So the 401k matching just went away

The Coffee Shop
1

My small company has a very poor (high expense, few options) 401k plan that was compensated by 50% matching to 7% total income plus random pre-tax profit sharing added.

Today the fund matching went away, and I’m mostly venting, but I could use some input as to my options. My wife doesn’t work so that opens up things like:

  • quit contributing to the 401k
  • reduce 401k contributions
  • pay into my Roth IRA (which I was doing anyway)
  • pay into my wifes’ IRA or Roth
  • extra pay down of my mortgage (5% 30 year fixed)

I’ll sit down over the weekend and work out some of the math but the first thing is that strikes me is that with or without 401k contributions I can put a total of $10,000 to tax deferred accounts, and with the 401K I can put an additional $16,000 to tax deferred accounts.

Thoughts?

Bob

2

This may help:

http://www.kiplinger.com/columns/ask/archive/2009/q0108.htm
.

3

You’re still getting the advantage of investing with pre-tax $'s in the 401k. I wouldn’t give that up.

The absolute last thing I’d do is to pay down your mortgage. Unless by doing so you can break through to < 80% loan to value and get out of PMI. Assuming that’s not the case, then additional principal paid does no more for you than sticking the $'s under your mattress. The house will appreciate (hopefully) no matter how much equity you have. You don’t gain any additional return on that asset because you have more equity in it.

FWIW…there’s a lot of that going on these days. My wife runs a mid-sized non-profit and has always been proud of the benefits she’s provided to her people. She’s just had to suspend her match against the 403b too. It’s a tough pill to swallow, but it beats the heck out of laying people off too…

4

David, help me out here, I’m slower than most. Leaving such issues as pride in home ownership aside.

I spent a few minutes trying to figure out the RoA thing. Say the home is worth x and appreciates at 6%. The more cash I invest in the home, the more of the asset I own, and my RoA is 6% (this equals my investment goal for our theoretical year).

Why should I not gaurantee myself a return on investment of 6%, increase the net yield of my RoA at the same time, and decrease the interest I’m paying out to others?

I trust you can figure out what I’m trying to ask.
(let’s leave out the obvious advantage of tax defered accounts)

5

Are you equating “invest in the home” with paying down your mortgage? If so, that’s your problem. You own 100% of your home (and all appreciation) whether you owe 80% or 0%. The only way the lender owns your home is if you fail to make payments and they foreclose.

Assuming your loan situation is reasonable…I agree with David in FL.

6

Nope; I rather badly asked if investing cash in a home (by paying more of a mortgage down) wouldn’t that insure that my cash was earning at exactly the appreciation rate of the home.

What I couldn’t figure out was the return on asset statement. If I only “own” 20% of my home, I can only return 20% of its growth in value back to myself. The more I “own”, the more I return to myself.

We own our property outright. We may borrow to buy a few more, though, and I am confused on the RoA thing.

7

I spent a few minutes trying to figure out the RoA thing. Say the home is worth x and appreciates at 6%. The more cash I invest in the home, the more of the asset I own, and my RoA is 6% (this equals my investment goal for our theoretical year).

Why should I not gaurantee myself a return on investment of 6%, increase the net yield of my RoA at the same time, and decrease the interest I’m paying out to others?

Let’s say that your house is worth $200k today. Unlike other investments, that value is irrespective of the *equity *that you have in the house. If you own it free and clear, it’s worth the same as if you’re mortgaged to the hilt. As the house appreciates, it does so independently of your equity in the house.

Let’s say you’re a prudent homeowner and bought with 20% down. Your mortgage is $160,000, you have $40,000 in equity, but your house is still worth $200,000…

Now, over the next 5 years, let’s say the value of the house appreciates 50%, to $300,000…that appreciation, and the subsequent value of the house is the same no matter how much additional principal you pay into your mortgage along the way. If you started with $40,000 in equity fr your 20% down payment, after the 5 years, your equity is now $140,000. Now let’s say that instead of just making your monthly mortgage payment, you also pay down an additional $10,000 per year in principal. After 5 years, you’ve paid down and additional $50,000 and your total equity is now $190,000…the difference being exactly equal to the amount of additional principal that you paid down. You’ve earned nothing on that $50,000. The same as if you’d simply put it into a shoe box in your closet. You’d be far better off with a safe investment that offers a minimal return like a cd or money market.

