Have you ever been dissatisfied with your 401k investment choices? Or thought that maybe you could do better investing on your own but don't want to miss out on the tax savings from a 401k? Maybe you can have the best
of both worlds. A 401k is an important, and advantageous, retirement tool, but it doesn't have to be your only option for retirement savings. The following is not meant to discourage you from using a 401k for retirement savings in any way, only to suggest that it is not the only strategy worth considering.
Every article written about the best practices of saving for retirement, and probably every financial advisor, will encourage you to try to save the maximum amount possible in your 401k, up to the legal limit. The annual contribution limit for a 401k is currently $19,500, with a limit of $26,000 allowed for those over 50. At face value that certainly seems like good advice - everyone strives to have a financially comfortable retirement, so if you have the ability to save that much, why wouldn't you? But the better question might be, if you're going to save that much, does it need to be saved exclusively within a 401k? Is that really more advantageous than investing on your own with after-tax money? The answer is that there are definite advantages to using a 401k, but maybe not as much as you might think.
A 401k is an excellent method of saving and provides many benefits: the money is saved pre-tax, it never crosses through your hands if it is automatically taken from your paycheck (eliminating the temptation to spend it), and best of all, most companies will provide matching funds based on your contributions and a certain percent of your salary.
The money grows tax free and your employer gives you free money. What's not to like? The question is not whether or not you should contribute to a 401k - you absolutely should, at the very least, up to the amount of a company match - but should you automatically contribute all the way up to the legal limits?
Let's look at an example comparing two separate couples using the following assumptions:
• Couple #1 has a 401k balance of $1M (for the sake of round numbers) and plans to contribute $26k/year pre-tax for the next 10 years. They will also get a $4k/year company match. They expect to earn a 5% return.
• Couple #2 also has $1M in a 401k, also earning 5%, but instead of contributing $26k/year pre-tax to their 401k for the next 10 years, they will contribute $4k/year pre-tax (to get a $4k/year company match), and will then invest $19,715/year in after-tax money ($22k pre- tax) to a personal investment account.
After 10 years, couple #1 will have $2,006,231 in their 401k.
After 10 years, couple #2 will have $1,729,518 in their 401k, and $260,372 in an investment account, for a total of $1,989,890. That's $16,341 less than couple #1, after paying $22,850 in taxes. Let's dig a little deeper.
Both couples have now decided to retire, have no other income, and will need to take $50k/year from savings to pay expenses. They are both entitled to the Federal standard income tax deduction of $25,100/year.
After 10 years of withdrawals, couple #1 has a 401k balance of $2,567,490, and they have paid $29,815 in taxes on the 401k distributions.
Couple #2 used their investment account to pay their expenses before touching their 401k. Their investment balance of $260,372 was able to provide 5.8 years of $50k withdrawals before running out. No tax was owed since they have no other income and the annual capital gains were offset by their Federal tax deduction. They used their 401k, now having a balance of to $2,207,352, to cover the remaining withdrawals for the next 4.2 years, leaving them with a balance of $2,566,218. They paid $11,924 in taxes on the 401k distributions.
Couple #2 ends up with $1,272 less in savings, and has paid $34,774 in total taxes, or $4,959 more than couple #1, making the net difference $6,231 in favor of couple #1. Not a jaw dropping difference, but at the very least comparable, which is the point.
Let's consider two more factors:
• 401k plans typically charge fees that can average ~.45%/year (according to a 2019 TD Ameritrade study). Let's be optimistic and use .35%. Couple #1 had an average balance of $2,266,745 over 10 years and couple #2 had an average balance of $2,176,445 over 10 years. This would result in Couple #1 paying ~$3,160 more in fees for the same time period, cutting their net advantage over couple #2 to $3,070.
• Couple #2 had more options for how to invest their after-tax savings. If they earned only 1% more on that money, or 6%/year rather than 5%, that would earn them another $15,000 over 10 years, delaying/lowering 401k distributions, and saving another $2,000in taxes on those distributions. This would give them the overall advantage over couple #1 by ~$14,000. Over a span of ten years, let's call it even.
• Couple # 1 paid $18,636 more in taxes on their withdrawals, but $4,959 less in total taxes over 10 years.
• Couple # 1 paid $3,160 more in 401k fees, significantly reducing their tax advantage.
• Couple # 1 had less flexibility when choosing their investments, and less access to their savings (if needed) since they would incurr a 10% penalty on any withdrawals before age 59 1/2.
• If couple #2 had earned 6% on their after-tax savings rather than the 5% that was assumed, that would have given them another $15,000 over 10 years, delayed 401k distributions further, and saved another $2,000 in taxes on 401k distributions.
• At the end of 10 years there is a small, and relatively insignificant, difference in the two strategies.
This exercise is in no way meant to encourage only saving enough in a 401k to get an employer match. The purpose is simply to illustrate that maxing out your 401k contributions may not be the slam-dunk that it is often portrayed as. There is one last factor to consider. When you automatically save with a 401k, the money never passes through your hands. If you decide to invest the same money after-tax, you will have to behave with the same regularity and discipline in terms of saving a precise amount, and carefully choosing your investments. This brings a behavioral issue into the equation. If you will be tempted in any way to not save and invest religiously, and not touch those investments for any reason until retirement, stick with a 401k. If you can promise yourself that you have the ability to buy and hold without the temptation to alter your overall investing style, then you may have an opportunity to end up with a slight advantage by saving (partially) outside of a 401k. This may be easier said than done, but at the very least, it's food for thought.