I'm on David Phelps's email list. He's a dentist who has freed himself from his clinical practice not once, but twice (there was a divorce.) He does this primarily by bringing in associates to work for him and investing his earnings in his real estate side business. The purpose of his email list seems to be primarily to pitch his “Mastermind Conference” where you meet with other dentists interested in freeing themselves from their clinical practice (which I actually think would be really interesting to attend, but haven't had the chance yet to do it.)
There is usually a fair amount of hyperbole, hype, and appeal to emotions in the brief emails, so I've gotten a bit used to it. However, the latest one was a little bit over the top to the point where I thought talking about it in a blog post might be interesting to readers. Here's the email in its entirety.
Let's start by pointing out the falsehoods in the email, and then we'll finish by pointing out some actual issues with 401(k) investing.
401(k)s Aren't a Bad Idea
First of all, 401(k)s aren't a bad idea. That doesn't mean they're the best possible option in every situation, but to paint them broadly as a bad idea is just foolish.
Second, “financial advisors” (typically salesmen masquerading as financial advisors) don't typically recommend investing in a 401(k) because it is not money they can control and make commissions off of. In fact, real financial advisors being paid an Asset Under Management fee might not even advocate for them if their definition of assets doesn't include the 401(k), but most of them will if they take their fiduciary duty seriously.
Third, your 401(k) money is neither safe, nor useless. 401(k)s aren't investments. They are an account in which an investment can be held. The investment itself is either safe or risky or somewhere in between. The account has nothing to do with it. The money is not useless. It is being invested to meet real future financial goals. If useful means “I can spend it today without taxes, expenses, or consequences” everything outside of a banking account is also useless.
Fourth, your money is not locked away until you're too old to enjoy it. This seems to be an odd way to refer to the Age 59 1/2 rule. Let's start with the fact that I know plenty of people in their 60s, 70s, 80s, and 90s who are “enjoying their money” just fine. But beyond that, the age 59 1/2 rule has so many holes in it that you can drive a truck through it. Check out some of the reasons you can use to pull money out of an IRA (to which a 401(k) can be converted as soon as you leave the employer providing it) without paying the 10% penalty.
- Unreimbursed medical expenses > 7.5% of your adjusted gross income (which may not be that high if you’re retired)
- Pay for medical insurance
- Disability
- Inherited IRAs (if your father leaves you his IRA, you can take out the money before you get to 59 1/2)
- Qualified Higher Education Expenses- for you, your kids, or your grandkids
- A First Home. Keep in mind the IRS definition of a “first home” is that you haven’t owned one for the last 2 years. Also, it doesn’t have to be YOUR first home, it can be your kid’s or grandkid’s first home too. See how this works? You pull out $10K from your IRA to pay toward their home, and they gift you $10K for Christmas. No 10% due. Ethical? Perhaps not. Legal? Certainly. Keep in mind there is a $10K limit.
- IRS Levy
- Reservist Distribution. A military reservist can withdraw money while activated without paying the 10% penalty.
Don't forget the really big one either- early retirement. That's right. You can retire early and spend your IRA money penalty-free. That's called the Substantially Equal Periodic Payments (SEPP) Rule. Basically, you can start taking it out any time you like but you have to take the same annuitized amount out each year from the time you start until you turn 59 1/2, at which time you can turn the spigot off until RMDs start at age 70. Or just pay the penalty if you want a little more once or twice.
Now, if you want to buy a boat with it at age 45 the IRS is going to have a problem with that. 401(k)s are for retirement. That's why you get such a HUGE tax benefit out of it. Let me remind you again of that tax benefit in case you've forgotten:
- Every dollar going in is pre-tax. If your marginal tax rate is 40%, contributing $50K to a pre-tax account knocks $20K off your tax bill THIS YEAR.
- Tax-protected growth. There are no taxes due on dividends and capital gains on the investments in the account.
- Tax arbitrage between contribution and retirement. A typical doctor saves money at a 40% marginal tax rate, then pulls most of the money out in retirement, filling the brackets as he goes, at 0%, 10%, 15%, or 25%. Contributing at 40% and withdrawing at perhaps 15% is a winning strategy.
In addition, most 401(k)s have a loan provision. While I'm not a big fan of taking a 401(k) loan, most 401(k)s allow you to borrow up to half of your 401(k) balance or $50K, whichever is less. Plus, with a 401(k), the 59 1/2 rule doesn't even apply. It's an Age 55 rule as long as you've separated from your employer.
