A reader question pushed me to look at 401(k) investing in a completely new way. This reader asked me:
Hey Jesse – The problem with 401(k) accounts is that they “lock up” your money until you’re 60.
But “normal” taxable brokerage accounts keep your money “free” to use as you see fit.
What are your thoughts? Should you always utilize/maximize your 401(k)?
This is a great question. The personal finance community loves to push 401(k) accounts. As I’ve written before, I maximize my 401(k).
But as our questioner points out, we pay a cost when we use our 401(k). Namely, we “lock up” our money until we retire. However, we should be aware that there are many ways to access 401(k) money early (e.g. a Roth conversion ladder). But that’s another article for another day…
This “lock up” is good from a behavioral point of view. It encourages us to only use that money for retirement.
But you and I are responsible and financially savvy. Do we need to “lock up” our dollars in a 401(k)? If we use a “normal” taxable brokerage account instead, we could withdraw our money at any time. This is especially important for:
- Early retirees. It’s hard to retire at 45 if all your retirement money is in a 401(k). Though, Roth conversion ladders can help with this.
- Changes of plans. At age 22, I exclaimed, “I’m going to put this money away for the next 37 years!!!” That’s a long time. My plans might change.
- Over-saving. You saved $3 million for retirement but you only need $2 million. It sure would be nice if that extra $1 million was in a flexible brokerage account.
All that said, there are subjective pros and cons to both accounts.
Let’s Look at the Numbers
But what are the objective differences?
I’m going to approach this question in two unique ways.
- Scenario 1: 401(k) Employer Match vs. Using a Brokerage Account
- Scenario 2: Maxing a 401(k) vs. Using a Brokerage Account
The first scenario will ask, “How much benefit do we get from a 401(k) employer match? How much better is that match than a taxable brokerage?”
And the second scenario will ask, “How much benefit do we get from maxing out our 401(k)? How does it compare to a taxable brokerage?”
Scenario 1: 401(k) Employer Match vs. Using a Brokerage Account
Every financial expert always says, “You MUST get your 401(k) employer match. It’s FREE money.”
I’ve always taken this advice at face value. And yes, I’ve always given this advice to others.
But what do the numbers actually tell us?
Let’s look at Mike, who gets his match, and Tom, who only uses a taxable brokerage account. Mike = match. Tom = taxed.
Mike gets his match. If you’re into the details, here are Mike’s numbers:
- Mike contributes $6,000 per year, pre-tax
- Mike’s employer matches 50% – another $3,000 pre-tax
- Using current income tax brackets as a basis, we assume Mike’s future overall Federal income tax rate will be 13.6%. This assumes $80,000 of annual withdrawals at current Federal income tax rates, with no other income. (see spreadsheet for details)
Tom uses a taxable brokerage. His details are:
- Tom contributes $6,000 pre-tax too, but pays income tax up front at a 22% marginal rate. His contribution is $4680.
- Tom does not get an employer match.
- Using current capital gains tax brackets, we assume Tom will pay a future rate of 7.5%. This assumes $80,000 of annual withdrawals at current Federal capital gains tax rates, with no other income (see spreadsheet for details)
Both Mike and Tom invest in a total market index fund that achieves:
- Capital growth of 5%
- Dividend growth of 2% – on which Tom has to pay a 15% tax in his taxable account.
After 30 years and accounting for all taxes, Mike will have $786,000 vs. Tom’s $413,000.
That’s a 90% difference in total value. Or, you could say that Mike’s portfolio compounded 2.16% annually more than Tom’s.
Is it worth “locking up” your money for that difference?
For 99% of you reading this – absolutely. An extra 2.16% per year is significant. This result is why all the experts say, “Get your employer match!”
What About Other Employer Match Percentages?
Mike’s employer matched 50% of his contributions. What if they matched 100%? What if they only matched 25%?
With a 100% match, Mike would have ended up with $1.05 million. That’s 153% more than Tom, or an annual growth rate 3.15% greater than Tom
With a 25% match, Mike would have ended up with $655,000. That’s 58% more than Tom, or an annual growth rate of 1.55% greater than Tom.
