With the end of the year approaching, I suspect several people are considering whether to contribute or increase contributions to their 401(k)s. I still run into people confused about the merits of saving for retirement. People say things like, “By the time I retire tax rates are going to be much higher. Look at the national debt and the possible Trump spending plans on the horizon. Why should I pay taxes later at a higher rate when I can pay them at today’s low rate?”
This misconception about today’s rates vs tomorrow’s rates causes a lot of people to make poor decisions on whether to use tax-protected accounts, particularly during their peak earning years when the value of a tax deduction is at its greatest. Even if your firm doesn’t offer a 401(k) match, contributing to a 401(k) is like getting a free match from the government. It’s too good to pass up.
1) Today’s Tax Deduction
The most obvious value of contributing to a 401(k) is taking the tax deduction on today’s bill. Since the 401(k) dollars come off the top of your income, you save at your marginal rate. In other words, if my marginal rate is 33% (not including state and local taxes) and I contribute $18,000 to my 401(k), I save $5,940 on my taxes today.
People opposed to the 401(k) will quickly point out that you’re not actually saving the money. You’re just delaying when you will ultimately pay the taxes. For a 401(k), the amount will be taxed as ordinary income when you withdraw it in the future. If the tax rates are higher in retirement, you should have paid the tax today at the lower rate, right?
Not so fast.
First, there’s a benefit to having the extra money today. When are you more likely to need extra money in your life? Perhaps during your 20s when you’re in school and purchasing your first car. Or maybe it’d be nice to have in your 30s when you’re saving for a down payment. You probably could even use the money in your 40s and 50s when you are looking for extra cash to pay college tuition.
The truth is that dollars in your pocket when you are younger can often be put to great use as opposed to the pain of paying taxes in your 60s and 70s when you’ll have less overall expenses.
Plus, you’ve probably heard the phrase that a tax delayed is a tax not paid. It’s absolutely true! We have no idea what the tax situation will look like in 30-40 years. Maybe the US will have replaced the income tax with a flat national sales tax. Taking the tax savings today is a locked in benefit. Counting on a tax savings in the future is taking the risk that the rules will change.
2) Money Grows Tax-Free
If you have a taxable investment account, you’ve probably noticed how you get dividends and short-term capital gains distributed each year. These dividends are added to your taxable income each year and you pay a small tax. If you’re in the accumulating phase of life, it’s a bummer to have to pay taxes on these amounts today when you’re quite possibly at the highest marginal tax rate of your life. It’s not like you’re using/spending those dividends, right?
In a 401(k), you can accumulate those dividends and short-term capital gains without fear of paying taxes. This is known as eliminating the tax drag. Think the tax drag isn’t that significant? If you’re getting the market return of 7% on an index fund, which includes a 2% yield (i.e. 2% of the profits are distributed as dividends each year) and you’re paying 15% capital gains taxes, your real return is only 6.7%. On a $100,000 investment over 30 years, a 0.3% tax drag amounts to $61,492 in lost money. If you take advantage of the 401(k), you’ve eliminated the tax drag and will see a faster accumulation of your retirement funds.
3) Tax Rate Arbitrage
Perhaps the most important benefit of a 401(k) is taking advantage of the tax rate arbitrage. When you contribute to a 401(k), you save at your marginal rate (think of any contributions to your 401(k) as made with the last dollars you make each year). For example, if you’re in the 33% federal tax bracket, each dollar saves you $0.33 cents. Don’t forget to include state and local taxes too, which means you’re saving even more today.
Yet, when you withdraw the money later in life you will be paying taxes at your effective tax rate. What’s the difference? If your marginal tax rate is the amount of tax on the next dollar you earn, your effective tax rate is the amount of tax you pay across all of the dollars you earn.
If you’ve retired at 60 years old and are married taking the standard deduction and personal exemptions, the first $20,700 you withdraw from your 401(k) will be tax free. After that, you’ll only pay 10% taxes on the next $18,550 you withdraw.
Since you’re filling up the lower buckets with your 401(k) money, it’s easy to see that you’ll be paying a much lower blended tax rate on the withdrawals than the 33% you saved by making the initial 401(k) contributions. This is true even if tax rates go up substantially in the future, since there will presumably be lower brackets to fill first.
Saving taxes at 33% put paying them at a blended rate of 12% in the future is a winning bet you should make each and every time.
4) Tax Diversification
I’ve covered this in depth in a previous article, but don’t forget about the benefits of having diversified tax accounts in retirement. If all of your money is in a taxable account, it’s great that you won’t have to pay any future taxes when you withdraw the money, but you’re leaving money on the table by not being to pick and choose from different accounts.
For example, as discussed above, you can withdraw up to $20,700 a year tax free from your 401(k). If you have taxable or Roth accounts that can make up the difference between that amount and your living expenses, you effectively have avoided ever paying taxes on the money in your 401(k). That’s a pretty good deal! Do yourself a favor and give yourself options in the future to diversify your withdrawals to take advantage of the tax code.
The takeaway? If you’re in your peak earning years, you should be taking advantage of every tax-deferred account available to you.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.
This post really hits home to me as our marginal tax rate continues to increase with the robust increases in our income. In 2017 our marginal tax rate will be something like 51%, so by maxing out my 401K with $18,000 I am getting the benefit of my employer match of 50% on 4% or about $5,020. Then add the tax savings at our marginal rate of 51%, that is an additional benefit today of $9,180.