Fifth, Phelps argues there are better ways to protect your money from taxes. The only one I can think of is a Health Savings Account (HSA), where you don't pay any taxes at all when the money comes out so long as it is used for health care. Certainly his favored investment of real estate does not have better tax treatment than a 401(k). Does it have some nice tax advantages? Sure. Are they better than those in a 401(k)? If you think so you either don't understand how real estate is taxed or you need to read that list above again.
Sixth, Phelps talks about how awesome it is to invest in real estate in a self-directed IRA. Where does he think an IRA big enough to purchase properties comes from? $5,500 a year isn't going to cut it. So it doesn't seem he is so much against retirement accounts as he is against non-real estate investments like mutual funds. He might be amazed to learn of the existence of self-directed 401(k)s.
Finally, Phelps is obviously an advocate for entrepreneurship and taking control of your destiny. I have no problem with that. What I do have a problem with is that he doesn't mention a rather obvious fact- that someone with a physician (or dentist) level of income can free themselves from their practice in just a decade or two by simply controlling their lifestyle, saving a bunch of money, and investing it in some low-cost, broadly diversified index funds, both inside and outside retirement accounts. The reason dentists are coming to him at 55 trying to figure out a way off the hamster wheel is because they spent all that money they made in their 30s and 40s and let their lifestyles get so big that they can't ever afford to let the wheel slow down, much less get off it. It doesn't matter what you invest in if you don't have anything to invest. Phelps is right that his pathway (business ownership and real estate ownership) takes work. If you're not interested in that type of work, realize it isn't mandatory if you're willing to control your lifestyle.
Exhibit A: The Physician on FIRE, who reached financial independence a decade out of residency while never having owned a practice or been a real estate investor.
Some Reasons to Actually Hate 401(k)s
Now, let's talk about some points that Phelps maybe should have included in his email.
A 401(k) is Not Enough
Some doctors think if they just throw some money into their 401(k) that their retirement will be covered. Investment gurus claiming they should expect 12% returns on that money don't help. First, you have to actually become financially literate, learn about what you're investing in, and create and follow a reasonable investing plan. Second, chances are that even a maxed out 401(k) isn't enough savings. I recommend a 20% savings rate for someone who wants a full career, and if all you can get into a 401(k) is $18K a year, that's only 9% for a doctor making $200K, and 4.5% for a doctor making $400K. You're going to need to invest somewhere else too such as Backdoor Roth IRAs or even a taxable account (which is a great place for those real estate investments Phelps loves.)
Some 401(k)s Do Suck
I'm lucky in that I have a pretty good 401(k). The account fees are very low, the investment options are all low-cost, broadly diversified Vanguard index funds, and if you want to do something else you have a brokerage window option where you can buy just about anything else. But there are still plenty of 401(k)s out there with egregious fees and bad investments. They might even come attached to a salesman masquerading as a financial advisor. While it may still be a good idea to contribute to a bad 401(k), (particularly if you won't be there long or if you have some hope of getting it changed), it does make it a less attractive option.
You Can't Add Value
The public equity markets might not be perfectly efficient, but they're efficient enough that you can't monkey around with your 401(k) in a way that will add value. In fact, studies show the less you touch those investments, the better off you'll be. That's not the case when you're a small business or income property owner. Your time and work can actually add significant value to those investments.
You Have To Cover Your Employees
If you are a practice owner with employees, using a 401(k) comes with some additional costs, like the match for the employees. That amount could be so high that it essentially eliminates the benefit of using the account to you, at least if you don't reduce their other compensation enough to make up for those costs.
Business Ownership is the Pathway to Wealth
This is a good place to acknowledge the truth of Phelp's main point. If you want to get really rich, really fast, be a successful entrepreneur. Investing in mutual funds in a 401(k) is likely to get you a 5-10% nominal return. That's a slow, steady path to wealth. If you're already burned out of your clinical practice, you're going to need something with higher returns that works faster. It will require significant risk and even more work, but it is a viable, and perhaps even preferable pathway to wealth, depending on your goals. If you have an investment available to you that will give you 15%, 20%, or 200% returns such as improving your practice, and you cannot make that investment AND max out your 401(k), obviously making the investment is the smarter move.
Conclusion
In conclusion, what I really hate about that email is the “either/or” nature of it. There is no reason you cannot invest in stocks AND real estate. There is no reason you cannot max out retirement accounts AND be an entrepreneur on the side. Both approaches have advantages and disadvantages. Moderation in all things.
