401(k) Always Taxed Short Term Capital Gains
March 14th, 2008 | Published in 401K
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.
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