“Max out your 401(k).”
That advice is Personal Finance 101, right up there with “Get a budget” and “Have an emergency fund.”
But is that universally solid guidance?
Yes, tax-sheltered retirement plans offer the convenience of automatic investments and tax breaks—pretax contributions and tax-deferred compounding for traditional 401(k)s and tax-free compounding and withdrawals for Roth contributions.
But the availability and quality of the 401(k) are also important considerations. Some workers don’t have access to an employer-provided retirement plan, and 401(k) quality can be uneven. While some 401(k) plans, particularly those of large employers, are gold-plated, others have high administrative costs, meager employer matching contributions, and subpar, costly investment lineups. Those negatives can detract from 401(k)s’ tax-saving features.
Meanwhile, the tax efficiency for investors’ nonretirement accounts has improved over the years. Broad-market equity exchange-traded funds have dramatically reduced the tax drag for taxable accountholders, effectively simulating the tax deferral that accompanies investing in a 401(k). And many robo-advisors use other techniques to reduce the tax drag on investors’ taxable accounts—specifically, selling losing positions to offset gainers elsewhere in investors’ portfolios. That has the potential to reduce the capital gains taxes on positions when they’re eventually liquidated.
Even as investing in a taxable account has grown more attractive, it’s a given that investors should put enough in a 401(k)—even a poor one—to earn matching contributions. If the 401(k) plan is weak and they have additional retirement assets they have to invest, they should opt for an IRA in lieu of steering more money to the poor 401(k) plan. Income limits apply to IRA contributions, but anyone can invest in a Roth IRA through the “backdoor,” provided they have earned income to cover the contribution amount.
Multiple Factors Determine Whether a Taxable Account Can Beat a 401(k)
But what if they have additional retirement assets to invest? Once the IRA is fully funded, would those dollars be better off in a weak 401(k) or in a brokerage account held outside of a tax-sheltered account?
The answer here, as with so many financial questions, depends on a couple of key factors, especially the following:
- 401(k) plan quality: Just how bad is the plan? Does it have high administrative costs and subpar and/or expensive investment options? Or is it simply that the lineup includes some lackluster funds that are past their prime, while also including some reasonably priced options? Comparing your plan to others can help you make that assessment.
- The quality and tax efficiency of the investments in the taxable accounts: Investing in a taxable account will rarely be the better option unless you’re able to invest in securities that make few ongoing distributions of income, capital gains, or both. The good news on this front is that investors can opt for a brokerage platform that offers a good array of low-cost, tax-efficient options—namely, index-tracking ETFs and municipal-bond funds.
- The investor’s tax bracket at the time of the contributions: The ability to make pretax contributions—as is the case with traditional 401(k)s—will be more valuable to the investor who’s in a high tax bracket at the time of that contribution than it will be to the person who’s in a lower tax bracket.
- The tax bracket at the time of withdrawals: Withdrawals from taxable accounts receive more favorable (and flexible) tax treatment than withdrawals from traditional 401(k)s. Investors pulling from their taxable accounts will owe capital gains taxes, whereas money coming out of a traditional 401(k) is taxed at the investor’s ordinary income tax rate, which is higher. Moreover, because the 401(k) money has never been taxed, investors owe taxes on the entire withdrawal, not just the appreciation; taxable-account investors, by contrast, will only owe tax on their gains. Finally, 401(k) assets are subject to required minimum distributions at age 72. For investors who expect to be in a high tax bracket upon retirement, having assets in a taxable account—and enjoying more favorable taxation on the distributions—will be particularly beneficial. (Of course, Roth 401(k) withdrawals are more favorable still: While Roth 401(k)s are subject to RMDs, those assets can be rolled over to a Roth IRA to avoid RMDs. Better still, qualified withdrawals from Roth 401(k)s and IRAs are tax-free.)
Weighing the Trade-Offs of Investing in a Taxable Account vs. 401(k)
Because these factors all work together, it's difficult to make one-size-fits-all assessments about the virtues of investing in a 401(k) versus investing inside of a taxable account. Here are some simplified examples that help illustrate the interplay between all of these variables—and specifically the trade-off between tax costs and investment expenses.