What do you think? Do you think entrepreneurship and real estate investing is a viable path to wealth for the majority of physicians and dentists? What did you think of the email? Comment below!
If I were a bit more thin-skinned, it would be really insulting that he thinks I’m too old to enjoy my retirement, when I’m not even thinking of retirement. Of course, you can have a 401k AND invest in real estate but that’s not what he’s selling. And, of course, entrepreneurship carries its own set of risks, particularly for those who are not willing to put in the hours and the critical skills necessary. That was a nice rebuttal – maybe he will notice it.
It’s not particularly about David (who I think is a great guy doing a great service) but this particular email of his advanced an argument I see a lot that I think needed to be refuted.
In addition to things I do in the personal finance arena, I coach/advise/mentor a number of entrepreneurs. (I ran and grew my own company for 18 years before having a decent exit.)
I find that many are banking 100% on the business. Bad idea. Just like assuming that ONLY a 401k will be enough for you (for some people it will be, but don’t assume) – assuming that your personal business will cover 100% of your retirement needs is just as (“even more”?) risky.
Personally I love entrepreneurship. I also love (most) 401ks – and SEPs, Solos, IRA, etc. But just picking one of these options exclusively is rarely a good solution. They need to be combined and work together.
I think the key to becoming wealthy is learning to maximize your specific circumstance. If you have an entrepreneurial idea thats great go for it. Lets face it most docs don’t. Whatever your retirement plan is you need to study it and maximize your options. Contribute to it each and every year and never take loans. If you do this it is unlikely to be enough in and of itself. If you can do a backdoor roth great do it. If you cannot (SEP) then do not stress about it just go directly to a taxable account. If you avoid lifestyle inflation you can and should start working on a taxable account. Yes you will pay some taxes. Accept this and learn how to tax loss harvest . I started my own practice at 35. This will not be feasible for many people now. What is feasible is to learn a little personal finance and apply it your situation. You need to understand whatever you invest in. I feel like I understand stocks and bonds better than real estate so that is what I focus on. Good Luck.
I have met a few people who invest solely in real estate and believe that investing in the stock market is crazy and never use retirement accounts. They have a hard time investing in electronic assets that they can’t see and hold like the brick and mortar buildings that they actually own. There is something to be said about physically being able to touch your investments. You have to have some mental nimbleness to realize when owning a US index fund you own a small piece of just about every business you see.
Succesful entrepreneurship can lead to significant wealth, but the reality is that most endeavors leave in failure. Not only that, making a successful business takes significant time, effort and money. If you make $1k+ per day working in your career, it is very hard to choose to take a day off and toil on something that provides no immediate value. Often times you are far better off working on your own practice being able to make more money there as opposed to working on some side project that very well may never pay out.
Above are my current excuses. They may not be yours. I hope in a few years when I semi-retire I will be less lazy to try out some of my ideas and see if I can build something worthwhile with it.
Are you saying real estate investors aren’t “mentally nimble?” Not sure I’d go that far. But I see little reason to only do one or the other.
Not at all. Maybe I misspoke. I was just referring to the thinking that owning an index fund is an intangible asset when in reality you own many many assets. You just have no control over how the business is run.
An average physician makes more money than an average dentist, and many dentists have huge practice loans ($1M in total or more), something that most physicians would never have, even if they own a practice. So dentists start at a disadvantage. Also, many dentists’ careers are shorter. Many want to retire earlier, but due to financial burdens, they are not able to do so, and their ability to practice dentistry can significantly decline vs. doctors.
I would say instead that “401k is not enough” for those dentists fall into the above category. In many cases they would need a Cash Balance plan if they want to save enough for retirement. I also prefer the 3 buckets investing approach though, not just concentrating on the 401k/tax-deferred:
1) Roth/HSA. This one is maxed out.
2) After-tax. Closer to retirement this bucket should be nearly as big as the tax-deferred one. If real estate is part of the investment portfolio, it should not take up the entire bucket because of liquidity issues.
3) Tax deferred. This one is maxed out for those in highest brackets.
Someone saving significant money in a tax-deferred account must have an after-tax account. Why? Several reasons:
1) Create an income stream at retirement
2) Pay the taxes for massive Roth conversions that can be done prior to 70 and 1/2, which can result in significant RMD taxes saved, while converting much of the tax-deferred investments to Roth.
This would result in a huge Roth bucket distributions from which are tax-free, and which can then be used for multiple purposes (estate planning and income generation being the top two).
So from that standpoint a 401k plan is a great tool for a small practice owner to build wealth and to transition to retirement. And of course Dr. Phelps refers to crappy 401ks offered to dentists. I had a chance to examine many such plans, and most of them plain suck, with fees going up as high as 4% AUM (for no services or advice whatsoever). Often, local dental organizations push plans (like they do in California), and these plans are also rather expensive (~1.5% AUM at least), and not managed with the dentists’ best interests in mind.
Provided one can get a 401k plan with no AUM fees whatsoever, with the best possible plan design available and fiduciary advice to help the practice owner make the best financial decisions, it is a great tool which can be customized to the needs of the small practice owner:
http://whitecoatinvestor.com/how-to-reduce-your-practice-retirement-plan-cost
It just takes some time to consider the top level situation first and figure out what tools one should use to reach their goals. A 401k plan is just one of the available tools, so blaming a tool for the failure of the docs to plan and to learn how to best use all of their available tools to their advantage is just plain silly.
I think you’ve overstepped here with your “must have a taxable account.” I certainly would NOT advocate that a doc who hasn’t maxed out his tax protected and asset protected options (i.e. retirement accounts) invest in taxable just so he has some money to pay for Roth conversions. If you do that you’re paying taxes at your highest marginal tax rate when you earn it, letting that money get taxed as it grows, and then putting it in retirement accounts. Better to just put it in the retirement account in the first place. But yea, lots of people will have a taxable account and using it to pay for Roth conversions between retirement and Social Security is often a good idea.
I also agree it’s more of an issue for dentists. Not only is the road to FI harder due to a higher loan burden and a lower income, but they usually have employees which causes big problems with a 401(k)- i.e. your costs to give it to your employee may be more than the tax benefit you get from it. And a really crummy 401(k) with high fees and crap investments can eat up all the tax benefits by itself. But the upsides of even an average 401(k) are much more than its downsides for most.
Sorry, I didn’t want to write an article, it goes without saying that tax-deferred and HSA/Roth is maxed out before after-tax. That has been my approach all along. I was discussing the near-distribution stage, at which point the after-tax should be a decent size portfolio in relation to tax-deferred, which would be maxed out easily by high earners/good savers. And if one is consistently in the highest brackets, it is not unlikely to have a taxable portfolio that is the size of the tax-deferred one. This won’t be the case for those in the middle though, but those with huge tax-deferred assets can benefit disproportionately by having a large after-tax portfolio (not only would they need a higher income level, but their Roth conversions would cost more, so it is only natural).
Sounds like we don’t have a disagreement here.
But we dentists start our careers much earlier than physicians and those years are quite crucial in the world of compounding. As such if planned properly we should be able to retire sooner than physicians
Not necessarily. Many dentists are still associates or work in corporate dentistry trying to pay down student loans, so by the time they own a practice it can be quite a while. In some areas buying a practice is expensive and very challenging, too. Physicians have it easy in comparison. But physician income is probably less certain and there are more transitions for a typical physician vs. a dentist with their own practice. Also, physicians can ‘shop around’ to find a better deal, while if you own a practice you are more often than not stuck in place, as changing practices is a lot more complex than changing jobs.
How do you factor in the value of the dental practice in the retirement planning process? A good practice can fetch a decent price when the dentist transitions off.
I would not consider the practice value in retirement. I realize that some fee for service practices can cost upwards of $1M, but I doubt that many practices will be worth this much, and many factors can significantly decrease the value of a practice down the line, so just like social security, I would consider the proceeds from the sale of a practice to be a nice addition to your overall wealth, but not something I would bank on.
It’s all about valuation, but just like with your house, you’ve got to be realistic. Most practices probably aren’t worth what most practice owners think/hope they are worth. And in medicine, the value of lots of practices is rapidly dropping.
I agree with you WCI. We all have the ability to slowly grow our wealth but if you want to sky rocket there then you need to take some risk. This typically means starting your own business (what ever it may be) and hoping/working for it to be successful. Otherwise if you want to reach FI it will be the slow steady path.
