Tax Dangers of 401k investing

     The hidden tax risks of 401k investing (besides high fees and limited choices) is the “tax opportunity cost trap”. When you invest in a 401k and make a long term gain the income is treated as ordinary income, which has a higher tax rate than if the gain occurred in a taxable account. If you buy real estate in a 401k you can’t do a 1031 tax deferred exchange. If you own appreciated assets in a 401k and die then the appreciated assets don’t get a “basis step-up” and thus your estate will pay more in income tax on the capital gains then if the assets were held in your taxable account.

  Perhaps the biggest hidden opportunity cost is that if assets are in a taxable account then one can borrow against them and buy more assets without selling. Then they can save on taxes by waiting for a long term capital gains tax treatment, or a basis step-up on death or a 1031 exchange. During a long bull market an affluent investor could live off of dividends and loan borrowings from appreciated assets without selling and incurring capital gains tax. Then when the owner dies the basis step-up means no income tax is due on the capital gain. This is not possible with assets held in a 401k.describe the image

  Open the doors to creative investing

     If someone wants to start a business it would be nice to have one’s assets outside of the 401k so that it would be easy to raise cash for the business. (There is a way to buy a business inside of a 401k, but it has some problems and limits that make it risky).

   For estate planning purposes one should give as much as possible to their children up to the $13,000 annual limit. A married couple with a married child could give four times $13,000 a year free of gift tax. Over 30 years this is $1,560,000. Assuming a 55% estate tax, this saves $858,000, which may be more tax savings then that provided by a 401k. Further, the heirs could invest the funds and have the assets grow, hopefully in the form of long term capital gains, thus reducing the heir’s future tax. If the funds were trapped in a 401k then this would not be possible. If assets are in your 401k you can’t give away those assets until you die and then your estate would have to pay estate tax on them. Of course, estate tax is a problem mainly for “rich people” but with inflation it is possible middle class people will pay estate tax in forty years from now. The AMT tax has never been adjusted for inflation and now traps people who make as little as $50,000, but was intended for those who were very high income when the law was created in 1969.

   I wrote an article “Are your funds trapped in a 401k?” and “401k contributions not always a good thing.”

   On the other hand, the risk is great that some naive, selfish investors will gamble recklessly with their funds, so having funds in a 401k increases the odds that they will be forced to invest conservatively, which is the best way to invest. A 401k reminds me of a state liquor license law that tries to discourage drinking by making people buy liquor only at special stores with limited hours and limited customer service.

Investors should seek independent financial advice.