The exception lies in the length of time that you’re going to own the house. If you do expect to be there for the entire length of the 30 year mortgage, then you will save some $'s on your interest by paying down the principal. Even then though, you’ll need to take a careful look at the time value of the money that you’re paying into additional principal along the way to ensure that it still doesn’t exceed the interest savings. For most of us who aren’t going to be in a house for 30 years, it’s not even close.

Does that help?

8

Well said and clear enough for an old farmer like me.

The only issue I would bring up would be paying principal down and the resultant effect it would have on interest. If I owed at a rate of 5%, I could guarantee myself 5% by paying the debt down.

don’t answer that and the time value of money question, as I need food and something to ponder this weekend. I just sold May wheat and can’t figgr out why I did.

9

what about interest at 5%?

I borrow lets say 150k at 5% and the total repayable is over 300k, give or take. If I can pay off an additional 10 now, that saves years off the mortgage. There are some sound reasons for overpaying, increasing equity may not be one, but when interest rates in saving accounts are in the UK an average of .19% or thereabouts I am better off investing in my home aren’t I?

10

… If I owed at a rate of 5%, I could guarantee myself 5% by paying the debt down.

…
That is the part I’m pondering as well. If I assume that I have same amount of money to save just different piles to put it in, and somehow compensating for pre-tax vs. post-tax value, it seems to me that paying down the 5% principle is the equivalent of a 5% rate of return - tax free. Now I lose on the other side by have less tax right off in interest over time. I did this calculation a few years ago when I was considering what to do with “extra” money, and IIRC I would have to get a 7% rate of return to match the improvement in my net asset value that I would have gotten if I had applied that to the mortgage. On top of which the rate of return on the mortgage is known.

I’m not thinking of putting it all into the mortage, but as part of a balanced portfolio it seems like a good conservative “investment”

11

You’re still getting the advantage of investing with pre-tax $'s in the 401k. I wouldn’t give that up.

 Yes, but I'm looking at 2.5% fees, with the only fund-like investment that I currently trust being an S&P Indexed fund.   I could be with this company for a long time and without the matching it seems like I'd be better off elsewhere, at least until the matching comes back.
12

Mortgage interest is simple interest, and it’s deductible from your income taxes.

Investment interest is compounded. Even if the rate was the same you’d come out ahead investing.

13

You’re still getting the advantage of investing with pre-tax $'s in the 401k. I wouldn’t give that up.

Yes, but I’m looking at 2.5% fees, with the only fund-like investment that I currently trust being an S&P Indexed fund. I could be with this company for a long time and without the matching it seems like I’d be better off elsewhere, at least until the matching comes back.

What is the 2.5%? Is it a front or back load on all transactions? If so, that really sucks, but you still need to balance that against the benefit of deferring tax at your current effective tax rate, which is obviously far greater than 2.5%.

14

what about interest at 5%?

I borrow lets say 150k at 5% and the total repayable is over 300k, give or take. If I can pay off an additional 10 now, that saves years off the mortgage. There are some sound reasons for overpaying, increasing equity may not be one, but when interest rates in saving accounts are in the UK an average of .19% or thereabouts I am better off investing in my home aren’t I?

You’re right, if as I said you intend to stay in your home for the entire mortgage term. If so, then you need to balance the savings in interest vs the opportunity value of the investment that you could be making during that period. Remember too, the overall interest cost of that mortgage is reduced by the tax benefit that you receive along the way…and the savings through early repayment are likewise reduced by the same factor.

15

Mortgage interest is simple interest, and it’s deductible from your income taxes.

Investment interest is compounded. Even if the rate was the same you’d come out ahead investing.

Bingo. The effective “rate of return” there is the decreased by the income tax savings. As a simple example, at 5%, with an effective income tax rate of 25%, the effective rate of return is only 3.75%, and it’s likely that you can improve on that by investing the extra money rather than buying down the mortgage.

16

David, I’m pretty sure you are wrong on this one…though I’d love to be convinced otherwise.

The value of the house is irrelavent. If you owe the bank 6% on your principle, then you are losing 6% of every dollar that you owe the bank. To use VERY rough numbers as an example, if your priniple is $100,000, you will pay the bank $6,000 in interest that year (+ the compounding). If you had a $100,000 stuffed under a matress, the net result would be losing $6K to the bank. If you, instead, piad off your mortgage, that would be $6K that you didn’t pay them in interest that year.

The difference between paying off your mortgage or putting the money under the matress is ~$6K in that scenario. It’s independent of the sale price of the house.

The ta x deduction only makes a difference of about 1-1.5%, and this depends on how much you pay in interest that year. In the scenario above it wouldn’t make a difference if you had no other deductions as you would still be under the minimal standard deduction. This would, of course, be a case by case basis. People with a low prinicpal and low deductions might not benefit at all from the mortgage tax deduction.

