When I explain to people that you can contribute to your 401(k) tax free but then you have to pay taxes on withdrawals at retirement, people often ask “if you get taxed on it eventually anyways then what’s the advantage?” The answer, as it turns out, is fully understandable but not all that simple. To explain, I’m sharing one of my favorite tools: Google Spreadsheet. Feel free to follow along and copy-then-edit the actual sheet.
First off, all of this is only applicable if you’re one of the lucky few individuals on this Earth lucky enough to have money left over every year to save for retirement. Don’t lose sight of that and take a moment to appreciate your great luck (combined with the fruits of your hard work!). Now let’s get to the analysis!
Let’s say you’ve got $5,000 pre-tax that you’re thinking of either putting in a 401(k) or taking it now to invest in a regular after-tax account. Right off the bat, if you choose the 401(k) option you’ll have the whole $5,000 (maybe even more if your company does 401(k) matching!!) in your account whereas if you choose the after-tax account you’ll have to, well, pay taxes on it. For this analysis, I only look at Federal taxes, but keep in mind some states (like California) have significant income tax rates that should be added on top.
Now keep in mind something here. The tax rate you’ll pay is your marginal tax rate since this is “last dollar” money, it comes after the rest of your salary, other income, etc. For 2017 marginal federal tax rates you’re mostly likely in are:
|Marginal Rate||Taxable Income|
|25%||$37,950 to $91,900|
|28%||$91,900 to $191,650|
These are for single filers based on taxable income (i.e. after all your nice deductions). Let’s assume you’re in the 25% bracket (you can play with this number and all numbers discussed here by copying the spreadsheet into your own sheet and changing the numbers). If you choose the after-tax amount, Uncle Sam takes 25% of your $5,000 leaving you with $3,750. Oh, one more thing. Here I assume you’re 30. So this is what it looks like so far
So far the 401(k) looks pretty good. BUT WAIT, there’s more! Since this is for retirement it’s a long term investment and as such hopefully you chose a long term investment such as stocks (more specifically, I recommend a low cost index fund such as the Vanguard 500 Index Fund Investor Shares). These index funds make money in two ways: capital gains (the value goes up) and dividends (they just give you cash couple times a year because hey, when you buy stocks you’re one of the owners after all). For the 401k, year after year you’ll get the sum of capital gains and dividends. For the regular account, you’ll also get capital gains and dividends BUT you’re be taxed on the dividends each year. Assuming you re-invest the after-tax dividends, at age 31 you’re looking at:
Let’s see how we go these numbers. First, we assume a dividend yield of 2% and a capital gains rate of 6%. So for the 401(k):
Start at $5,000
Dividend: $100 (2% of $5,000)
Capital gain: $300 (6% of $5,000)
For the regular after-tax account, it looks more like:
Start at $3,750
Dividend: $75 (2% of $3,750)
Taxes: $11.25 (15% of $75)
Capital gain: $225 (6% of $3,750)
So the after tax account not only suffered from having to pay taxes on the initial $5,000, it also suffers from having to pay taxes on the dividend EVERY YEAR. That means that instead of re-investing the entire dividend (which further increases future dividends!), you have to give some to Uncle Sam. Bummer.
Ok, so year after year you have to pay taxes on the dividends and reinvest what’s left. Fast forward until you’re 65 and after years of attending overly long meetings and otherwise doing real work, this is what your piggy bank looks like:
Cool!!! Starting with only $5,000 your money grew into pretty significant sums WITHOUT ANY WORK ON YOUR PART! This is the power of compounding investment gains. Of course, all the while inflation was eating away at your purchasing power at around 2% annually (image how much gas will cost when you’re 65) but let’s not get into that right now.
Ok, now is when the nay-sayers get their revenge right? Because now is when the 401(k) is taxed whereas the regular account is “already taxed.” Well…not quite. Here’s what the numbers look like after taxes assuming you sell everything all at once at age 65:
|65 (after taxes)||$62,838||$49,576|
See? You’re still ahead if you had investing the original $5,000 in a 401(k) instead of a regular after tax account. In fact, you’d be ahead by 27%! So what happened? Let’s take a look.
For the 401(k), it’s true you now have to pay taxes on the whole amount, not just the capital gains portion. But at what rate? You see, back when it was only $5,000 it was the “last dollar” money from your paycheck on top of your regular salary so it was taxed at the marginal tax rate. But when you retire, you don’t have a regular salary. This means you’ll be taxed at your effective tax rate. This will be lower because you take your pre-tax value, subtract your exemptions, subtract your deductions, then pay taxes from the lowest bracket on up. For this example, I just assume and use an effective tax rate of 15%. Here’s the math:
401(k) balance before taxes: $73,927
Taxes: $11,089 (15% of $73,927)
After-tax balance: $62,838
For the regular account, the tax situation is a bit different. If you sell everything when you turn 65, you’ll get taxed only the capital gains portion since the original purchase was already taxed back when you were 30. To know the capital gains, you’d have to keep track of what you paid for everything, including the initial purchase ($3,750) all that dividend re-investing you did, which comes up to $14,027 (remember, you’ve been re-investing the ever-growing dividends and thus automatically buying stocks for 35 years!). For the effective long term capital gains tax rate, I assume 2%. This may even be lower since like in the 401(k) case, you don’t have retirement income so you can subtract exemptions and deductions and pay from the lowest long term capital gains tax bracket up (the lowest bracket is 0%!!!). Here’s the math:
Regular account balance before taxes: $50,301
Cost basis (i.e. amount you paid to buy the stocks including re-investing dividends): $14,027
Capital gains realized: $36,274 ($50,301 – $14,027)
Taxes: $725 (2% of $36,274)
After-tax balance: $49,576
As you can see, although you pay more taxes at retirement for the 401(k) ($11,089) vs the regular account ($725), you still end up ahead after taxes with the 401(k). Why? Because in the 401(k), you started with a much higher balance and dividends were re-invested tax-free for the whole 35 years. Small differences become huge because of compounding over such a long period of time.
There’s also side benefits to a 401(k) that shouldn’t be under-estimated. The fact that it comes from your paycheck makes it harder to re-route to another purpose. The fact that it’s a regular contribution forces dollar cost averaging. The fact that you can’t touch it until you’re older means it’s harder to use it to pay for some luxury.
Well, if you made it this far into the article, congratulations! You care enough about personal finance and took time to learn an important topic that really should be taught for an entire year in college. Here’s some links from other websites you might also be interested in: