Why you should contribute to your 401k- part 2

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In part 1, you see the clear advantages provided by a traditional 401k investment for Jenny through her peak earning years. In this article I want to write about what this money means for Jenny during her retirement.

From the last article, we arrived to her nest egg at retirement assuming she invested only in pretax 401k account vs a taxable account (i.e. post tax).

Pretax investment Post tax investment
Jenny’s nest egg after 20 years

$651,158

$520,9276

Jenny’s nest egg after 40 years

$3,281,0176

$2,624,813

That’s a huge difference, right? Her investments accumulated over $600,000 more in the pretax account after 40 years.

Well, not so fast. Don’t forget that there are taxes when withdrawing from both of these accounts. And they are taxed differently.

At age 59.5, Jenny is allowed to start making withdrawals from her 401k account. How much she wants to withdraw is totally up to her. Usually people spend far less in retirement after they pay off mortgages, as their children become independent, having no more life insurance payments, or receiving Medicare coverage, etc. In retirement, Jenny withdraws from her retirement account what she needs to survive and to enjoy her life. In our case, Jenny may effectively lived off a budget of $26,400 a year all her life. If we make the assumption that her lifestyle doesn’t change in her retirement. That puts her at marginal tax rate bracket of 15%!

Unfortunately, that’s not the whole story, at age 70.5, Jenny will run into Minimum Required Distributions or MRD (sometimes you see RMD, same thing). What it means is that she will be required to take out a minimum amount calculated according to her age and her wealth. Yes, it sucks. I will talk about this MRD in another article.

If Jenny invested in a taxable account instead of 401k account, her withdrawals will also be taxed but only partially and at a lower rate. Her taxable account really has two parts to it: 1. Her initially investment capital which was taxed before the investment so it will be tax free at withdrawal; 2. Long term capital gains from the initial investment which will be taxed at long term capital gains tax rate. What’s the long terms capital gains tax rate?

Single Married file jointly Marginal Tax Rate (Tax Bracket) Long-Term Capital Gains Tax Rate
$0-$9,325 $0-$18,650

10%

0%

$9,326-$37,950 $18,651-$75,900

15%

0%

$37,951-$91,900 $75,901-$153,100

25%

15%

$91,901-$191,650 $153,101-$233,350

28%

15%

$191,651-$416,700 $233,351-$416,700

33%

15%

$416,701-$418,400 $416,701-$470,700

35%

15%

$418,401 and above $470,701 and above

39.60%

20%

So, if Jenny required only $26,400 a year to survive in retirement, she may never have to pay tax on her withdrawals in retirement!

Isn’t that even better than her pre-tax investment? Here’s how her nest egg is really worth in withdrawal after tax.

Pretax investment Post tax investment
Jenny’s nest egg after 40 years

$3,281,016.75

$2,624,813.40

less taxes at withdrawal (15% marginal)

$3,044,455.44

*$2,624,813.40

* As long as she withdraws less than $75,900 a year, her money will not be taxed.

As you can see, her 401k investment still comes out better than a post tax account.

There are a lot assumptions in this example: Jenny is a medium level earner but a very low user and high saver. She invests militantly from the beginning of her career. Her life environment never changed over the years. Her needs during retirement is very low. All these assumptions may not apply to my readers. It’s important to factor in your own life situations such as your mortgage, kids school cost, etc. You may be wondering at this point, what’s the point of saving so much if you can’t spend it in retirement? Let’s talk about it.

Using our 4% rule in our example, Jenny can spend up to $131,000 a year in retirement and never have to worry about running out of money. If she decides to do that, Jenny will be taxed at a higher bracket in her retirement than during her peak earning years which defeats the 401k tax arbitrage, i.e. delay being taxed until the tax rate is lower in retirement. In that case, perhaps, she was better off putting her money in a post tax account (getting taxed during her career) as long as she is a disciplined investor. Or alternatively, perhaps Jenny can invest in a Roth account. I will talk about Roth account in detail in a separate post. For now, you need to know that in a Roth account, you investment your money in a post tax fashion and everything at withdrawal (principal and growth/interest/dividends) is tax free.


So is there a way to spend $131,000 in retirement and still pay less tax? Of course! Imagine this, Jenny invested in traditional 401k, Roth IRA, and taxable accounts during her career. In her retirement, she decides to splurge a bit and spend $131,000 a year. Instead withdrawing from a single account, she withdraws from all her accounts in a calculated fashion. First, she withdraws $75,900 qualified dividends and interests from her taxable account and pay $0 taxes (long term capital gains tax rate). Second, she withdraws $10,000 from her Roth account which is also tax free on withdrawal. Finally, her last $45,100 withdrawal is from her 401k which is taxed at federal income tax rate of 15%. Without even accounting for the standard deduction and various exemptions Jenny will be qualified for during retirement, she is paying at most $6,765 of tax on $131,000 of income in retirement: that’s 5% effective tax rate!

In summary, in order to maximize your investment efficiency, you should always invest in traditional 401k (with very few exceptions). Additionally, in order to take full advantage of the tax arbitrage, you should diversify your investment accounts in traditional 401k, Roth 401k or IRA and taxable investment accounts.

What do you think? Do you have a strategy to pay $0 tax during your retirement? Are you a disciplined investor? How are your financial calculations in comparison to Jenny’s?

Did you miss Part 1? Click here.

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