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.
401(k) Approach
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:
What to Do with a Crummy 401(k)
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
- Disability
- 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:
Early Retirees Should Max Out Retirement Accounts
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!
Not to mention – many states do not tax 401k and IRA income, so you pay only Federal taxes when taking money out.
I used to think I was in the super saver exception as were fortunate to have high income and high savings, but my retirement income will likely consist of SS, dividend income, and distributions from Traditional 401k. We don’t do real estate and don’t plan to, interest income is in the form of munis, and capital gains will likely be managed via tax loss harvesting and DAF contributions. I don’t see those sources of income pushing us above the top marginal rate in retirement, almost no matter how much we save. Am I missing anything, or is there a super saver exception exception? Thanks!
I also thought we were supersavers- but not so: with the next higher brackets for married filing jointly being 191K and 364K, and any long term cap gains and dividends not counting towards those numbers, unless we empty our tax deferred accounts over 5 years or less we won’t reach those heights of regular non-qualified income. So as early ish retirees we are doing Roth conversions to the top of our lower tax bracket only to avoid future (likely small) tax rate increases and just in case one dies before we’ve hit RMDs.
You have to run the numbers to know if you’ll be withdrawing a similar or higher rate in retirement as you received as a tax break upon contribution. You’re right that one can spend A LOT of money in retirement without paying much in tax thanks to spending principal, tax free muni interest, Roth IRA withdrawals, LTCGs, qualified dividends etc. You really have to put away A LOT of money (or have a bunch of rental property income or pension income) in retirement for this to be an issue.
More info here: https://www.whitecoatinvestor.com/supersavers-and-the-roth-vs-tax-deferred-401k-dilemma/
72(t) distributions – For early retirement it is the most important and least known.
Recognize that while working contributions to 401K come from the top – that is they save taxes at the highest marginal rate which is bound to be higher, possibly much higher, than the average rate when retired (SSRB is generally preferentially taxed, old people have larger standard deductions, and while it is hard to believe tax rates continue to drop).
Finally, having retirement money in a 401k allows the flexibility to roll it over to a Roth. Things like huge casualty losses or medical costs happen.
What about saving up 3 yr worth of salary in a brokerage account (currently invested in short duration bonds and t-bills) ahead of early retirement (from academia)? That will be the money we live on while we figure out our next adventure (probably an online business). I’m still saving half of what I used to in my 403b (split 50/50 between the Traditional and Roth options), but the rest is going into the brokerage account mentioned above. Am I doing the wrong thing? What am I missing? Thanks!
I think you nailed it. Make sure to account for health insurance as most employed (academic) physicians get their health insurance through an employer.
Nice thing about taking a break from a job is that you don’t have to account for taxes from W2 income. Just those coupons from your bond brokerage. Usually short duration bonds and bills weather inflation spikes fairly well. Consider laddering the maturities of your bonds such that a third mature within the first year, a third the second, and a third the last year. Maintaining individual bonds until maturity avoids that small bit of volatility that comes with a short term bond fund. Perhaps even CDs would be a good option since their FDIC insured as well ($250k per person per account).
This- with CDs to minimize number of accounts for my spouse and heirs when I quit managing the money – and enough for 5 years is our strategy in early retirement. Hard part is getting myself to sell enough stock mutual funds to get to the 5 year goal. Keep wanting to time the market – have to remind myself (this year, I know it’ll be harder sometime in the future) “price is lower than last week or month, but still higher than last year and WAY higher than X years ago”.
Thanks Daniel, much appreciated! I absolutely hate that I’m no longer maxing out the 403b, but the savings for 3 years of early retirement has to come from somewhere! I’ll double check to make sure I’m laddering the bonds such that 1/3 mature in years 1, 2, and 3. We have over a million in the 403b and a SEP IRA, and another $500,000 in a taxable brokerage account – so that’s there too if we need it, although it’s invested more aggressively. In addition to the bond coupons, I do have self-employment income and expect to still make north of $100,000/yr outside of academia – but the health insurance is still a stress. We’re still looking into that. Thanks again for your helpful reply!
And thanks to Dr Dahle for another great post!
You know about the 72(t) rule and all the other exceptions, right? Read these two posts and make sure you disagree with them before proceeding with this plan.
https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
https://www.whitecoatinvestor.com/early-retirees-max-out-retirement-accounts/
Why is health insurance a stress? You can buy it just like everything else in life. Why not stress about groceries instead? They’re harder to buy than health insurance. If you don’t have the money to pay for everything you need including health insurance, then you don’t have enough to retire yet. Even Medicare isn’t free.
https://www.whitecoatinvestor.com/health-insurance-in-early-retirement/
Don’t get me wrong. Health insurance is expensive (possibly $25K) but it’s just another expense.
if you are in academia, you likely have access to a 457 which is generally better than a taxable brokerage account, and also gives access to less volatile investments
Why would the investments in a 457 and a taxable account be different?
poorly written sentence on my part. The OP was looking for stable investments. I was trying to point out if they have a 457 that plan also probably has investment options that aren’t equities
I agree with that but those investments are also available in a taxable or really any other account too.
Sure. 457 money can be pretty useful in early retirement too. I’m all for having a taxable account.
I’m just saying don’t do that INSTEAD of putting money in a 401(k)/403(b) most of the time.
Dr. Dahle,
Thank you for the great post.
One question:
For someone in the 22-24% brackets with 1099 income, does the QBI deduction mathematically save one more money versus maxing out the employer solo 401k contribution?