Example 1: Anne plans to invest $10,000 per year in a balanced portfolio within her lousy 401(k). While her account earns 5% per year on a pre-expense basis, that number shrivels to a 3.5% return once all the fees are taken out. She makes pretax (traditional) contributions to the 401(k) account for 30 years, at which time she begins pulling the money out and paying taxes on the withdrawals at her 24% income tax rate. Anne would have about $516,000 on a pretax basis at the time of retirement, but the taxes on her withdrawals would take that amount down to about $392,000.
Anne’s situation illustrates how high expenses can erode the tax benefits of a tax-deferred account.
Example 2: Jerry, Anne’s colleague, skips the costly 401(k) and goes straight to a taxable account. He doesn’t receive the tax break on his initial contributions, so he can only contribute aftertax money into the account. Whereas Anne can send the whole $10,000 into her 401(k) each year, Jerry—in the 24% tax bracket at the time of his contribution—can only afford to contribute $7,600 to his taxable account. He, too, invests in a balanced portfolio and earns 5% on a pretax, pre-expense basis. But he sticks with low-cost, tax-efficient equity index funds and municipal-bond funds, so he’s paying just 0.50% per year in taxes and just 0.25% in fees. He’d accumulate about $444,000 over 30 years. When Jerry withdraws the money in retirement, he won’t pay taxes on the $228,000 he put in—his basis, which he has already paid taxes on—but he will owe capital gains taxes of 15% on his appreciation of $216,000 (assuming he’s in the 15% capital gains tax bracket). Thus, Jerry’s aftertax, take-home total would be about $412,000—better than Anne’s. Better still, his account isn’t subject to RMDs, so he can take the funds out on his own schedule.
Jerry's situation illustrates that a low-cost, tax-efficient taxable portfolio can beat a higher-cost tax-deferred one.
Example 3: James’ 401(k) includes a 0.5% layer of administrative fees, but he opts for the ultracheap index funds within his plan, bringing his total costs on a balanced portfolio to 0.6%. He invests $10,000 into the plan for 30 years, earning a 5.0% pre-expense return that drops to 4.4% once the plan’s expenses and fund costs are factored in. He amasses about $600,000 in the plan, which drops to about $456,000 once he pays taxes at a 24% rate on the withdrawals. By taking advantage of the tax benefits of the 401(k) while also finding a way to keep his overall costs low, James comes out ahead of both Anne and Jerry.
James' situation illustrates the best-case scenario for 401(k) investors: Take advantage of the tax break on contributions, take part in a low-cost plan, and opt for low-cost investments.
Example 4: Monica bypasses her company’s poor 401(k) and instead invests $7,600 per year in a taxable account. (Like Jerry, above, she’s contributing aftertax dollars so we’re assuming lower contribution amounts to account for a 24% income tax bracket on an ongoing basis.) She chooses low-cost funds—with average expense ratios of 0.50%—but they’re tax-inefficient, so she pays an additional 1% per year on their taxable capital gains and income distributions. While her balanced portfolio returns 5% on a pre-expense, pretax basis, she earns just 3.5% once taxes and expenses are taken into account. She has about $392,000 at the end of the 30 years—$228,000 of her own contributions, which she can withdraw tax-free—and another $164,000 in appreciation. Once the 15% capital gains tax on the appreciation is factored in, she ends up with about $368,000.
By not taking advantage of the ability to make pretax contributions to the 401(k) and failing to invest in tax-efficient investments inside of her taxable account, Monica fares the worst of any of our hypothetical investors.
Taxable Account vs. 401(k) Takeaways
The preceding examples illustrate that investors would do well to weigh their own personal tax situations—both current and future—as well as the quality of their 401(k)s when determining which account types to fund. Obviously, the preceding examples are highly simplified: Rarely does an individual's tax bracket stay the same over a 30-year period; tax rates on a secular basis are also apt to change. (Capital gains tax rates, in particular, are quite low by historical standards.) That underscores the virtues of tax diversification—splitting assets across accounts with varying tax treatment, whether tax-deferred, taxable, or Roth—when saving for retirement. It also illustrates the value of taking a deliberate approach to Roth versus traditional tax-deferred account funding.
Editor’s Note: A version of this article previously appeared on April 14, 2022.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.