Retirement Accounts Still Worth Funding?

Q: I bought your book, Investing for Dummies and I am learning tons but my options are limited. My employer is saying that we can only put our 403(b) investments into Fidelity and I do not like my choices. After learning about expense ratios and management fees, I'm not sure I'll have anything left in my portfolio. How can I calculate how much I will actually be paying in taxes if I just take the money directly from my checking account instead of pre- tax deductions in a 403(b) account? I live in California.


A: You can calculate the tax savings of contributing to your 403(b) or conversely the increased taxes you'll pay, through determining what's called your marginal tax rate. That's the rate of tax, both federal and state, you pay on your last dollar of earnings. Because our tax system is graduated, you pay a lower rate of tax on your first dollars earned and higher rates as your income pushes you up into higher income tax brackets.

Based upon the salary you stated in your longer note to me, I'm estimating that between federal and state taxes, your marginal tax rate is about 35 percent. Thus, for each $1,000 you can contribute to your 403(b), you can save yourself about $350 in income taxes. If you instead direct this money into your checking account and then invest from there, you will only have $650 left to invest from each $1,000 you earn - that's like suffering through a 2008-like stock market decline every year!

Potentially even more valuable than the up front tax break is the fact that your investment earnings compound sheltered from taxation over time inside the retirement account. See this analysis which compares investing inside versus outside a retirement account from Vanguard.

Fidelity has some solid funds. Please remember as you examine their mutual funds that stock fund return numbers everywhere look bad due to a lousy 2008. If you want to do something simple and be highly diversified, consider Fidelity's Freedom funds which are funds of funds that gradually scale back on the risk of their holdings (stock portion of the portfolio) as you get closer to the retirement date.