Re: 401K - Your 401K contributions DO get taxed…they just get taxed later rather than now. I’ve worked the numbers a million different ways and in the end, it doesn’t make much of a difference…at least not these days when the upper tax rates are not very high. Save 30% in taxes by investing now but pay 30% when you draw later. Same thing. What if the rates go up by the time you retire? Then you’ve screwed yourself.

You have to throw fees on top of that as well. The big difference is going to be how the market appreciates from now until then. Its low right now, so buying cheap may not be a bad idea. On the flip side, paying off the mortgage is a GUARANTEED 6% return…which is pretty damn good.

17

Barry, mortgage interest is simple, it doesn’t compound.

Interest is also heavily front-loaded. Look at the amortization schedule for a mortgage loan – the loan payment is often 60-70% interest the first few years, but much more principal the later years. If you are already 20 years into a 30 year fixed mortgage, you aren’t saving much on interest by paying ahead, as you’ve already paid the majority of the interest.

18

You’re still getting the advantage of investing with pre-tax $'s in the 401k. I wouldn’t give that up.

   Yes, but I'm looking at 2.5% fees, with the only fund-like investment that I currently trust being an S&P Indexed fund. I could be with this company for a long time and without the matching it seems like I'd be better off elsewhere, at least until the matching comes back.

What is the 2.5%? Is it a front or back load on all transactions? If so, that really sucks, but you still need to balance that against the benefit of deferring tax at your current effective tax rate, which is obviously far greater than 2.5%.

 Unfortunately the 2.5% is the total yearly fee on the entire account (i.e. you pay more, the more you have).  This seems independent of the number of transactions you make, but can be lowered to about  2.0% in the correct fund.
19

Actually, I’ll back down just a little…the “shoebox” analogy was prob a little overstated, because it only addresses the appreciation which is completely independent of equity in the house.

As to the savings on interest by paying down, I’m still going to stick to my guns that you’re usually much better not to do so. As Peter mentions, the compounding of the investments gives a much better time value opportunity than the simple interest savings. At a 5% mortgage rate that the OP has (great rate BTW!), when you factor in the point and a half or so in tax benefit, you’re only looking at 3.5% simple interest. If he’s 20 years to retiring, we’ll use that as the compounding term for our time value calculation. That shows an equivalent interest rate of about 2.7% vs the 3.5% simple interest. Now we still have to factor in the additional 20% or so of pre-tax $'s that are available for investing and compounding due to the tax deferred nature of the 401k. While you’re right that the 401k $'s aren’t tax free, but rather tax deferred, the presumption is that when it comes time to withdraw those $'s for use, you’re likely to be in a lower tax bracket than you were during the height of your earning years and as such those tax deferred $'s will be taxes at an incrementally lower rate.

One other consideration. As a practical matter, the $'s “invested” into the mortgage are completely inaccessible short of an equity loan, cash out refi, or selling the house…and of course, there are additional costs associated with those limited options as well.

All in all, I really believe that taking money out of a 401k to pay down a mortgage is seldom going to make sense in the longer term.

20

I’m in a similar situation with the 401K, and it makes sense to still contribute. Just choose funds with low(er) expense ratios. I’m in an index foreign stock fund.

As for the mortgage question: I ran the numbers, and I get the financial part. I’ve spent 80-90% of my extra $$ paying off my home. Now, I have a paid off house at 31 years old. I go to sleep knowing that I owe nobody, and that’s worth a whole lot to me. Plus, all of that money I put into my home is 1) money I did not lose in the markets, and 2) money that I do not have to pay out in ‘operational’ cash.

Just like a business, operational cash flow is important. Theoretically, I can live on a fraction of my salary because I have little overhead. There is also savings to be had in reduced insurance (I have a lower policy because I don’t need to worry about paying off the home if I or my wife die). Plus, I have the freedom to make decisions, financially and professionally, that do not include meeting a mortgage payment. I’m not placed in a situation of needing to take a job if, heaven forbid, I lose mine. I also need less in my emergency fund, so there’s additional operational cash.

The tax deduction is good, if you qualify, and if the government chooses to retian it. I believe they will slowly phase mortgage tax deductions back. The goal of that policy was to promote home ownership, and at 80%, that goal has been met.

I don’t think you should cash out the 401K, however. I’m just putting another aspect out there. As Dave Ramsey says; personal finance is personal.