Total benefit of $14,200 (that is 79% of my contribution). Seems like a no brainer to me.
Cheers!
That’s a pretty sweet government match! Are you maxing out your 401(k) in the beginning of the year or spreading it across the year? In a future post I’m going to detail my decision to max out my 401(k) in January of next year.
Definitely using the 401k…well 457b in my case. The biggest benefit for me as you mentioned is having the money today. With a growing family, having the extra money now is more important whereas I would assume that if you’re a good saver, you should be okay in the later years. As for those you spoke to who were afraid of higher tax rates, there’s always the Roth 401k. I considered switching to the Roth when I read a blog post on the Finance Buff where he said that the Roth might be more beneficial for someone with a pension: https://thefinancebuff.com/most-tsp-participiants-should-switch-to-the-roth-tsp.html
But I’m still sticking with the traditional…though I do have a Roth IRA.
I tried to tackle the Traditional 401(k) vs Roth 401(k) in an earlier article:
https://www.biglawinvestor.com/should-lawyers-choose-a-roth-401k-or-traditional-401k/
Interesting take from Harry on the added twist of having a pension.
Yep, 401ks are the bees knees. Some additional things to consider:
1. Aren’t 401ks protected if you need to file for bankruptcy?
2. Are 401ks somewhat protected if someone files a lawsuit against you and you lose?
3. You may be able to avoid taxes on your 401k completely if you use the Roth Conversion ladder method of withdrawing from your 401k, and you do the conversions in years where your income is relatively low. I believe both GCC and RootOfGood are taking advantage of this right now.
1. Yes, but with some limitations. Still, retirement accounts carry an added benefit of being able to offer you asset protection.
2. Same as above, although there are limitations. In a lawsuit, you’ll also have to consider your particular state’s laws. Most states will protect retirement accounts, but it’s not universal.
3. There are some ways to get 401(k) money out tax free, which of course would be the ultimate tax arbitrage. Saving at your marginal rate and paying 0% tax is pretty great. Come to think of it, that’s the exact benefit you get from an HSA when you spend the money on health related costs. Keep in mind that you can only convert a limited portion of your 401(k) each year before you fill up the tax-free buckets.
I defer as much tax as humanly possible. The only Roth contributions I make are via the Backdoor.
With $18,000 in a 401(k), $18,000 in a 457(b), and $6,750 in an HSA, I’m reducing taxable income by nearly $43,000, which means about $20,000 less to Uncle Sam (and $20,000 more to the taxable account).
Thanks for the great write-up!
-PoF
I’m surprised you don’t have access to more retirement space. Do anesthesiologist work in partnerships like the arrangement WCI has an ER doc? It seems like you’d benefit from being able to make the business owner’s contribution. Still, $43,000 is pretty good. I’m limited to just 401(k) + HSA at the moment.
I’m an employee of the health system, but I’ve been an independent contractor in the past. I had a SEP-IRA then, and maxed it out at $49,000. If I were to go IC again, I would open a solo 401(k).
I also receive contributions from the hospital to the 401(k) – a profit share of nearly $16,000 and $5,300 in a match. I don’t get a tax deduction for those of course, but it’s another $21K in the retirement accounts annually.
Cheers!
-PoF
Thanks for explaining about the additional contributions to the 401(k) from the hospital. Why don’t you see it as a tax deduction? Wouldn’t you count the profit share and match as part of your income even if you don’t have a choice as to where that particular incomes goes? And presumably you’ll pay taxes on it some day in the future when those big doctor RMDs happen.
Great summary. One small (or big?!) advantage of the 401(k): tax-free rebalancing. Your target portfolio allocation may change over time or your actual allocation might drift over time due to differential returns in different asset classes. Rebalancing is easy and tax-free in the tax-deferred accounts but may incur capital gains and taxes in a taxable account.
Yeah, pretty hard to rebalance your taxable account and probably best avoided. Good point ERN!
I also like that money in a 401k is harder to get to and harder to spend. Some see this as a con, but for most it’s actually a pro because it keeps our paws off of it when we’re tempted to spend it impulsively. It forces us to either spend less, work harder to save, be more creative, or all three.
Yes, the penalty does a good job of keeping most people from raiding the cookie jar. Unfortunately, it also keeps a few people from contributing in the first place (which it shouldn’t).
Related: The Dreaded 401(k) Penalty Clause
I had debated the Roth 401K versus Traditional in a recent post on my site. At the end of the day I decided Traditional was the way to go for many of the same reasons you mentioned. I need the tax savings now as my income is high. I can risk taxes going up in the future as by then my kid will be out of the house and hopefully our mortgage will be paid off. Much like PoF I do the backdoor IRA but my 401K remains in the traditional mode.
It’s hard to say no to immediate tax savings today!
How does social security play into the standard deduction? If my wife and I are eligible for max social security payout? Will it offset some of the standard deduction? I’m over 3 decades away but curious.
It’s pretty difficult to plan for social security payout when it’s 3 decades away. A lot will change between now and then, so I’m not sure how much value you’ll get by thinking about a SS payout (other than making sure you’re both contributing to Social Security, which it sounds like you are).