After Scenario 2, we’ll discuss that this is still pretty damn good!
Scenario 2: Maxing Out a 401(k) vs. Using a Brokerage Account
What if Mike continues to invest in his 401(k) to the full extent? He’ll get a tax advantage up front, but he’ll no longer benefit from an employer match.
Will Mike continue to vastly outperform Tom?
- Mike contributes another $14,000 pre-tax
- There is no employer match on this money
- We again assume Mike’s future overall Federal income tax rate will be 13.6% (see spreadsheet for details)
While Tom continues to plow money into his taxable brokerage…
- Tom contributes $14,000 pre-tax too, but pays income tax up front at a 22% marginal rate. His contribution is $10920.
- Tom does not get an employer match.
- We again assume Tom will pay a future rate of 7.5% (see spreadsheet for details)
Again, both Mike and Tom invest in a total market index fund that achieves:
- Capital growth of 5%
- Dividend growth of 2% – on which Tom has to pay a 15% tax in his taxable brokerage account.
After 30 years and accounting for all taxes, Mike will have $1.22 million vs. Tom’s account of $965,000
This is a 27% difference in total value. Or, you could say that Mike’s portfolio compounded 0.79% annually more than Tom’s.
We’ve got to ask:
Is it worthwhile to “lock up” your money for 30 years to achieve a 0.79% annual difference?
This is where the subject gets murky.
Murky Reason #1: 30 years is a long time! No flexibility is…rigid! Is that cost worth a 0.79% annual difference? Some say no.
But don’t forget – there’s a behavioral benefit to earmarking that money strictly for retirement. Verrrry murky.
Murky Reason #2: 401(k) accounts charge fees. Could those fees add up to more than 0.79%? Absolutely!
David Blanchett’s research at Morningstar found that average 401(k) fees range from 0.37% (for large companies with big plans) to 1.42% (for small companies with small plans).
That’s right. Mike’s 0.79% annual advantage could get completely eaten—and then some!—by his plan’s annual fees.
Murky Reason #3: Future tax rates are incredibly murky, which is why I use current rates as a proxy for future rates.
How should we think about this problem? Mike’s 401(k) is hurt by future income tax hikes. Tom’s brokerage account is hurt by future capital gains tax hikes.
Some people would rather pay their income tax now (like Tom), and not have to worry about it later (like Mike).
“But My 401(k) Doesn’t Have Fees!”
Maybe. But are you sure?
95% of 401(k) plans have fees. But many people aren’t aware of them.
Here’s how to check your plan’s fees.
Conclusion: Get the Match, But Then…?
The objective analysis today shows two conclusions:
- An employer match is virtually always worth getting. The match percentage has to be near-zero before questioning whether it’s worthwhile. In our example, Mike’s 50% employer match provides him with so much long-term value over Tom. That’s why you should get your employer match!
- The rest of the 401(k)’s tax benefit can be questioned. The most important questions to consider are:
- How do you feel about “locking up” your money in a 401(k) until you’re 60 years old? Is that too strict? Alternatively, are you the type of person who needs the behavioral support of earmarking your dollars strictly for retirement? These are both subjective, personal questions.
- What are your 401(k) plan’s fees? High fees (>0.8%) can completely negate any tax benefit from maximizing your 401(k).
- Do you know how your taxes might change in the future? If your future income taxes will rise, 401(k) maximization looks bad. If your future income taxes will drop, 401(k) maximization looks good.
These findings opened my eyes. I have a new respect for the power of the taxable brokerage and for the potential drawbacks of 401(k) maximization.
Big dog Nick Maggiulli wrote a great article addressing “Scenario 2” last year. Our results are similar (which is good!). Whereas I found a 0.79% annual benefit from a 401(k) max-out, Nick’s analysis showed a 0.73% benefit. The difference is likely caused by our tax assumptions. Check out Nick’s work here.
