A lot of people don't realize just how much using a 401K can be worth. Consider someone who gets a match on his 401K savings. Say the employer will match you 100% of your first $5,000 you put into the 401K. That's basically the equivalent of earning a guaranteed 100% return on the first $5,000 you save each year. You're not going to get that kind of return anywhere else. It boggles my mind to think about how many people don't contribute enough to their 401Ks to get their full match each year. That's like leaving part of your salary on the table, and it's not even salary that you have to negotiate hard for.
Is a 401k Worth it?
Many doctors, however, don't get any kind of a match, and if they do, it's their own money they're matching with anyway. How much is a 401K worth then? Let's run the numbers.
There are two significant tax benefits to a 401K, and one potential downside — high expenses and fees. Let's see if we can't quantify each of these in turn.
#1 Tax Benefit of a 401k: The Tax-Deferral
Example — The California Doc with High State Tax
You get to save money at your marginal tax rate when you contribute to a 401K. Let's consider a married physician couple with a taxable income of $350,000. Let's say she puts $30K into the 401K. For 2019, they're in the 32% tax bracket. Just for fun, let's say she lives in California, with an 9.3% state tax. So she is now saving money at 41.3%. So, by putting $30K in, she saves $30K*0.413= $12,390 in taxes.
Let's say they pull that money out 30 years later. In fact, maybe they move to Vegas to retire and so also eliminate state income tax. Are they going to have to pay 41.3% tax on that money? Unlikely. Assuming no other income, the first $24,400 they pull out that year comes out tax-free thanks to the standard deduction. The next $19,050 comes out at 10% tax. The next $58,350 comes out at 12% tax. So let's say she pulls out $100K from her 401K that year. At what rate does that money actually get taxed in retirement?
Bracket | Income | Tax Due | |
0% | $24,400 | $0 | |
10% | $19,050 | $1,901 | |
12% | $56,550 | $7,800 | |
Total | 9.70% | 100,000 | $9,701 |
It gets taxed at 9.7%. Saving at 41.3% and pulling money out at 9.7% is a winning formula. That's precisely like getting an extra 31.6% return on your investment. You're not going to get that anywhere else. Now, your own percentage might be a little higher, or a little lower, but so what. Even if my numbers are off by a figure by 50% you're still looking at a guaranteed, instantaneous, automatic return of 17%. Where else can you find returns like that? You can't. Even if they stayed in California, it would still be dramatic savings.
#2 Tax Benefit of a 401k: Tax-Free Growth
If our physician investor had decided to invest in a taxable account instead of a 401K, she would have lost that instantaneous 33.6% return we discussed above. But in addition to that, she would have lost the benefit of her investment not being taxed as it grows. Every time an investment is bought and sold in a taxable account, you have to pay capital gains taxes. Not so in a 401K. Also, every month, quarter, or year, an investment throws off dividends. These are also taxed outside a 401K. Having assets in a 401K allows even a diehard buy-and-hold investor to avoid the costs of rebalancing. A more active investor might save thousands.
But let's just consider the value of having untaxed reinvested dividends. Let's say our investment grows at 8% a year; let's say 2% of that is a dividend taxed at 18.8%. So in the taxable account, that means the investment grows at 7.624%, while in the 401K it grows at 8%. After 30 years, a $30,000 investment in the taxable account is worth $277,710.53, or about $24K less than the $301,879.71 it would be worth in the 401K. Now, this additional gain would be taxed when withdrawn from the 401K, of course, as we saw above at about 12.5%, so we'll subtract out ~$3000. Even so, avoiding that tax as the money grows results in an additional 7.6% return for the 401K investor.
An active investor may realize a much larger benefit, while a careful buy and hold investor who would have invested very tax-efficiently and tax-loss harvested aggressively may realize a smaller benefit, but this is a reasonable approximation for the average investor. So adding 7.6% onto 29.8%, and we're up to an automatic, instantaneous, guaranteed 37.4% return just for contributing to the 401K. Alas, this will be reduced a bit due to our current 401K system.
What About Those High Expenses and Fees of a 401K?