One would have to run the numbers. That’s not too hard to do with tax software like Turbotax. The QBI is a great deduction if you can get it though. It’s our largest deduction.
Solid analysis.
Being a Super Saver raises the importance of Estate Planning. We enjoy your thoughts in this area as well.
For those aspiring retirement before 59 1/2 (or 55 if you use the retirement exceptions), I’ve been encouraging others to grab their 401K match, max their IRA, and then save 3x that number in their Taxable account. Once the early retiree reaches their number, they can use the Taxable account as a “bridge” to early retirement.
What you give up in investment efficiency via the 401K you gain in retirement optionality. Many roads to FIRE.
Why invest in taxable as opposed to tax advantaged plans given the SEPP rule allows you to take it out penalty free until 59.5? If fire is the goal, then take as many tax advantages as possible. If you’re retiring very early, then I assume your pre-retirement income is substantially higher than post-retirement, making the tax arbitrage with a traditional 401k/IRA even more appealing. What option am I missing here?
That’s probably bad advice you’re giving as discussed here:
https://www.whitecoatinvestor.com/early-retirees-max-out-retirement-accounts/
The truth, however, is that most who have enough to retire before 55/59 1/2 have a taxable account anyway, even if they maxed out their 401(k) etc every year.
Slightly tangential. Roth vs tax deferred. I’m close to a “super saver” but still expect to be in a lower bracket in retirement because most of the non-tax benefited investment will be taxable capital gains rate. The main reason I select Roth 401k despite being in the highest bracket now is to max out my effective retirement money primarily for the estate protection benefit. Retirement percent like you is becoming a smaller and smaller amount of my portfolio so I’d rather pay the tax now and get more in the 401k (since it’s after tax) than if it was only pretax money. Is that crazy?
No. One has to run the numbers. Supersaverhood isn’t just about savings rate, it’s also about how much you earn and how long you earn it for.
Isn’t it partly about how big your 401k tax deferred is plus any pension and real estate? If you have 20 million in taxable but no real estate and maybe a $2M 401k, only the RMDs and a little SS is taxed at regular rates right? The $20 mil is all capital gains? So it’s not really the size of your savings but more importantly what it’s in. Either way my goal is if I have “enough” might as well get more of it in the asset protection of 401k by doing roth even if that costs a little in tax arbitrage.
Yes, it’s about income, not assets. Assets typically lead to income but LTCGs and dividends do stack on top. s
I think you still get QBI after maxing out employer contributions. If you’re in the phase-out range for QBI, employer contributions to a solo 401k may shift you into the full QBI range.
I feel that I’m stuck in analysis paralysis over this. My wife and I have consistently stayed in the 12% tax bracket as our incomes have increased (we’re not MD’s, couple of RNs) and have invested much into our 403b/Roth IRA’s. Now as we approach our 40s we are stepping back to parent (keeping us within the 12% marginal bracket despite raises). However, as our income has dropped, we also will want greater “pots of money” to be accessible in the case of emergencies and/or future planned expenses (e.g. next car/roof, etc…). The benefit of a taxable account seems to be good for us as we’re still able to utilize the 0% capital gains bracket.
While we would certainly be with more money if we continued to stick it in our 403b’s, the flexibility benefit from a taxable account seems to be fairly high, especially given our marginal tax bracket.
Currently we’re splitting the difference between continuing to invest in our 403b’s (never giving up company match or maxing our Roth IRA’s) and a taxable account. Advice on getting over the paralysis?
That 0% LTCG/QD bracket is awfully nice for someone like you. While you’re welcome to read the blog and will find much of what it says applies to you, you must, however, remember that you are not its target audience. Few in the target audience are in the 0% LTCG/QD bracket. A 403(b) is far less valuable for you than it would be for someone earning 2 or 3 times as much as you.
I laugh at RMD concerns. Having a huge net worth and income is a problem? Be more charitable, retire sooner, just pay the tax, etc. First world problems.
This is a very good article and helps people really simplify the investment strategy. One comment about real estate having investing in real estate since the crash of 2008. There’s definitely some times where I am made some money or significant funds but majority of the time it’s been hassles. nothing beats just investing and index fun and not worrying about minor events. The other aspect, many people promise you much higher returns on your real estate investors that you really get. When you look retrospectively many times, the return on the investment is not as high, as initially promised in terms of real estate.
I might have misunderstood the post but early withdrawals from a 401K for qualified educational expenses do not avoid the 10% penalty. That is possible for IRA withdrawals (so I suppose you could rollover 401K money into an IRA if your plan allows it) but not early 401K withdrawals.
Thanks for the correction.
I recently saw a variation of this sort of claim, saying that if you have $1M or more in regular IRAs or 401ks you will pay outrageous amounts of taxes on the RMDs and have huge Medicare IRMAA payments, so you should do massive Roth conversions to empty out the accounts that are subject to taxes. It sort of made sense to me (a long time follower of James Lange who is also a big-time Roth conversion advocate), so I put together a big spreadsheet to run the numbers according to my situation (of course YMMV) and I seemed to find, similar to your numbers, that yeah, I’d pay a fair amount less in income taxes and Medicare IRMAAs, but would also end up with the same or less total net worth down the road. As I come up on retirement and have substantially less income than I used to, I’m still making Roth conversions to fill up the lower tax brackets, but doing massive conversions doesn’t seem to be worth all the hoops you have to jump through to pay the taxes and fees involved.