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Good one 🙂
Back in the day i worked for a startup that matched 100% of 100% you put into your 401k up to the legal limit (which i wanna say was around $14,000/year maybe?!). I maxed my 401k out so fast – living on $200 paychecks at times, lol, but to my surprise i was only one of 3 doing it!! no one seemed to care!! I told people even if they maxed it out, got the free $14k, and then cashed it all out, you’d STILL be ahead after all the taxes and fees… But no one got convinced.. To make it sweeter it was during the housing crash so all the stocks were 50%+ on sale (!!!).
One other thing about 401k stuff – the odds that you stay with the same company (and plan) is slim to none, and eventually you’ll either be able to roll it over into a new account OR better – your own account where you can control the fees/etc (like an IRA) which is what I did when I finally went out on my own… So those moves can drastically change the outcome as well, probably for the better 🙂
J Money! Thanks for writing in, dude.
Yeah – that 100% match is near-impossible to beat. So much free value there.
And great point about how plans (both 401k and other) change over time. Roth conversions are the real deal. Is that what you used?
Hope all is well,
Fascinating to see the actual numbers on this. I definitely didn’t realize the differences were that dramatic. My concern with employer matches has always been the vesting requirements. Of course, they’re designed to keep people, which isn’t a bad thing if people want to stay. But I’ve also heard people say they’re sticking it out at a job just because of the vesting requirement and the feeling that they’ll “lose” money if they leave. It’s probably worth trying to ignore the match until it’s vested.
Hey Mrs. FCB! Thanks for stopping by The Best Interest, it’s really cool to hear from you here.
Your story is so reminisicent of “The Endowment Effect.” We can’t stand to lose the things that we already own. I’m sure some of that is at play with vested matches.
I got lucky in that a majority of my earnings were big lump sums, and so it all ended up in my Taxable Brokerage. But, after we were acquired, I maxed the hell out of my 401(k) for 5 years and ended up with about $250K in my IRA by the time I was all said and done.
So now, I will just let the money sit there and compound and hopefully turn into about $1.4M by the time I can withdraw it.
So my accidental discovery, is that it is probably worth it to max out your 401(k) for at least 5 years, and then you could go back to company match and topping off your taxable brokerage. This way you can let that money do its thing for years, and years, while you work on your early retirement planning.
This is great! I’ve been thinking about this the past few months. We’re approaching coastFI and I’ve had the same worries if we end up needing/wanting money long before 60. Thanks for the write up and analysis!
Hey Stevo, thanks for reading and for the kind words!
The Roth Conversion Ladder has always been my go-to for early retirees who need money before age 60. I’m not an expert on it, but I’ve heard great things.
Jesse, I loved the post! I agree that people should almost always take advantage of a company match, as they will nearly always come out ahead. Plus, if you genuinely need access to it early, you can do a Roth conversion on the pre-tax match dollars to get them out early (with a five-year waiting period). However, it is worth questioning the 401(k) as the appropriate vehicle beyond that. While Roth conversions can be great for many early retirees, they are not perfect for everyone, and having dollars that are not tied to rules and regulations is always an excellent backup plan.
Olaf!! What’s up man? Thanks for the nice note.
Yes, I love this line that you wrote: “having dollars that are not tied to rules and regulations is always an excellent backup plan.”
That flexibility is big.
I’m not sure how to put a monetary value to it…but if there’s a close call between 401(k) and brokerage, then the flexibility of the brokerage is an amazing tie-breaker.
I did all three, maxed 401K, maxed ROTH and a healthy taxable brokerage account. Now in retirement I pull from taxable and 401K. I don’t touch the ROTH.
Nice work Steve! That’s huge.
I’ve been able to follow a similar path so far – max 401k, max Roth, small amount in brokerage – and hope to have plenty come retirement!
Get the match and maximize 401(k) and then invest in taxable account with dividend growth stocks.
My employer has a flat fee every quarter ($11) and given I invest to get the match, it makes the decision of max or no max harder. That said, this ignores the Roth option and the effect of financial aid for college which many parents need to consider.