You can do all you can to minimize high expenses and fees but it is a rare 401K that doesn't have additional costs when compared to an IRA at a low-cost institution such as Vanguard. Even a careful investor could easily pay 0.5% more a year in investment expenses in his 401K. Sure, if he changes jobs he can roll that money out to an IRA, and obviously he can do that at retirement, but even so, these additional costs and fees (and sometimes poor investment choices) are sure to take their toll.
Let's assume a 0.5% drag on his returns. Take our physician investor investing for 30 years at 8% (actually 7.5% due to costs) in his 401K. That'll reduce his returns by about 13.1%. So subtract that out from the 37.4% in benefit we found above, and that still leaves a 24.3% instantaneous guaranteed return for contributing to the 401K.
But what if the fees, expenses, and investment choices of your 401K REALLY sucked, you didn't get a match, and you didn't expect to either be able to change the 401K or roll money out of it for decades. At what level of expenses should the 401K benefits be abandoned in favor of a taxable account?
Well, given our assumptions, we see that 13.1% of that 37.4% in benefits was erased by additional fees and expenses of 0.5% per year. Increase those fees to 1.5% a year and you'll have erased all the 401K tax benefits and then some. Certainly, at 2% expenses, you'll be better off in a taxable account. But it is a pretty rotten 401K that doesn't have at least some investment choices with expenses under 1%. My own 401K, while it has a few pesky minor fees, at least offers a total stock market index fund from Schwab at 0.07%. That's pretty comparable to what I'd get in an IRA.
Plus, it is getting to be more and more unusual for any employee, physician or non-physician, to stay with the same employer for his entire career. You might change jobs (allowing a rollover) or the 401K expenses might improve after a few years. You could even lobby for an index fund to be added to the offerings. So even if your 401K expenses are pretty high now, you might want to think twice before passing up that tax break. And if you have a good 401K, thank your employer.What do you think? Do you disagree with my conclusions? Has investing in a 401k been worth it to you? Comment below!
Another great article. While I personally feel maximizing your tax deferred space is useful even without the match, it should be repeated that some of these calculations require the tax rates to remain similar. If you believe that all taxes will go up substantially in the future, the benefit decreases. Of course all plans require assumptions.
Great article! Our group has a profit sharing plan in which the member of the group can contribute the lesser of 22% or 49k. Is there any other tax deferred vehicle for physician if he/she already participated in profit sharing plan?
I have the same question as above comment (Stu). Further, if I start a side business, can I start a seperate 401k or profit sharing plan for myself and my wife. Presumably, I could keep my main job (clinical care)’s profit sharing plan of 49k and add another seperate plan for myself through the side business?
J- You can have as many 401Ks as you like, but can contribute not more than $49K to all of them.
Stu- Other options include backdoor Roths, defined benefit plans, cash value life insurance and annuities (ugh, don’t recommend them), 529s, HSAs (stealth IRAs), and even a good old taxable account.
Nice job. Your article presents the clearest argument I have ever seen for the value of tax deferral.
I believe there is one more major benefit to 401k’s and 403b’s that you may ave overlooked: creditor protection. Assets in employer-sponsored retirement accounts and, to a certain extent, contributory IRA’s are excluded from creditors’ claims during bankruptcy nder the Bankruptcy Abuse Prevention Act. I once shephered a physician family through bankruptcy and I saw their retirement accounts come through unscathed.
There’s even more benefits than that. Fro example, 401K money doesn’t count toward expected family contributions when it comes time for your kid to apply for financial aid for college. You could have millions stashed away and still look poor on the FAFSA (unless you’re still working).
Can also consider I-Bonds for tax deferral.
Great website. I have been looking for a doctor related investing website that is not full of unrealistic tips. My wife is currently in med school and I have been looking into ways of attacking student loans and decreasing tax liability.
I think you should consider talking about vesting periods for employer contributions. Also, I haven’t seen it yet, but how do you feel about putting 10k from your 401k towards your down payment on a first home? I understand that you can save some income with that method, but didn’t know if fees were substantial.
I’m not sure what I would say about vesting periods except don’t leave a job until your employer contributions vest if you can at all help it. I don’t think about it much, since I’ve never had a job with an employer match in the 401K.
