It’s a great question. I’ve always had a traditional 401(k) plan and lately, I’ve been wondering why it’s considered such a staple in retirement planning. Take a look at these two rules governing traditional 401(k)s:
- You have to wait until 59 and a half years of age to start withdrawing.
- After the age of 72, you must withdraw RMDs (Required Minimum Distributions) yearly, even if you have enough funds coming from elsewhere. (Seriously?)
To me, these two rules are quite the downsides, so the upsides must be quite spectacular to make up for it, right?
The advantage of a 401(k)
It’s generally agreed upon that the main advantage of a 401(k) is its tax deferral. This allows for larger compounded growth over the years. In some cases, it would allow almost an additional 10% compounded growth year-over-year. That is absolutely great! No one would argue against that.
Don’t underestimate the powers of compounding, learn more here.
The 401(k) advantages have eroded
But that was back then when tax laws were more favorable. Like around the 80s and 90s. Nowadays, those returns have eroded all the way down to less than a 1% advantage over that of a non-tax deferred option. Keep in mind, having a 401(k) is still better than having no retirement account, plain and simple. You’re still going to get the benefits of stock market growth.
But to have an apples-to-apples comparison, you’ve got to compare it to other viable options.
Pros of a taxable brokerage account
A competing viable option would be a taxable brokerage account. This money won’t be tax-deferred, but there are plenty of things to like about a taxable account. Let’s take a look at some of them:
It’s not even close. Take a Vanguard mutual fund that goes by the name of VTSAX. If you were to invest in it, which at the moment requires a $3,000 minimum to invest, you’d be looking at a 0.04% expense ratio, which is essentially a management fee. That’s not a typo by the way. It’s not supposed to be 4 percent. It’s actually four-hundredths of a percent! If you invest $100,000, you’d be paying a management fee of $40 per year.
Compare that to a managed 401(k), where fees are generally over 1 percent, and commonly even 2 or 3 percent. Let’s take the middle, 2%. That ends up being $2,000 versus a mere $40 per year!
And that’s for the same stock market performance assuming similar investing choices such as an S&P 500 tracker. Those expenses add up significantly over say a 30-year working career. Especially given the compounding opportunity lost year-over-year.
Even if you don’t feel comfortable managing your own funds, there are still cheaper alternatives like Betterment or Wealthfront. Their fees are a quarter of a percent, well below 401(k) fees. That means for every $100,000 you invest, you’re looking at spending $250 instead of $2,000 per year.
No restrictions on access to funds
Taxable brokerage accounts don’t restrict access based on age. Unlike 401(k)s, you can take your money out well before you reach 59.5 years of age. It usually takes a few days, maybe two or three to get your money out of your account if you need it in a pinch.
Compare that to waiting 30 years or however long until you’re 59.5 years of age. That’s a long time. There are emergency situations where you can take out your 401(k). It’s called a hardship withdrawal. But if you have to withdraw due to hardship, you still would have to pay taxes on the amount you took out for the year. And you still may have to pay a 10% penalty on top of it.
In taxable accounts, you’ve already paid taxes on the money that went in. Capital gains may have accumulated, but it won’t be nearly as much in terms of taxes owed at end of the year.
And by the way, let’s get into these capital gains.
Capital gains tax rates
You may have heard Warren Buffett talking about how he pays a much lower tax rate than his secretary. And it’s true. That’s because the taxes he pays are at a long-term capital gains rate, while his secretary’s rates are at an ordinary income tax rate.
If you’ve had money in a taxable brokerage account and its amount has gained in value due to stock market increases, you’ll be paying taxes on those gains when you take the money out. The rate you pay depends on how long the money has been in your account. For anything more than a year old, you’ll pay a flat capital gains rate of 0, 15, or 20%, depending on how much you sell. These rates are usually much more favorable than what you’d pay on ordinary income. This is why the rich get richer. The majority of their income doesn’t come from a traditional wage. It’s accumulated from the fruits of their investment, which allows them to take advantage of the lower tax rates.
In the past, investing in a 401(k) allowed you to gain an extra 2.5% each year, but with current long-term capital gains tax rates, that benefit has basically dwindled to zero.
No need to withdraw RMDs
This can be valuable if you have other sources of income that allow you to fund your retirement. You could keep all your money in your taxable account and capture all its gains, potentially giving them to your kids later. Unfortunately, if you’ve got a 401(k), you’d have to start spending the money at age 72, whether you want to or not.
No contribution max
If you make $1,000,000 per year, you can put $1,000,000 into your taxable account. But you’d still only be able to contribute up to $20,500 into your 401(k). If you’re over 50 years old, you can put up to $27,000 as of 2022.
Want to retire early? Find out how to retire early using a taxable brokerage account and the 4% rule.
Pros of a 401(k)
As stated above, its main advantage is its tax deferral. But is it really an advantage, always? Because you have to pay the tax either now or later. If you pay later, whether you benefit tax-wise really depends on whether you’ve made more in the current year versus the amount you plan to take out during retirement.
If you decide later that you want a more lavish than expected retirement, you may end up paying more in taxes upon cashing out. Sure, you’ve had some tax-deferral working for you, and that can’t be ignored. But it’s likely the advantages the 401(k) gives you compared to a taxable brokerage account will be largely overstated.
We rarely see this nowadays. It’s becoming less common of a practice. However, if you’re one of the few lucky ones to have this option, we always encourage you to put into your 401(k) any amount that your company will match. It’s a no-brainer. Free money.
The recommendation is that you should only put in the amount that the company would match. The advantage of a 401(k) goes only as far as the free money it can bring in.
Is a 401(k) a scam?
Not at all. Although corporations profit ridiculously from it, it is still a better option for the average individual than not investing at all. Plus, if your company does any matching, which is extremely rare now, you are receiving free money.
Plus, if you’re the type of person who can’t be disciplined enough to save whenever money hits the bank account, perhaps it’s better to have a 401(k). By having one, you allow the company to set aside money before you see it. It forces you to save and thwarts any chance of splurging the money irresponsibly.
The numbers speak for themselves. Whereas before, you were benefiting almost 10% per year, now you’re lucky to even have a 1% advantage with a 401(k) over a taxable account in terms of year-over-year performance.
Previous advantages that used to exist with a 401(k) are now eroded by much cheaper investment alternatives as well as more favorable tax rates with a taxable account.