I often feel for fortunate to be north of the border. The structure of our retirement vehicles and incorporation possibilities are two reasons. Our RRSPs are personal and not tied to the employer which I like. I disagree with them not being enough alone. Started investing in the mid-eighties first with GICs, then bank mutual funds and finally got smart in the 2000s and went with index ETFs. I am very far from an investment genius but DW and I each have 1 million in our RRSPs at 56 and 61. There is no penalty in withdrawing from RRSPs at any age in Canada other than the tax payable at one’s marginal rate of course. When I was working alternate summers as a student in a high paying factory job I used my RRSP for income smoothing. We are also very lucky to be able to incorporate and money staying inside the corporation is only subject to a 13% tax rate up to about 400k a year. (haven’t checked the numbers recently – corp tax rate may be plus/minus a percent or two and amount might be up to 500k now). This is a huge benefit in tax deferral, avoidance and income smoothing and splitting. There have of course been rumblings from the government about revisiting this situation. Time will tell.
Overall, things just seem simpler here which is much to my liking.
You should send me a guest post some time about what is different in Canada. It would be super interesting for every one and very useful for my Canadian readers. Plus I love BC. Like, a lot. I even looked into practicing there once.
I think it is a terrible idea to invest in leveraged real estate inside an IRA or 401(k)… The general situation is, you lose opportunities and jack costs…
http://evergreensmallbusiness.com/self-directed-ira-real-estate-investment-problems/
P.S. Your CPA firm will love you for putting real estate into IRAs and 401(k) plans. Good profit margin in those 990-Ts.
Sure, if you have an equity position. But if it’s a debt position then it’s better in a retirement account, at least from a tax perspective.
At any rate, I agree with you. I think your taxable account is a great place for buying real estate. That’s where all mine is but the REITs, but I’ve considered a checkbook IRA for hard money loans.
I agree with regard to loans… Good point.
Also, agree with your point about putting the REITs in the tax-deferred account… Another good point.
Investing in real estate isn’t limited to Roth accounts, so the $5,500 annual contribution limit isn’t applicable. It’s usually done through a 3rd party trustee/intermediary or establishing a self-directed IRA/401K with help from a service like The Entrust Group. I’ve met people with millions in their IRA/401K retirement who actively invest in real estate using those funds.
Retirement plans only guarantee deferring taxes, not reducing them. You either pay them today or pay them tomorrow. Which is better depends entirely on your tax rate at retirement vs when the money was earned and how tax rates change in the future.
Anyone planning on building their wealth indefinitely (instead of the traditional earn/save/spend model) is likely to have the same or higher tax rate through retirement. That can certainly makes paying taxes upfront and investing today more attractive than investing through the more restrictive options available with traditional retirement plans.
Retirement accounts do reduce taxes- the taxes due on income produced in between contribution and withdrawal. And in the case of a tax-free account, they eliminate taxes on earnings.
I agree that if you’re a super saver (meaning leaving 8 figures behind) that it makes more sense to use tax-free accounts instead of tax-deferred accounts when able.
Thanks for the very respectful rebuttal, Jim.
You and I are both very passionate in our desire to help our colleagues through the minefield of financial wealth-building to freedom; a path that is more treacherous today and for which many of our colleagues, unfortunately, fall very short.
As you have often well-stated, citing John Bogle, “there are many roads to Dublin.”
I’m married to a former Wall Street institutional broker who left that career in 2007 when she and many others saw the writing on the wall – the onerous regulation as well as the gross mismanagement and manipulation of those markets. Needless to say, she’s fully on board today with what she’s witnessed in our real estate ventures.
I admit to speaking harshly against what I believe to be true. I want to shake up people’s thinking. I want people to question traditional investment advice and portfolio strategies. At the same time, I respect, as you do, those who have different experiences, opinions, and outcomes.
I know what can be done via real estate – I’ve done it twice over a 37-year investment career. I know what works and what doesn’t.
Perhaps some day in the near future, we could live-stream a debate and bring both camps into focus. I love to present (or have presented) both sides of an argument – that’s what we do in our mastermind. Iron sharpens iron and the attendees get to make the final decision.
Keep up the good work!
I figured you’d be by at some point today. Thanks for what you do for docs and keep up the great work. I suspect the publicity you get from this “negative” piece will turn out to be very positive anyway and I hope to make it to one of the mastermind events soon, particularly as I find my way with the real estate portion of my portfolio.
I’d add a big one to the tax break – a 401k provides a known tax break today versus an unknown tax break down the road. Particularly for high income professionals. For example, one of the biggest benefits of real estate is the 1031 exchange – effectively, once you run out of depreciation expense, you can trade your building tax-free, get another bigger building, and start getting a new set of depreciation benefits. However, guess what tax break has constantly been discussed for being removed or restricted in a tax reform bill: 1031 exchanges!
