Why contribute to a 401k if you spend <$40k/yr and plan to retire early?

[Swansong]

TL;DR conventional wisdom (e.g., this pinned post on the MMM forum https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153) is that you should always max out your 401k before investing in a taxable account.

However, it looks like folks whose annual spending falls within the lowest long term capital gains tax bracket (currently $40,400 or less) can retire faster if they don't contribute to a 401k at all due to the income taxes they'll incur on their 401k distributions - even if they receive a generous $10k/yr employer 401k match and live in a low tax state like Texas.

Am I crazy, or should MMM have an article to warn folks that they might not want to contribute to their 401k if they plan to be in the lowest long term capital gains tax bracket during early retirement?

Here's a detailed example to illustrate why some people might not want to contribute to their 401ks:



My friend (let's call her Samantha) makes $123k/yr before taxes and lives on $40k/yr in Texas.

Using the "Retirement Savings vs. Years" calculator linked in this Mr Money Mustache post (https://www.mrmoneymustache.com/2012/01/13/the-shockingly-simple-math-behind-early-retirement/), Samantha has determined she needs to work around 14 more years at her current salary to accumulate a ‘stache of $1M, which will allow her to withdraw around $40k/yr (adjusted for inflation) for the rest of her life to cover her expenses.


If Samantha pays for all her expenses in retirement using long term capital gains and dividends, she will be in the $0 to $40,400 tax bracket (https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates) and owe $0 tax on her investment income in retirement.

Samantha has the option to contribute to an employer-sponsored 401k plan that pays a generous $10k/year match. She knows that even if she locks up money in her 401k to get the match, she can access it penalty-free before age 59.5 using a Roth IRA conversion ladder, provided she rolls over any money she needs to spend before turning 59.5 at least 5 years before she needs to spend it.

If Samantha maxes out her 401k each year, in 14 years she will have saved an additional $165,219 vs. if she contributed nothing to her 401k (this includes her $10k/yr employer match and assumes 5% investment returns after inflation). Maxing out her 401k should be a no brainer, right?



However…

When Samantha wants to access the money in her 401k - whether by rolling over the funds into her Roth IRA via the conversion ladder strategy, or by making traditional penalty-free distributions after age 59.5 - she will have to pay income tax, not long term capital gains tax, on the money she withdraws.

Put another way, if Samantha never withdraws money from a 401k and lives on $40k/yr exclusively from the long term capital gains and dividends in her taxable account, she won’t owe another dollar of income or capital gains tax in her life.

However, if Samantha has to withdraw some of her money from her 401k, she will owe income tax every year she makes a 401k withdrawal. She will need to withdraw $47,660 (~20% more) from her 401k each year before taxes to end up with the same amount of money she would have in her pocket if she withdrew just $40k/yr tax-free from her taxable account.

Because of the unavoidable taxes on 401k distributions, it seems like Samantha’s ‘stache would have to be almost 20% larger to allow her to retire in 14 years if she contributes to a 401k vs. if she doesn’t. Specifically, if Samantha follows the Roth conversion ladder strategy and rolls over $47,660 each year (in order to provide her with $40k after taxes 5 years later), she will need a ‘stache of $1,191,500 to retire in 14 years. This is more than the $1,165,219 she will have saved if she maxes out her 401k.

Samantha’s net worth will be over $165k higher 14 years from now if she maxes out her 401k…but is it really worth it if she has to delay her retirement due to the higher tax obligations she will have on 401k withdrawals vs. on long term capital gains and dividends from her taxable account?

I ran similar calculations in different scenarios (screenshots attached), and it seems like Samantha would be able to retire earlier if she doesn't contribute anything to a 401k regardless of how much she contributes. i.e.:

• if Samantha maxes out her 401k and receives a $10k/yr match, her retirement will be delayed by ~5 months vs. if she contributes nothing to her 401k

• if she only contributes $10k/yr to her 401k (the minimum amount needed to receive the match), her retirement will be delayed by ~2 years

• if she maxes out her 401k and doesn’t receive a match, her retirement will be delayed by ~3 years

Am I crazy, or would Samantha be better off not contributing at all to her 401k and foregoing her company’s $10k/yr match if:

• her goal is to retire in 14 years or less, and
• she plans to keep her annual spending below the lowest long term capital gains tax threshold of $40,400/yr?

Maybe delaying retirement by ~5 months in the best case scenario above feels negligible for some folks, but I feel like contributing to a 401k should at least let you retire earlier to compensate for the (potentially) decades of slightly more administration and complexity in your finances you will commit to if you follow the Roth conversion ladder strategy.

Please let me know if you think my reasoning is incorrect. Thanks a lot for reading for anyone who made it to the end!



