Should you invest more in your 401(k)?

The tricky thing about retirement and financial planning is that there are often no single right answers. Sure, there are plenty of wrong answers, such as paying high interest rates on debt or withdrawing money from a 401(k) plan to fund a vacation to the moon.

Moon

When people often think of the right answer, what they really want is the best answer. What should I invest my 401(k) in? Should I pre-pay my mortgage? For most questions there is no right answer. If there was, your 401(k) provider would offer a single fund to invest in and your mortgage company wouldn’t accept additional principle payments.

So you know how to spend your paycheck, but now you’re wondering the best way to invest.  There is plenty of advice out there, but the simple answer is you should invest in what you reasonably believe will give you the highest return on your investment.  There are a lot of gotchas in such a simple statement, and to answer it you need to grab your crystal ball down from the attic.

Crystal Ball

In general, a good course of action for most people is to:

  1.  Contribute as much as it takes to get your company match in your 401(k)
  2.  If you’re under the income limits, max out a Roth IRA
  3.  Contribute to your 401(k) until you reach the tax deferred limit ($18,000 in 2015)

The best part about step 3 is if you have a higher income, it may lower your adjusted gross income (AGI) enough allow you to contribute to your Roth IRA.  If not, don’t worry, the Roth IRA back door is still open.  There’s also another back door available, and depending on how your 401(k) plan is structured, and it’s a big one.  We’ll get back to this point a little later.

If you’re looking at the steps above and looking for step 4, you’re in luck!  Step 4 varies for a lot of people, since there may be college savings accounts to fund, you may have access to special investing accounts, or you may be saving money for short-term goals.  Since this is Retirement Rocket Science, my goal is financial freedom.

4.  If you have a health savings account (HSA), max it out
5.  Continue to invest in what makes sense

Step 5 isn’t a cop-out, it’s generic because everyone is in a different situation.  Some 401(k) plans are horrendous with high fees and horrible options.  If that’s the situation you’re in, you would be better served investing on your own outside of your 401(k).  But for a lot of 401(k) plans, if you like the investment options provided, it may make sense to continue investing there with after-tax dollars.

Many people think that $18,000 is the most you can put into a 401(k) a year.  There are rules for higher income earners, but in general you can invest $53,000 a year in 2015, plus catch-up contributions.  There are a couple of things you should consider before deciding if you want to invest on your own in a brokerage account, or in your 401(k).

The first is, what are the fees?  Now that 401(k) fees are in the limelight, companies are taking actions to reduce them.  In my plan, the Vanguard S&P 500 fund (VOO) has a fee of .01%.  If I were to invest in that fund myself, the fee is .05%.

The second, is tax rates.  You’ll need your crystal ball for part of this one, but I like to plan things will stay similar to what they are now, but leave enough wiggle room for other scenarios.  Since you’re talking about after-tax money, your tax rate today doesn’t really matter for these calculations.  Either way you’ll pay income taxes this year on the money you invest.  What will change is future taxes.

For these calculations we’ll assume you have an extra $10,000 a year to invest, and you’ll be working for 20 years.  We’ll also assume you’ll not begin retirement for until another 20 years.  For the second set of scenarios, we’ll assume you have an extra $10,000 a year to invest, and you’ll be working for 10 years in the same job, but not begin retirement for 30 more years.

After 20 years of investing $10,000 a year, your 401(k) and Vanguard account would have $438,651.77.  There is a rub though, if the funds you own pay out dividends, you would be paying capital gains taxes on them.  If your 7% gains were entirely from distributions, you’d have only made $387,654.97 in your Vanguard brokerage account.  You would have made $50,996.80 or 11.6% more by investing in a 401(k).  But, taxes are also due on your 401(k) when retirement comes, so the after-tax 401(k) might not be all it’s cracked up to be.

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Uncle Sam always wants his cut, and when you withdraw your money from your 401(k) your earnings are taxed as ordinary income, or the 28% if you manage to stay in the same tax bracket in retirement.  Currently if you’re in the 28% income tax bracket your ordinary dividends are taxed at 15%, the same as the long-term capital gains rate.

If you withdrew all of the money from your 401(k) at once, of the $438,651.77 balance, $238,651.77 was earnings, on which you’d pay $66,814.10 in taxes, so you’d get a check for $371,829.27.  If you cashed out your brokerage account, of the $438,651.77 balance $238,651.77 was earnings, on which you’d pay $35,797.77 in taxes (15% long-term capital gains), so you’d get a check for $402,854.00.

So taking into account taxes, after 20 years your 401(k) would be worth $371,829.27 and your brokerage worth $402,854.00. That’s a difference of $31,024.73 or 32.5% in favor of a brokerage account.

If all of your gains were from dividends, instead of from the market value of stocks increasing, your 401(k) you would have the same $371,829.27, but in your brokerage account you would have $387,654.97.  Now you’re talking about a difference of $15,825.70 or 4.1%, still in favor of your brokerage account.

Is your head spinning yet?  So a brokerage account is the right way to go, right?

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Now I can get back to the reason for this post.  Recently I was listening to a presentation by a financial advisor when a question came up: should you ever invest more in your 401(k) beyond what it takes to get the company match?  His answer was no.  While he didn’t give background on the reason why, he went on the assumptions above.  Well my fellow retirement rocket scientists, when does anything dealing with retirement ever have a yes or no answer?

So here’s the other Roth IRA backdoor I mentioned earlier, and it’s a doozy.  When you leave a company, you can roll your 401(k) over into an IRA.  Pre-tax contributions are rolled over into a Traditional IRA, and post-tax contributions go into a Roth IRA.  You may have an excellent plan that allows you to take periodic in-service distributions for your after-tax money and your earnings while you’re employed, but not many do.

Continuing with the example above, let’s imagine you work for a company for 20 years and save $10,000 a year with after-tax money.

In scenario 1 you put the $10,000 into your 401(k) using after-tax dollars, and keep all of the money in your 401(k) for another 20 years.

In scenario 2 you put the after-tax dollars into a brokerage account for the same 20 years, and cash it out a further 20 years later.

In scenario 3 you put $10,000 after-tax money into your 401(k), but when you leave your company in 20 years you roll the money over into a Roth IRA.

What do you end up with?

If you don’t take your money out until 40 years later, you’d have:

—————–   Before taxes     After taxes
Scenario 1:  $1,697,443.93    $1,278,159.63
Scenario 2:  $1,697,443.93    $1,472,827.34
Scenario 3:  $1,438,861.96    $1,438,861.96

Scenario 3 is 11.2% better than scenario 1.

Now, lets run the numbers if you left a company after 10 years instead of 20:

—————–   Before taxes     After taxes
Scenario 1:  $1,125,365.28    $838,263.00
Scenario 2:  $1,125,365.28    $971,560.49
Scenario 3:  $979,681.35       $979,681.35

Scenario 3 is 14.4% better than scenario 1.

This is a situation where you really need to think about how long until you plan to touch your money, and how long you intend to work for a company.

Hopefully this is clearer than mud, but there are a few lessons here.  If you invest in funds that pay distributions, pay attention to the taxes you pay each year.  They add up, and make keeping money in a Roth IRA or 401(k) more attractive.

With all the gains as distributions, here are the scenarios again:

—————–   Before taxes     After taxes
Scenario 1:  $1,697,443.93    $1,278,159.63
Scenario 2:  $1,231,585.52    $1,231,585.52
Scenario 3:  $1,438,861.96    $1,438,861.96

Scenario 3 is still 11.2% better than scenario 1 (both scenario 1 and 3 are tax-advantaged, which is why the results are the same).

—————– Before taxes After taxes
Scenario 1: $1,125,365.28 $838,263.00
Scenario 2: $788,954.17 $788,954.17
Scenario 3: $979,681.35 $979,681.35

Scenario 3 is 14.4% better than scenario 1 (both scenario 1 and 3 are tax-advantaged, which is why the results are the same).

The less amount of time you think you’ll work at a company, the more it makes sense to put after-tax money into your 401(k) so you can take advantage of this giant Roth IRA loophole.  For me, if I don’t see any distributions, I’d do better if I work for 20 years by investing in a brokerage account ($1,278,159.63 vs. $1,472,827.34 vs. $1,438,861.96).  If I do receive distributions, I’d do better moving my money into a Roth IRA if I intend to take it out in 20 ($1,278,159.63 vs. $1,231,585.52 vs. $1,438,861.96).

For the 10 year scenarios, the Roth IRA option makes the most sense with or without taxable distributions: with ($838,263.00 vs. $788,954.17 vs. $979,681.35) and without ($838,263.00 vs. $971,560.49 vs. $979,681.35).

The spreadsheets to calculate this using your own numbers is available here:

  1.  401(k) options – dividend paying investments
  2.  401(k) options

So the takeaway is the longer funds in a Roth IRA can work for you, the more you benefit from loading one up.  This makes sense in that tax-advantaged accounts are given time to grow.  If you’re going to work at a company your whole life, and you can’t take early periodic in-service distributions for your after-tax money and your earnings, invest in a brokerage account.  If you can take periodic in-service distributions, consider yourself lucky, and really look into maximizing this benefit; you’ll do much better then you can if you work at a company like mine where you can only move money after you leave the company.

If you have any questions or comments, you can reach out below or continue the discussion in the forum.  If you are interested in receiving a notification of new posts, you can subscribe here.

3 Comments


  1. I did exactly as this article suggests. Putting after tax money into my 401K. My company got bought out and I was involuntarily retired. I rolled my 401K into an IRA at Vanguard but the after tax money was commingled with the pretax money. Unfortunately, I didn’t discover this until several years later.

    Is there any way I can get the after tax money out of the regular IRA and into a Roth without penalties or taxation? I posed this question to Vanguard and they had no answer.

    Reply

    1. That’s really surprising that Vanguard didn’t have an answer. I would actually recommend asking the IRS, RetirementPlanQuestions@irs.gov. I’m don’t know if it’s too late for you, as the rollover to both a traditional IRA and a Roth IRA was supposed to occur at the same time. Maybe if you have good documentation something can be done, but I wouldn’t be too optimistic. I hope you didn’t have too much after-tax money in the account, because someone screwed up royally, and you’ll be the one to pay the price with double taxation.

      Reply

      1. Thank you for the response and suggestion / email address. Will definetly follow up with IRS. I do have documentation.

        Reply

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