Have you ever wondered whether or not a 401k was the absolute best way to save for your retirement? The conventional advice has always been to save toward tax deferred accounts (i.e. 401k’s) and tax free accounts (i.e. Roth IRAs) first and then to taxable accounts afterwards. But is this actually good advice?
3 TYPES OF INVESTMENT ACCOUNTS
Before I answer that question, let me first give you an overview of the three different types of investment accounts that exist:
I. Tax Deferred Accounts
These types of accounts provide you with a tax deduction today when you make a contribution. For example, if you contribute $1, then you don’t pay tax on that $1 today. However, in the future, your withdrawals (contributions + earnings) will be fully taxable. Common types of Tax Deferred Accounts include 401k’s, 403b’s, SIMPLE IRAs, SEP IRAs, and Traditional IRAs.
II. Tax Free Accounts
For these types of accounts, you use your take home pay (i.e. money that has already been taxed) to make contributions. In the future, your withdrawals (contributions + earnings) will be completely tax free. A common type of Tax Fee Account is a Roth IRA.
III. Taxable Accounts
For these types of accounts, you also use your take home pay to make contributions. However, you pay tax every year on some of your earnings; although some earnings may be deferred which will be taxed when you withdraw them. Common types of Taxable Accounts include jointly titled accounts, accounts in your individual name alone, or accounts owned by a Trust.
IS CONVENTIONAL WISDOM ACCURATE?
As mentioned above, the conventional advice has always been to contribute to tax deferred / tax free accounts first and then to taxable accounts afterwards. And if you’ve read some of my articles in the past (e.g. Is Tax Loss Harvesting Really That Beneficial and Risks of Tax Loss Harvesting) you know that I sometimes challenge the conventional wisdom. However, in this case, the conventional wisdom is spot on.
This is because your dollar is extremely more valuable in your tax deferred (i.e. 401k) account. For example, if you are able to contribute $18,000 per year to your 401k (the maximum allowed in 2017; $24,000 if age 50 or older), then you get to invest the full amount since it is not taxed today. However, if you decided instead to contribute to a taxable account you would only be able to contribute $18,000 minus your tax rate. So, if you were in the 25% tax bracket your contribution would only be $13,500 ($18,000 minus 25% tax).
It’s this phenomenon that makes tax deferred accounts so powerful and 401k’s so popular!
Let me use a couple of examples to show you the difference.
Example 1: Invest $100,000 in a 401k
Assume you could invest $100,000 in a 401k, were in the 25% tax bracket, and could earn 10% per year. After 30 years and after you paid tax, you would have $1,308,705.
Example 2: Invest $75,000 in a Taxable Account
Now let’s assume that you could invest $100,000 into a Taxable Account. To compare apples to apples, we have to take tax out of this amount as mentioned above. As a result, you end up initially investing $75,000 ($100,000 minus 25% tax). In a Taxable Account, tax is paid on some of your earnings yearly, and in this case we’ll assume the tax rate is 15% (tax rates in Taxable Accounts can often times be less than tax rates in 401k’s). At the end of 30 years and after you paid tax, you would have $866,869. Even if we assumed that you didn’t pay tax until the end of the 30 year period (which is a very unlikely scenario), you would still only have $1,123,649, which is far less than the 401k example above.
So the takeaway is that even though you pay higher tax in the 401k (25% vs 15%), you end up with a whole lot more money. And this is all due to the fact that you get to invest more money in the 401k since it is not immediately taxed. And in case you’re wondering, even if you are in a much higher tax bracket (say 45%) the numbers still work out to where the 401k is superior to the Taxable Account by quite a large margin.
But the question still remains. Is a 401k the best way to save for retirement?
The answer is a resounding yes when it comes to the 401k over the Taxable Account. But about about investing in an IRA? Stay tuned for next week when I discuss the 401k vs IRA.
Brad E.S. Tinnon