Reader David left a comment with the following question in it:
Every other mutual fund I have ever owned has at one time or another paid out dividend distributions.This includes funds that I have held on my own, and some that were held in Traditional and Roth IRA’S. Not so with any funds I have had in two 401k plans over the years. Going all the way back in my annual statements I cannot find a single entry for dividend distributions. Do you have any ideas why this might be so and whether or not I would be better off making contributions to an IRA that go above and beyond the company match??
There are several ways that I’ll attempt to answer this. Keep in mind, I’m not a financial planner, or a financial adviser, so take what I say with a grain of salt. Perhaps a few of my adviser readers will have slightly better advice, we’ll see. I think there are really two questions there though (I won’t charge you extra.), so let’s break it down a bit.
Dividend Distributions in 401(k) and IRA accounts
Several things could be happening here, but here are the most likely scenarios. Because of the difference in how a 401(k) and an IRA are handled for taxes, (401(k) is pre-payroll tax while IRA is post-payroll tax) the tax that you would normally pay on a dividend distribution is deferred in a 401(k). What that means is that the dividend income in a 401(k) doesn’t have to be reported and is usually automatically reinvested. Depending on the 401(k) provider, dividend income might just be being shown as a capital gain on the fund since that’s what it becomes in this tax scenario. Another possibility (although somewhat unlikely) is that, like stocks, not all funds will pay a dividend. The only way to figure that out is to do some research into the individual funds that you own in your 401(k) and determine if they pay a dividend or not. I like finance.google.com for quick lookups, but the best place would be the website of the fund, or the prospectus for the fund.
Make Contributions to an IRA that go above and beyond the company match
I wanted to tackle this question separately. First, you should, absolutely, take advantage of your company match to it’s full extent. If your company will match x% up to y% of your income, you should contribute y% at a minimum. It’s free money, and I guarantee you the company looks at it as a part of your compensation package. You wouldn’t leave a paycheck un-cashed would you? Once you’ve met that amount, several things come into play. I think the biggest of these is your personal tax situation. A 401(k) acts as a deferred tax account. You don’t pay any taxes on your contributions, and then pay taxes (at your then tax rate), on the withdrawals. With a Roth IRA, you pay taxes on the contributions, but not on the withdrawals. Let’s say you make a lot of money now, and your tax rate is 35%. When you retire, you’re no longer making those fat stacks of cash, and your tax rate drops to 25% or less. You’ll now pay 10% less in taxes on those withdrawals. Keep in mind that those withdrawals will include any capital gains that the account has accrued over your working career. In the Roth IRA, you’ve already paid the taxes on contributions at 35%, and you don’t pay any taxes on the withdrawals. In this scenario (10% drop in tax rate), you’ll need to have managed gains of 10% above your contributions by the time you retire to realize any significant difference.
Another thing to look at, is whether you are able to contribute to the limits. In 2012, the 401(k) contribution limit is 17,000. If you’re 50 or older, you can also make an additional “catch-up” contribution of $5,000, for a total of $22,000. There’s an additional overall limit of $50,000 for employee plus employer contributions. So, if you make the max contribution, your employer can only contribute the additional amount to $50,000. For the IRA, the maximum annual contribution is $5,000 (or $6,000 if you’re 50 or older). There are also some restrictions on how much of the contribution is tax deductible, and how much can be contributed based on income.
The simple suggestion here is that you should contribute to your 401(k) up to the % that the company will match to take full advantage of that added compensation. Once you’ve hit that %, contribute to an IRA up to the full amount you’re allowed. Once you’ve hit that contribution limit, invest any additional contributions into your 401(k). Obviously, it takes a bit of math to figure all of that out, since you won’t likely know whether you’ve hit the max on the IRA without some pre-planning. But, if you can manage to sock away the $5,000 (or $6,000 if you’re older than 50) into a savings, you can write one check at the beginning of the year as your current year contribution to your IRA, and then take whatever you’re comfortable with out of your paycheck for your 401(k). Using a tax refund as a boost to the IRA contribution can be helpful (if you get a refund).
That’s a very high level overview of the IRA vs. 401(k) question though, and you really should consult your accountant or a financial adviser on the subject. There are lots of factors that go into the the tax ramifications of both, and you really want to know as much as you can so that you can adjust your retirement planning accordingly.
I’m sure many of my personal finance friends who know more about the subject than I do will offer their wisdom in the comments, so be sure to check back and see what nuggets they have to offer. 😉
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Excellent breakdown of the components leading into these questions. I fully back the strategy of getting everything you can out of your 401k company match before moving on to fully investing in a Roth IRA.
