing to look beyond public markets for investments. Most people are none of these and therefore a 401K plan makes sense. For some, they are better off looking away from these plans. If your goal is financial security in retirement and you do not have time to manage your investments judiciously, go the 401K route. If your goal is to create substantial wealth before you retire and are willing to put time and effort and are a savvy investor, maybe taxable investments are a better choice

Final word: A Roth IRA, if one qualifies, may still be better than taxable investments, specially due to the fact that dividends are reinvested tax-deferred. But again, if one constructs a taxable portfolio carefully one can minimize dividends (letting the company reinvest for capital growth) and still come out ahead

I would like to hear your views around this. Please speak your mind

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