Long Term Capital Gains & 401(k): Conflict!

401(k)’s are great but one of the greatest drawbacks is the fact that you will always be taxed at the short term capital gains rate, your marginal tax rate, on investments in a 401(k) and that hurts.

With investing, the government wants you to hold onto an investment for the long haul and thus taxes you at the long term capital gains rate, which has always been considerably lower than your marginal tax rate. For example, if you would’ve paid a short term rate of 33%, your long term rate is a mere 15%; that’s a 50% discount on taxes just to own an investment for at least a year. This is why the buy and hold strategy is so powerful, you get to weather the deviations while getting “paid” by the government to wait and not be a day-trader.

The trouble with 401(k)’s are that you take disbursements, or payments, in retirement and those payments are taxed at income all the time. You could have held stock for 40 years but you’ll be collecting any sales proceeds as income regardless of the underlying tax implications.

However, before you jump the gun and dump the 401(k), the saving grace is that you start off with a bigger pot because you can contribute to a 401(k) and deduct the contributions. If you start with $10,000 of salary, you can put the whole $10,000 into a 401(k) versus a smaller amount into a taxable account after taxes.

So, if you’ve considered not doing the 401(k) for this reason, you can read the math contained in this CNN Money article for proof that the 401(k) is still superior.