Great explanation. I would just be sure to note the difference between a Roth IRA and a traditional IRA. Roth IRAs are post-tax and have different implications in the long run than traditional IRAs.
You say not taking full advantage of employer match is like leaving money on the table, but keep in mind that that match (as well as the funds you contribute) are STUCK in the 401k until retirement age and you are LIMITED to only the investments provided by the investment company that handles the company’s 401k.
I have been able to contribute for the last 5 year, and I have seen my employer match (and more) disappear to market losses. I can’t keep it as money market / cash account, because between now and retirement age that would completely lose its value to inflation.
Five years ago, my retirement planner said I would need to average 8% return during the next 40 years. I’ve worked for just over 5 years, faithfully tithing 10% of my paycheck to the Stock Market Gods, and I’m not at all on track for retirement.
I used to hear the stock market, over any 30-year period, always goes up…. invest for the long-term, etc. But how many phenomenal years will I need to get back on track?
@MyMoneyDesign Thanks for the comment!
@Eric Part of the reason that I didn’t go into the differences between a traditional IRA and a ROTH IRA is that I’m not that up on the differences myself.
@Joseph The money isn’t necessarily “stuck”. It can be withdrawn, but will incur taxes and a 10% penalty if you’re under the age of 59.5. You are limited to the investments that the provider of the 401(k) offers, and that can be a problem at times. Ideally, your employer would use a company that provides a good variety of options. As a whole, the Dow has been stuck in neutral since about 1999. (http://stockcharts.com/freecharts/historical/djia1900.html) It’s had ups and downs, but overall, it is up slightly. That’s as a whole, of course. Depending on the investments, your mileage may vary. Putting all the money into a money market or cash fund isn’t a very good idea, as you figured out, because inflation will eat pretty much all of your gains. If you’re looking for something a bit more stable, while outpacing inflation, bonds might be a good option, but, again, that will depend on your options for investment. Keep in mind that bonds are usually a fixed income sort of investment, so you won’t see any wild swings in either direction.
In the end, it’s hard to predict what the markets will do. Yes, historically, they’ve gone up. But, history is history, and there are some pretty powerful market variables that are floating around at the moment that make the market pretty volatile.
There are other places, as I’m sure you know, that you can invest your money. Real estate is one. Starting a business can sometimes work out well, but often doesn’t. Recently, peer-to-peer lending has taken off as well and many are seeing returns that exceed what the stock market has been able to do. (You can see my most recent returns update here: https://www.beatingbroke.com/lending-club-returns-update/)
When it’s all said and done, I have to be honest and say that I don’t know what the right answer is. The reality is that most of us will need retirement funds that exceed 7 figures, and few of us will make it that far with the traditional 10% rule and conservative investment. Even if you’re making 250k a year, you’ve also got to make the connection that saving is key and smart investing will help that.
Great strategy and one that I’ve used and teach others to use. Take the match up to the % and then go for Roth or Traditional. The only exception would be the years that it takes to be vested. Some companies are weird about this as it takes several years to become even partially vested. Example: If you know you’re only going to be at this job for 2 years and it takes 3 years to become partially vested, then just go for IRA options. This is a rare case, but I have heard of some. Just ask your benefits department about the vesting rules.
We have put our own spin on this…http://wp.me/p2h40p-j
Cliff notes, sometimes dividend distributions aren’t seen b/c the funds aren’t public. And as BB said, taxation doesn’t occur while accumulating. Typically, IRA funds are with a company which makes them public and has certain rules to follow (SEC). Combine that with other people investing in the same fund within a taxable account, a company needs to track when dividend distributions are made.
Thanks!
One thing that hasn’t been covered in regards to the original question is the fact that many 401(k) accounts are not held at brokerages, but with insurance companies. The “funds” that are available for investment aren’t real mutual funds, but rather vehicles that attempt to mimic the holdings of the actual mutual funds.
This happened to me a few years ago. The firm I was employed by held their 401(k) account with an insurance company. I was using Microsoft Money at the time (it has since been discontinued) to track all of my finances, and for the life of me, I couldn’t get my account balances to match the “mutual funds” I was supposedly invested in. When I called the number for the person who was the firm contact for the retirement account, they informed me that what they offered were not actual funds that were offered by Vanguard, Fidelity, etc. but their own products that they tried as best they could to match up to those products. Therefore, the holdings weren’t going to tie out exactly, the valuations weren’t going to be the same, and distributions weren’t paid out, but rather kept within the “funds” and used to increase the NAV as it were.