Resources used in my calculations:

• MMM “Retirement Savings vs. Years" calculator https://www.mrmoneymustache.com/wp-content/uploads/2012/01/Retirement-Savings-vs.-Years.ods
• Texas Income Tax Calculator https://smartasset.com/taxes/texas-tax-calculator
• Texas After Tax Paycheck Calculator https://smartasset.com/taxes/texas-paycheck-calculator
• Long term US capital gains tax rates https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates
• Explanation of the Roth IRA conversion ladder (aka ‘pipeline’) strategy that would allow Samantha to access her 401k penalty-free before age 59.5 https://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

[EvenSteven]

I don't think I am following all of your calculations, but I think there is an easier way to look at it.

At the zero percent capital gains rate, that would be the equivalent of a Roth account, i.e. no taxes due on investment gains. To determine if a Roth or traditional account is better, you should look at marginal tax rate going in vs. marginal tax rate coming out. At 123k/yr income, and 40 k/yr outgoing at retirement, that would be at the 24% going in, and 12% coming out. So in this situation traditional is better than Roth which is equal to taxable (assuming no dividends or capital gains distributions are paid along the way in the taxable, which probably isn't realistic).

[ixtap]

It doesn't look like you took into account the tax savings received for contributing to a traditional account in the first place, much less the savings on capital gains throughout the accumulation period. Most equities have some kind of distribution now and then that will be taxed.

In other words, it would appear that you are only looking at taxes at the time of retirement, and not over the course of a lifetime. For sure example, you say that Samantha saves the match, plus earnings, but what does she do with the upfront tax savings?

Further, as an early retiree, you can choose to convert your standard deduction each year and pull your spending from taxable and Roth. To the extent you can do this, you may still not owe any income taxes on those traditional accounts.

[Swansong]

Thanks for taking the time to read and reply! I agree I missed most of these points.

Here are the issues I can see with my reasoning so far:

• In the calculator, I increased Samantha’s expenses by the amount I thought she would need if she has to pay income tax on her Roth conversions in retirement (i.e., her biweekly expenses increased by $295 from $1,538.46 --> $1,833.08 when accounting for taxes on distributions), but I didn’t increase her biweekly savings by the same amount - which I think I need to, because Samantha wouldn't actually need to spend an additional $295 biweekly on taxes until she starts converting 401k funds. Since the calculator is based on % of take home pay saved, the $295 I added to her expenses should probably "zero out" with the same $295 added to her savings until she retires and starts doing Roth conversions, otherwise I think I am underestimating the % that she will save.
• This $295 number is incorrect because Samantha won’t owe FICA taxes on her Roth conversions, meaning that I overestimated the tax she will owe by ~50%. I didn't realize you don't have to pay FICA taxes on 401k distributions/Roth conversions - nice! https://money.stackexchange.com/questions/126612/fica-on-traditional-ira-to-roth-coversion
• The $295 number is also incorrect because Samantha can claim the standard deduction on her 401k distributions, which will further reduce her taxes (it looks like federal taxes are not charged on the standard deduction amount, however FICA is if you're not doing a 401k distribution/Roth conversion) https://turbotax.intuit.com/tax-tips/tax-deductions-and-credits/what-are-standard-tax-deductions/L7oiVM1DH
• I didn’t take into account the taxes Samantha will have to pay on dividends and capital gains distributions in her taxable account while saving for retirement, which will reduce her savings compared to what she might save in a 401k.

Does anyone know how to get the average annual taxable distribution for a Vanguard fund like VFIAX? This page shows historical distributions, but I'm unsure if I'm only looking at dividends or if the list includes all dividends and capital gains distributions: https://advisors.vanguard.com/investments/products/vfiax/vanguard-500-index-fund-admiral-shares#priceanddistributions

I'll try correcting my calculations for these issues and see how that changes things!

[ender]

It doesn't look like you took into account the tax savings received for contributing to a traditional account in the first place, much less the savings on capital gains throughout the accumulation period. Most equities have some kind of distribution now and then that will be taxed.

+1, the actual numbers here are incorrectly being compared because tax implications on the frontend are ignored.

OP is comparing pretax 401k values vs posttax taxable dollars. Surprise! If you have $100k in a pretax 401k you are paying more in taxes than if you had $100k in a brokerage... because you paid taxes on something like $120k to get to $100k in a brokerage.

[MDM]

At the zero percent capital gains rate, that would be the equivalent of a Roth account, i.e. no taxes due on investment gains. To determine if a Roth or traditional account is better, you should look at marginal tax rate going in vs. marginal tax rate coming out.

^That's the answer.

Traditional versus Roth - Bogleheads goes into more details.

[dandarc]

Your "annual savings" figure is obviously incorrect - it should be higher in any 401K scenario than no 401K scenario. Most obvious would be the "match only" version - employer match does not impact your taxes at all when they give you that. So in that case you should have exactly the same taxable account savings every year PLUS the $10K / year match. No matter how you decide to discount that it is additional money.

So there is no possible way for that one to come out behind an equivalent "no 401K at all" scenario. And yet your "analysis" says it does - that should be a big clue that you did something incorrectly somewhere.

Larger point just in general - odds are always much, much higher when you get an unexpected result like this that you just made a mistake than that you've discovered something new.

[swashbucklinstache]

Agree with the conclusions of other commenters without digging in at all. Commenting to say the term you might want to look based on your comments is "tax drag". Information reported on this term and written about it will help inform your thoughts on total return of various funds (spoiler: the more they trade the higher the tax drag probably is) and differences between taxable and other account types. Morningstar for example will show this for funds. Unsurprisingly index funds do well here and high dividend actively managed funds and fixed income do not, though you shouldn't let the tax tail wag the allocation dog.

[ChpBstrd]

I agree with the others who noted that the upfront tax deferrence benefit is not calculated, but the taxes to remove funds from the 401k are counted. If you count both sides of the tradeoff, you'll find that taxing earnings before contributions and taxing withdraws only amount to the same thing, mathematically, as long as the tax rates are the same, except to the extent that investment growth occurs on the money that is a deferred tax liability. In Samantha's case, her earnings will go from $123k during her career to $40k during her retirement.

I'll also note something else. The 401k contribution limit in 2022 is $20,500. That's before Samantha's employer contribution! However, Samantha's Roth IRA is limited to $6,000 per year.

Samantha will have a hard time socking away a million dollars in 14 years if a Roth IRA is her only tax-advantaged tool. To avoid a 401k, Samantha would have to pay taxes on a lot more of her earnings while in a higher 22-24% tax bracket, put a mere $6k per year into a Roth, and then plow the remainder of her savings into a taxable brokerage account where every dividend and trade is a taxable event. It's hard to imagine how that is more efficient than (a) deferring taxes at the $41,776-123k bracket of 22-24% now so that she can pay taxes at the $40k bracket of 12% later, (b) avoiding all taxes on capital gains or dividends for 14 years, (c) experiencing earnings growth on thousands of dollars in future tax liabilities, essentially borrowed from Uncle Sam at 0% interest, (d) earning a risk free, tax-deferred, and immediate 100% return on investment by maximizing the 401k employer match, and (e) just using a Roth ladder when necessary to retire early as described in lots of places.

[Swansong]

Thanks for your comments everyone!

I redid my calculations and (surprise) it now looks like Samantha maxing out her 401k and following the conversion ladder strategy will allow her to retire earlier in all previously mentioned scenarios vs. if she didn't use a 401k.

Even if Samantha's employer didn't provide a 401k match at all, she should still have a slightly higher multiple of her annual expenses saved in 14 years if she maxes out her 401k. There is some tax drag to consider in this case (thanks for the new term, swashbucklinstache!), because I think Samantha will owe up to 15% capital gains tax on whatever funds she withdraws from her taxable account to fund her first 5 years of retirement while her first 401k conversion is seasoning.

This means Samantha would need around $47,059/year in today's dollars to fund her first 5 years of retirement, vs. the $40,000/year she would need if not using a 401k or the $43,517/year she would need when living off 401k conversions. The extra $3,542/year in tax she will owe during her first 5 years of retirement (($47,059-$43,517)*5) adds up to $17,709, which is significantly less than the extra $94,016 she would save ($1,118,534 - $1,024,518) in the next 14 years if she maxed out her 401k with no employer match.

So it seems like Samantha would retire at least a couple months earlier by maxing out her 401k even if she had no employer match. Samantha would save some additional money on top of the $94k if she follows this strategy due to not owing as much tax on distributions in her taxable account.

In the scenarios where Samantha gets a $10k/yr employer match, her 401k is even more compelling and she should be able to retire in ~13 years instead of 14.

I'm including updated screenshots from the calculator (https://www.mrmoneymustache.com/wp-content/uploads/2012/01/Retirement-Savings-vs.-Years.ods) below. Please let me know if you see any issues with this reasoning!
 

[Swansong]

Adding a screenshot that shows the formulas I added to the spreadsheet in case anyone is curious

[ixtap]

I have a really crappy connection today and can't see your charts, but no one pays 15% on everything they withdrawal from taxable, only on the gains.

[Swansong]

That's fair - I wouldn't expect her to end up paying the full 15%!

Although it's unrealistic to expect paying that much tax on the amount withdrawn from her taxable accounts, I thought it was interesting that she seems to come out ahead by maxing out her 401k even with that assumption. 

[kpd905]

You could also withdraw any Roth IRA contributions during those first 5 years if you wanted to minimize taxes.  If they are maxing out a Roth for 13 years, this should almost cover 2 years of their expenses.

[swashbucklinstache]

Two small things are...
Remember that contributions aren't 1 for 1 with inflation. While each year with high inflation will see the limit you can contribute that year go up, previous years' contributions of course will not.
For those with higher expenses, remember that the share of growth in growth vs principal that you're selling will generally grow over time so the percentage you're taxed will too. This is intuitive, since growth continues but you're not buying new shares (excl. drip).

These are both dots of rain on a windshield of a well planned travel plan, to be drowned out by something as simple as capital gains tax going up 5%. But good to have a buffer for stuff like this or even, like, older people have more expensive dental care and might not be able to drive themselves back and forth...