But now, because the federal government is running deep deficits, many experts worry that tax rates will go up. President Obama has promised not to raise taxes on households earning less than $250,000 a year, but there’s no telling what the government will do by the time you’re ready to make withdrawals 10, 20 or 30 years from now.
Normally, the tax deferral on 401(k) contributions and earnings is valuable because it allows the investor to avoid tax at the relatively high rates of the present to instead pay at lower rates in retirement. But if rates will rise, it might be better to pay at today’s rates instead of high rates in the future.
Investors who believe income tax rates will go substantially higher can consider forgoing their 401(k)s in favor of taxable accounts filled with holdings subject to long-term capital gains rates rather than income tax rates used for 401(k)s. While capital gains rates could change as well, they tend to be lower – a 15% maximum today compared to 35% in the top income-tax bracket.
Capital gains are profits from holdings like stocks, bonds or mutual funds, sold for more than they cost. Because the capital gains tax is not due until after the investment is sold, you can get the same tax deferral you would in a 401(k) by investing in things like stocks that appreciate over time.
Under today’s rules, profitable stocks like Google (Stock Quote: GOOG) and Green Mountain Coffee Roasters (Stock Quote: GMCR) would be taxed at the 15% long-term capital gains rate held in a taxable account, or at the income tax rate as high as 35% in a 401(k).
So, if your employer cuts or eliminates matching contributions, and you expect your tax rate to rise, the 401(k) has far less appeal than it would otherwise.
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