I think borrowing from your 401K is a dumb idea because the loan comes due when you leave your job and that moment cannot always be planned well. You cannot withdraw $10K from a 401K for a house downpayment. You can take money out of a traditional IRA or a Roth IRA to do so. In fact, you can take out all your Roth contributions plus $10K of earnings without tax or penalty to buy your first house. However, for most physicians, Roth IRA “space” is so valuable over the coming decades that it seems silly to burn it on a house downpayment in your 20s or 30s. There are no fees associated with this, aside from perhaps an account closing fee.
There is no tax savings it is a deferral. 401ks/403bs are great accumulation vehicles but be careful on the back end when the tax is now due. It is poor planning to assume you will be in a lower rate especially if you are a good saver and invest wisely
Great article. I am having trouble figuring out if i should delay my pension and take money out of my 401K to meet living expenses or leave the 401K alone and start the pension instead. Every year i delay taking my pension it increases 8%. No COLA on the pension. Live in California. I am 65 y.o. and my dad lived to age 84. Mom still alive at age 92. Any thoughts? Thank you.
Like SS, I’d give serious consideration to delay, although this isn’t exactly the same without the inflation adjustment.
For married filing jointly, the 2018 tax table has the 9.3% bracket extending up to $572,984 in California AGI. The 11.3% bracket doesn’t start until $687,576. Just the same, this California physician couple should maximize their 401(k) and other qualified fund contributions.
It’s entirely possible I screwed that up while updating it. I thought I used the 2019 tax tables though.
How do you decide how much to take tax deferred? I have too much money in traditional IRAs and it is messy and expensive at this point to convert that to Roth. This means that backdoor Roth is a tough option for me (wish I had met WCI sooner!). As such I have been putting some of my 401k money away as a Roth 401k. This year I will have put away 10k as Roth 401k and the remainder (approx 40k) as traditional 401k (pretax 401k plus profit sharing) Is this a reasonable approach? And if so how to determine the mix of pretax and post tax that is ideal?
Why not roll those traditional IRAs into your 401k to allow for a Backdoor Roth IRA?
The Roth vs Traditional 401k contribution is a totally separate issue.
https://www.whitecoatinvestor.com/should-you-make-roth-or-traditional-401k-contributions/
I don’t understand how rolling over the traditional IRA into my employer 401k would work…:how would I keep track of what is what? My traditional IRA money is all post tax contribution and my 401k is pretax money.
This has always worried me. Am I creating an issue where one does not exist?
Oh, if the IRA is post-tax money then just convert it to a Roth IRA.
For a resident that has maxed out their Roth IRA would you recommend a 401k next? Or trying to do a backdoor Roth? Thanks for all the insight!
For a resident that has maxed out their Roth IRA would you recommend a 401k next? Or trying to do a backdoor Roth? Thanks for all the insight!
You can’t do a Roth IRA and a Backdoor Roth IRA. So yes, if you want to save more for retirement, go to the 401(k), probably Roth 401(k).
Hi. I just recently started following your blog. Finished the book within 2 days and now I want to keep learning. First I want to say THANK YOU! Second, I apologize in advance for the basic question but I was hoping to get a little explanation of 401k max contribution. You mentioned in a comment that ” You can have as many 401Ks as you like, but can contribute not more than $49K to all of them.”
I was under the impression you can only contribute 19,500 and if your employers matches you (or if you match yourself) 100% then its 39k. How does the 49k work? I know I am missing something.
Thanks again in advance.
LP
This post explains it all:
https://www.whitecoatinvestor.com/multiple-401k-rules/
And the contribution limit this year is $58K per 401k at unrelated employers, not $49K.
Wow! This is amazing. Thank you so much again.
My employer recently switched 401k providers, and I’m thinking it may throw a wrench in my asset allocation strategies.
I have held my 10% TIPS (VAIPX) in my 401k, and now the only bond offering is a “Fund of Funds” that does include TIPS, but it includes other funds and is actively managed. We do have the option of using a “self directed brokerage” option within the 401k where we can select any investments we want. The only difference is we will be charged a transaction fee whereas, with the core offerings, there are no transaction fees.
Are these transaction fees likely to make a meaningful difference, or am I overthinking this? VAIPX is a Vanguard fund, so I assume transaction fees will be low.
Thank you!
I use the self-directed brokerage as my only holding in both of my 401(k)s that offer it. Transaction fees are pretty minimal and you make fewer transactions to listen their impact. More hassle, but you get what you want.