Does it make sense to invest in a 401k for a short term?

Mohit left the following comment on the Suggest a Topic page recently:

Mohit Agrawal March 18, 2015 at 8:13 pm [edit]

Hi,

I would love to know your views on investing in 401(k) in USA if a NRI plans to remain in USA short term like 5-7 years. Is it still worth it?
Because the tax you save and employee matching comes down to around 40% benefit. But when you cash out your 401k account when you leave for India you have to pay tax on that amount in USA at around 30% and then 10% is penalty. Is is really worth the hassle to invest in 401(k) in USA? or should I be investing that money in India

First, let’s take a look at what happens when you prematurely withdraw money from your 401k

  1. Negative: You pay 10% of the withdrawal money as penalties because this is a retirement account, and you are supposed to keep money in it till retirement.
  2. Neutral: Pay taxes that you had saved in previous years on the money withdrawn at the time of withdrawal because you didn’t keep your money for as long as you said you would.
  3. Positive: You keep the employer match to your 401k intact as long as there were no vesting rules that were flouted, so this is free money that you still got to keep.

If you think of these three factors, you can look at your own situation, do a rough calculation of how much free money you are getting, how much you will pay in penalty, and then treat the penalty as simply reduction of the free money you get from your employer’s match. In most situations, I would imagine that the employer match will take care of your penalty, so from a numerical standpoint it will┬ámake sense to invest in a 401k for even if it is for a short term like five or six years.

Now, the next thing to consider is whether this employer match is a big enough sum that you couldn’t accumulate while investing in India for four or five years, and that’s a tricky question. I believe that the match will still edge out the high interest rates in India, but perhaps not the high equity returns.

The last thing to consider is that when you are withdrawing the money, you will effectively have to pay around half of it in taxes and penalties, and based on your salary, 401k contribution and employer’s match, the money that you get at the end may not be worth the little hassle you go through during the five or six years for investing it.

So, I think whether you invest or not is based on your situation, and how comfortable you are with the idea of a penalty, and paying a big sum as taxes at the end as opposed to extracting whatever benefit you can from this investment.

8 thoughts on “Does it make sense to invest in a 401k for a short term?”

  1. Hi Manshu,

    There is trick to lessen the taxes after you take money out of 401k.
    Its straight 10% penalty and remaining amount is added to your taxable income for that year. So it makes difference on exactly when you are going to stop working in USA. If you stop working in USA at the start of the year when your yearly taxable income is less for that year then you will pay less tax compare to stop working near year end.
    So if you have a choice of picking up time to return to india, make sure you return at start of the year rather end of the year. This will save you considerably good amount.
    Another way looking at this is, it doesn’t hurt keeping money in 401k as it is. You can take this money out of 401k when you reach retirement age. You will be able to monitor / communicate from India as most of 401k platforms are online. You can treat this as another retirement account which you will get at age of 60 years. This is little risky though I would not definitely suggest this to anyone who doesn’t understand drawbacks of this option.

  2. Interesting post and I have a similar situation. I have a 401K acct which was created after I left US by my former employer and some small amount was deposited.It has actually risen a little in 2-3 years.
    I have no clue on 401 but I understand from above you have a penalty if you withdraw early. I also learnt there is some form to be filled with IRS for same.
    What is the age for withdrawal without penalty(am in no hurry) and any idea how to withdraw from India?

      1. Maintaining a 401k account while in India is tricky. You may be liable to pay India tax on dividends that you earn even if you don’t withdraw it. With increasingly stiff laws on foreign assets / income, my advice is to withdraw the amount to avoid the taxation problem for years. If you are an RNOR, then withdraw immediately as you don’t have any India tax liabilities on foreign income in that period, otherwise phase it out to avoid US taxes.

  3. Hello,

    Can you please advise how can one invest in the Tata Motors (DVR) rights issue? Unable to find information anywhere in regards to the same.

    Can the same be done online through HDFC Securities?

    Thank you.

  4. Is this situation feasible? Let’s say, I invest $100 and my employer matches 100%. I invest and save tax but withdraw immediately which will negate the tax benefit. That means I am gaining 100% and then losing 10%, that leaves me with 90% profit?

    Any thoughts?

  5. Lets assume the following for the sake of discussions:

    1) Your annual base pay is $100,000
    2) If you were to contribute to 401K, lets assume you contribute 6%, and your employer matches 100% up to 6%
    3) You are in the tax bracket of 20%
    4) Recurring deposit in India fetches you 8.25% compounded 4 times an year
    5) In both cases, tenure is 5 years

    Amount contributed to 401K is exempt from tax in that fiscal, but will be taxed during distribution if withdrawn before retirement age.

    SCENARIO 1: Do NOT invest in 401K; deposit an equivalent amount in a recurring deposit (RD) account in India.

    Amount you’d have invested in 401K = $500. Less 20% tax, the amount you can now invest in the India RD = $400

    At the end of 5 years, the RD maturity amount would be $29,741. (The interest earned would be taxable too, but I not considering it here)

    SCENARIO 2: Invest in 401K

    At the end of 5 years, you would’ve accumulated $60,000. This entire amount is taxable because it is withdrawn before retirement age. Further, it attracts a 10% penalty because you are withdrawing it before retirement age.

    Net net, you’ll receive $60,000 less 30% = $42,000

    Note that I have not considered any earnings / interest on the contributions one could get from investing through 401K

    From a pure finance perspective, I believe it makes sense to invest in 401K. But one needs to weigh in other factors like vesting period, efforts required to withdraw, etc.

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