The centerpiece of any financial plan for retirement is the use of tax-advantaged investment accounts. The most well-known retirement account is the 401(k). While most readers of this blog know that the 401(k) provides significant tax benefits, they probably don’t know exactly how valuable a 401(k) actually is. Specifically, it’s hard to quantify how much more you will have in your retirement account if you invest your money in a 401(k) versus keeping it in a taxable account.
Overview of 401(k) accounts
The 401(k) was created back in 1978 as a way for workers to save for retirement. Back then, most people’s retirements were dependent on a pension from the company they worked at their entire careers. For better or for worse, pensions as a source of retirement income has slowly declined over the past 40 years, and workers increasingly rely on their 401(k), along with Social Security, for retirement income.
In the most common form of 401(k), investors contribute money to their 401(k) retirement account with pre-tax money. They do not need to pay income taxes on the money they contribute to the 401(k). The money grows tax-free over time. When it is time to withdraw money from the account at age 59½ or later, you pay ordinary income taxes on any withdrawals. Eventually at age 70½ and older, you are required to withdraw a certain amount of your 401(k) each year (required minimum distributions or RMDs).
The immediate monetary benefits of the 401(k) are three-fold:
- You receive an immediate tax break when you contribute to the account. This extra money can grow and earn investment returns for you.
- Any investment returns on your 401(k) are not taxed immediately. You are free to buy and sell in this account as you please without tax consequences.
- Most physicians will be in a lower tax break in retirement than in their working years. For example, they might be in the 35% tax bracket during their working years (when they contribute to the 401(k) and get a tax break), but in the 15% tax bracket during their retirement years (when they withdraw the money and have to pay taxes).
How valuable is a 401(k)?
The value of investing in a 401(k) over a taxable account depends on several factors:
- Tax rate at the time of contribution: the higher your tax bracket when you contribute to the 401(k), the larger upfront tax benefit you will receive.
- Tax rate at the time of withdrawal (retirement): the lower your tax bracket when you withdraw from the 401(k) at retirement, the less taxes you will have to pay.
- Investment returns: higher investment returns will yield more tax-deferred growth
- Time horizon: contributing to a 401(k) when you are younger will be more valuable than if you contribute later in your working years because you have more time for your portfolio to grow
- Trading frequency: If you are a frequent trader, than the benefits of being in a 401(k) increase, because you don’t have to pay taxes until retirement. In a taxable account, you would have to pay taxes as you bought and sold stock.
Consider a 35-year old physician who contributes the maximum $18,000 to her 401(k):
- Tax bracket at contribution – 35%
- Tax bracket at retirement – 15%
- Long-term capital gains tax rate – 15%
- Investment returns – 5% real (after-inflation) returns
- Time horizon – 30 years (retire at age 65)
- Trading frequency: never – she would invest her money in a low-cost index fund either way and never sell until retirement
- Withdrawal strategy: she will immediately withdraw money at age 65 (for simplicity)
Under these assumptions, the $18,000 contributed to a 401(k) at age 35 would be worth $66,100 at age 65. A comparable taxable account would only be worth $44,800 at age 65. The value of contributing to a 401(k) is $21,300 on a $18,000 initial contribution. Using our baseline assumptions, $1.00 contributed to a 401(k) provides a tax benefit of $1.20 in today’s dollars. You get a tax benefit of more than your initial contribution by investing in a 401(k) versus a taxable account. This highlights the importance of using tax-deferred accounts as the backbone of your retirement savings.
These calculations are highly sensitive to our assumptions. In future posts, we will modulate some of the variables to see how the value of a 401(k) can change. The value of contributing to a 401(k) can be much higher or lower than our $1.20 estimate depending on your assumptions.
What do you think? Did these numbers surprise you? Would you calculate the value of $1.00 contributed to a 401(k) to be higher than, lower than, or equal to $1.20?