By Dr. Jim Dahle, WCI Founder
I run into a surprising amount of negativity about 401(k)s.
A small amount of it is people appropriately reacting to bad 401(k)s, the latest way for employers to get sued for dodging their fiduciary duty to employees. However, a bad 401(k) is usually still worth using since you'll probably only be stuck with it for a few years and since the tax breaks are so large they outweigh a few years of high expenses and crummy investments.
A larger amount of the negativity is people trying to sell you something. It might be investment management services, but more likely it's some sort of alternative investment not available in your 401(k) (real estate is a common culprit). You need to be aware of conflicts of interest from those folks. However, a much bigger issue is people who simply don't understand how 401(k)s and/or the tax code works. Here's the latest example I've seen, but it's hardly rare.
William Million on the Bogleheads forum thinks he oversaved in 401(k)s because he now has to pay ordinary income tax on his withdrawals instead of lower long term capital gains taxes. William might have millions, but he is mistaken on this point. Let's run some numbers to demonstrate.
Why You Should Max Out Your 401(k)
Just for fun, let's go back 20 years and say William has earned $10,000 to invest. He can put it in a 401(k), or he can invest it in a regular taxable brokerage account. He is going to pull all the money out this year after 20 years of compounding. Let's say William was in the 33% tax bracket in 2002 when he made the contribution, and he currently has a marginal tax rate of 22% and a 15% long term capital gains tax rate in retirement. He uses the same investment which earns 8% a year, and expenses are similar in both accounts (i.e. a good 401(k)). Which approach results in more money?
Taxable Brokerage Approach
William earns $10,000. He pays $3,333 in taxes. He has $6,667 left to invest. His investment grows at 7.7% due to tax drag. After 20 years, it is worth $29,393.
=FV(7.7%,20,0,-6667) = $29,393
He has to pay some taxes, though. He has to pay 15% on all of the gains. Well, what are the gains? Certainly not the original $6,667. Plus he doesn't have to pay on the reinvested dividends on which he already paid. Let's be generous and call it $12,000 he doesn't have to pay taxes on. His tax bill is ($29,393-$12,000) * 15% = $2,609. Subtract that from the $29,393, and he ends up with $26,784.
William earns $10,000. He pays nothing in taxes. He has $10,000 to invest. His investment grows at 8% due to no tax drag. After 20 years, it is worth $46,610.
=FV(8%,20,0,-10000) = $46,610
He now pays taxes. He is in the 22% bracket. The tax bill is $46,610 * 22% = $10,254. The amount left after tax is $46,610 – $10,254 = $36,356.
Yes, using the 401(k) results in William paying $10,254 in taxes instead of $3,333 + $2,609 = $5,942 in taxes. But is his goal to pay the least amount in taxes, or is it to have the most left over after taxes? I hope it's the latter. If so, the 401(k) approach is clearly superior as he ends up with $36,356 – $26,784 = $9,572 more dollars (36% more money).
Honestly, that's probably understating the case, because there's a great chance he could've taken out some of that 401(k) money at 10% or 12% (filling the brackets) rather than it all coming out at 22%. I've written before that almost no one should fear Required Minimum Distributions (RMDs). You're still winning despite paying them. You don't even have to spend them if you don't want; you can just reinvest them in taxable. Think of an RMD as the government telling you that “Time's up, you can no longer have the benefits of investing in a 401(k).” Why would you want to give up those benefits before it's required?
More information here:
The Supersaver Dilemma
Now, there are some people who are such good savers that they will actually be taking money out of their retirement accounts in retirement at a higher tax rate than they had when they put money into those accounts. There are not very many of these people. However, if you can see yourself filling up all of the lower brackets with Social Security payments, pension payments, real estate rents, and tax-deferred retirement account withdrawals, then you may be one of them. That's not the case for most docs. An RMD in your 70s on a $2 million IRA doesn't even fill the 10% and 12% tax brackets for a married couple.
There are far more people with an irrational fear about tax rates going up that will somehow result in them withdrawing money at a higher tax rate than when they contributed it. I'm not saying tax rates can't go up. I'm just saying that's a very minor effect. What if instead of saving money at 35% and pulling it out at 22%, you end up saving it at 35% and pulling it out at 28%? You still win. And that'd be a HUGE tax rate increase. The arbitrage between tax rates is generally far larger than any potential change in tax rates.
Whether you are in this category due to supersaving or due to a fear of rising taxes, the solution is not to avoid using retirement accounts. Instead, you could make Roth contributions and conversions. This discussion should really be coming up when you're thinking about Roth vs. traditional 401(k) contributions, not when you're thinking about whether to max out that 401(k).
Young Widows and Widowers
There is another situation where you could withdraw money at higher tax rates than when you contributed. This is when your spouse dies relatively early, leaving you to fend for yourself with the higher single tax brackets. Consider someone with $185,000 of taxable income in 2023. If you're married, you're in the 22% bracket. If you're single, you're in the 32% bracket. Big difference. If your spouse is significantly older than you or in much worse health, you may want to do something about this. But again, that something isn't to skip out on your 401(k) contribution; it's to make it a Roth contribution (maybe).
Want to FIRE? Max Your 401(k) Out Anyway!
Another reason people may think they should not max out their 401(k) is because they want to retire early. I call bunk. There are several reasons why.
#1 If you separate from your employer, you can raid your 401(k) penalty-free starting at age 55, not 59 1/2 like with an IRA.
#2 The penalty-avoiding loopholes are so big that you can drive a truck through them. Look at all of the situations and expenses that allow you to get to tax-deferred money penalty-free:
- Unreimbursed medical expenses > 7.5% of AGI
- Medical insurance
- Qualified higher education expenses
- A first home
- New child or adoption
- IRS levy
- Reservist distribution
And most importantly, Substantially Equal Periodic Payments (72(t) distributions), i.e. the early retiree exception.
Note that there are slight differences between these rules as they are applied to IRAs and 401(k)s, with IRAs generally being more generous.
#3 If you have saved enough to retire earlier than age 55, the chances of all your money being inside 401(k)s rounds to zero. You've surely got something like an inherited IRA, a 457(b), or Roth IRA contributions that you can withdraw penalty-free. In fact, you've probably got a sizable taxable account despite maxing out your 401(k). You probably don't have to touch that 401(k) until 65 or 70, much less before age 55.
More information here:
The Only Good Reason Not to Max Out Your 401(k)
Honestly, I can only come up with one good reason not to max out your 401(k). That reason is that you have a better use for your money. That might even mean spending it, but hopefully, the high income professionals reading this site have plenty of money to spend despite maxing out a 401(k). A more common reason is that you have a more attractive investment option that is not available in your 401(k). These could include:
- Paying off 15%-30% credit card debt
- Paying off 8% student loans
- Buying into a partnership
- Buying into a business like a surgicenter, urgent care, radiology center, dialysis center, etc.
- Getting a short-term rental business started
- Some other investment likely to provide MUCH higher returns on a risk-adjusted basis, even after accounting for the 401(k)'s tax, estate planning, and asset protection benefits
Even so, in most of those situations I'd still prefer to see you doing both—maxing out the 401(k) and saving enough above and beyond to make these other investments.
The part I like best about William Million's complaint is that he did the right thing, even if he is unhappy about it. Better to do the right thing even if you did it for the wrong reason, I suppose. This situation also reminds me of what I would tell Katie in the early years when we had a four-, five-, or low six-figure nest egg.
“Let's max these accounts out. We can always take the money back out if we get in trouble. How awesome is it to get a tax break and yet still have the money?”
What do you think? Why do you think so many people worry that maxing out their 401(k) will somehow hurt them? Comment below!