The 401k is a great investment vehicle. My advice, don’t give up a known tax break for unknown tax breaks.
I found out that my current employers 457 and my “soon to be” employer’s 401K (start date 9/11/17) don’t have to be added together towards the max of $24,000 per year for those over 50 (I’m 53).
So, I will max out the 457 ($24K) and try to max out the 401K at the new job also. I can’t contribute to the new 401K until December, so I will tell the employer to put in as much of my pay in December as I can after paying the Medicare tax. I also max out my SEP-IRA on my “entrepreneurial” side work at about $28K.
Thanks for this article. I did not know you could use 401K monies for college tuition before age 59.5 and still avoid the 10% surcharge.
Why are you using a SEP-IRA instead of a solo 401(k)? If you used a solo 401(k) you could put the same amount of money into it as the SEP (more in some other people’s situations, but the same for yours) and still do a backdoor Roth IRA in addition.
Perhaps this varies by state but the other benefit to maxing retirement plan investing: sheltered from most lawsuits IIRC. Some states you might only keep your home and your pension plan if your umbrella policy isn’t there when you need it. So it is almost worth it to borrow money to max out your 401K/IRA. And doing it Roth means more for future and less to lose if a lawsuit goes bad.
The budget, legal version of the Swiss or off shore hidden account.
Excellent point.
And maybe for dentists- even us FPs are too rich- the 401K counts less for the kids’ college financial aid.
Much less. https://www.whitecoatinvestor.com/why-most-doctors-shouldnt-bother-with-financial-aid-planning/
Retirement accounts don’t count on the FAFSA.
I nearly tossed a 1000-count bottle of diclofenac across the room after reading this email. It’s just too all-or-none for me.
I agree with all of your pros for a 401k. One additional HUGE one that’s being left out is FREE MONEY! Most 401ks give you some form of a company match or other contribution added into it just for putting money into it. I can’t think of many other investments that do the same. Now that’s a win-win.
The reason you invest in index funds is because people in technical professions don’t usually have enough business-sense to make sound investment decisions, so you pay someone else to make those decisions. Sure, the upside isn’t as high as investing in your own business, being a landlord, or other options out there, but as with every financial decision there are trade offs, and with 401ks you give up short-term liquidity in exchange for for long-term stability. That should be okay for most people.
Besides, does a patient really want a surgeon spending their free time learning about investment strategies or reading up on the latest research literature?
I love my 401(k). Sure, my wife is also a partner in a small business, and we own an extra house (where an older relative lives, so it’s not income-generating). We each have IRAs and Roth IRAs. Our 401(k)s are low fee, with great low-cost funds, and have most of our retirement savings in them. 90% of my future pension was stripped away by changes after I hired on (I’m not a Doc, am in tech), and that is bad, but we’ll manage because of all we’ve saved. I love my 401(k).
And then there are the rules pertaining to real estate held in a self-directed IRA. All costs arising out of the ownership of the property have to be paid using money in the IRA. What if you don’t have enough money in the IRA to pay for a major repair? As I understand it, there are some pretty severe penalties applicable if you use other funds to pay for anything in connection with the real estate held in the IRA.
Let’s say 100% of your 401(k) is in equity index funds, so the cap gains and [qualified] dividends would be taxed at 15% if held in a taxable account. If your income tax rate when you withdraw from your 401(k) is higher than 15%, aren’t you paying more in taxes on your 401(k) withdrawals than you would be if you just held the investments in a taxable account?
Maybe it’s better to concentrate on just the cap gains (as taxes on dividends would be paid every year if held in a taxable account, and not benefit from the 401(k) deferral) – say you’re in the 32% tax bracket in retirement. If you realized the cap gains, you’d pay 15%; instead, you’re paying 32% on the 401(k) withdrawal. In effect, you’ve transformed cap gains income (at 15%) to ordinary income (at 32%) by holding the equity index funds in a 401(k).
I’m having trouble reconciling this in the context of one’s overall investment strategy.
You’re totally ignoring the initial tax break, the arbitrage between contribution and withdrawal tax rates, and the tax protected growth. Investing in retirement accounts pretty much always comes out ahead of investing in taxable, assuming the same investments and the same amount of post-tax money invested.