401(k) Always Taxed Short Term Capital Gains

March 14th, 2008  |  Published in 401K  |  6 Comments

401(k)’s are a great retirement investment vehicle. The two primary benefits of a 401(k) is that your employer will often give you some sort of small percentage match on your contribution and you get an immediate tax deduction for the amount you contribute. When your employer kicks in an employer match, that’s like automatic appreciation. To leave that on the table would be a huge mistake. The immediate tax deduction is also a plus because it softens the blow of not being able to access the funds and it’s a “reward” for thinking of the future.

There is just one huge problem with 401(k)’s: you are always taxed the short term capital gains rate.

Let me illustrate with an example. If you purchase a share of MRB Enterprises at $10 a share and it appreciates to $20 a share within a week, you may consider selling it. If you sell it within a week, the gains are taxed at the short term capital gains rate (your marginal tax rate). If MRB Enterprises stays at $20 for another year (51 weeks and a day), then you qualify for long term capital gains tax rates which are 10% or 15%, depending on your marginal tax rate. The difference between short term and long term capital gains can be staggering (the maximum individual income tax rate is 35%).

When you take disbursements from a 401(k), you’re taxed at your marginal tax rate no matter what. If you held an index fund within your account for the last forty years and start taking disbursements, you will be taxed not by the long term capital gains rate but instead by your short term capital gains rate.

I’m not mentioning this because I think it’s unfair, it’s totally fair; but it’s food for thought.

  

Responses

  1. M.jefferies says:

    April 19th, 2009 at 9:26 am (#)

    I have a brokerage link in my 401k and often short term trade with 10-15% fast returns. Are you saying I need to keep track of each and every one of them for tax purposes 20-30 years from now? I thought it was all taxed at the same rate when taken out at retirement? Thanks.

  2. retirehappy says:

    April 21st, 2009 at 8:16 am (#)

    No you won’t, it is all taxed the same. I was just saying what rate they were taxed at. 🙂

  3. TaPlun says:

    December 1st, 2009 at 3:50 pm (#)

    I’m assuming the capital gains rates are for both the Federal and State level income taxes – yes?

  4. cogcan says:

    February 25th, 2010 at 10:46 am (#)

    401k is ordinary income

  5. John says:

    March 31st, 2010 at 5:09 pm (#)

    The alternative would be not to defer, get taxed on what you would have deferred (say $10,000), net 40% less ($6,000), and invest that. So now rather than $10,000 in a 401k, you have $6,000 in a regular investment account. If you assume 30 years @ 5% annual, then you have only $26,000 vs. $43,000 in the 401k account. And you would still owe capital gains in the regular investment account.

  6. joe kid says:

    November 10th, 2011 at 3:13 am (#)

    I am 67 years old and have 50,0.00 in 401k. How much tax will I have to pay and how long does it take to get the lump sum?