The Myth of 401(k) Tax Breaks 17

There are several reasons for getting a 401(k). 401(k) tax breaks isn’t one of them. Over the last 3 years I have not had to pay federal taxes. This, because all my income is derived from capital gains and seeing as these barely put me past the 10% tax bracket, I owe 0% federal tax on these. This year preparing for taxes (2017) things look different. I started the Roth IRA conversion ladder, in the amount of $40,000. It’s a measure I have to take because my after-tax investment accounts will run dry, prior to my 401(k) withdrawal age of 59 (and a half).

Rolling over from a 401(k) to a Roth IRA implies that all money converted is subject to regular income tax. So for 2017 I owe at least income tax over $40,000.

I realized something, I really should have known

The often touted reason of, paying less taxes when contributing to a 401(k), is a myth!

For the Rollover I sold 175 shares of VIIIX. Based on First in/First out, these shares were bought in 2002 at an average of about $90.

Back in 2002, by contributing to the 401(k), I did not have to pay federal tax over $10,000 (the rest of the $15,750, paid for these shares, was from corporate matching). Today, I have to pay tax over $40,000. Whilst in the 30% tax bracket back in 2002, I delayed paying $3,000 so today, being in the 15% tax bracket, I can pay $4,500 ($1,500 more).

The other argument of paying into the 401(k) you hear all the time is: “When I retire, I will be in a lower tax bracket”. So what? By the time you retire your money will have tripled if not quadrupled, so even at a lower tax bracket you’ll end up paying more. Keep in mind; I’m selling 12 years prior to retirement age. Based on 8% growth that $40,000 I pay tax over today would have been worth $93,265 at age 59.5.

Yeah but..

That $10,000 plus corporate matching turned into $40,000, what’s your problem? Well, the “problem” I have is that, had I simply invested that money in the after-tax stock market, I would currently owe 0% in taxes. My main investments in my 401(k) are in the Vanguard index fund and my investments in my after tax accounts are in SPY. The investment is the same.

it would have seen identical growth, with the following differences:

Had I invested in after-tax accounts instead of a 401(k), I wouldn’t have to liquidate/convert today.

Had I invested in after-tax accounts instead of a 401(k), I wouldn’t have to pay taxes (as long as I stay withing the new 12% tax bracket).

There is a big but. On the flip side of the coin:

Had I invested in after-tax accounts instead of a 401(k), I would not have received the corporate matching….Hmmm


So what does this mean

First of all; for the government the 401(k) is awesome. It’s a win-win for them. They will collect way more tax dollars from you, if you contribute to the 401(k). If today, you’re 24 and choose to defer paying taxes over $200 you’ll save $24.00 in the 12% bracket. By saving that $24 today, you get to pay to pay $354.00 over that same $200.00 after it’s grown to $2,957.00 at early retirement at 59.5 (based on gains of 8% annually). Maybe the government isn’t so ineffective after all. They don’t mind, you not paying $24 today, knowing they’ll get 15 times that, 35 years later. Dirty little secret, they’re lending you that $24 today at a mere 8 percent interest (or whatever the market return is), to collect 30 years later.

A 401(k) ONLY makes sense, if there is corporate matching dollars. If there is no corporate matching you’re only signing up for paying way more taxes in the long run. There’s nothing in that 401(k) you can’t achieve by investing it yourself in an after-tax investment account.

401(k) distributions are subject to regular income tax. Capital gains however, has its own rules, which currently means 0% if you’re within the 12% tax bracket (that’s an income of $77,400 when Married filing jointly).

if you buy one share in VIIIX at $249 today in your 401(k) you save $29.88 in taxes. When you distribute that share of VIIIX in 30 years for $2,320  you’ll pay $278 in taxes. (based 12% bracket and 8% annual growth). There is no tax-break, just deferral with a high price-tag.

Update: based on comments by I have to point out; All of this applies only if your long term capital gains fall within the 12% tax bracket (today $77,400.00). Once your capital gains exceeds that amount you’ll be dropping in similar tax brackets as the 401(k) distribution. I do like to point out as well, that should you need more than 77K as a married couple in retirement, you better have a hefty retirement balance (million+).

Running the numbers

For my own sanity, I resorted to building a spreadsheet and comparing the scenarios of using after-tax accounts versus 401(k). Following is the setup of this scenario.

Starting age: 30
Starting income: $60,000
Annual raise: 3%
Return on investments: 8%
Early retirement at 59.5 (gotta dream)
Requirement budget after retirement: $70,000 (we’re all gonna live on less when we retire, right?)
Income includes funds needed, to pay taxes.
Tax brackets for Married, filed jointly, starting 2018 (the new tax ones)
The standard deduction $24,000 is taken each year
inflation after retirement 2.5%


Scenario 1: Contribute 8% to 401(k) without corporate matching versus investing in after-tax account

Based on the numbers above you will:

by age 59.5 have invested: $228,362.00
Have an account balance of: $791,637.69
Paid: $213,231.15 in federal income tax

After tax account:
by age 59.5 have invested: $228,362.00
Have an account balance of: $791,637.69
Paid: $245,143.68 in federal income tax

Having paid into 401(k) as opposed to After-tax would have yielded the exact same investment balances but, you would have paid less taxes. $31,912.53 LESS taxes paid. That great right? Yes, you saved on taxes while you were contributing to your 401(k) during your career. Only if life ended there.

It doesn’t though. You’re only 59.5 and will now start taking money from your investments. $70,000 based on the budget stated above.

When you take money from your 401(k) its all taxable as regular income. All $70,000 are subject to the 12% tax bracket. if you sell/distrubute $70,000 from your 401(k) you have to pay $5,139.00 in taxes that year and each year following. Based on inflation, you will live within the 12% tax bracket until age 73 (not accounting for SSN), after which inflation will have put your budget need back in the 22% income bracket.

When you take money from your After-tax account all distribution is subject to capital gains tax, which will effectively always leave you in the 12% tax bracket. Meaning you pay 0% in taxes. It also means you can take out less of your after-tax accounts as you don’t need to account for having to pay taxes.

from age 59.5 on until money runs out of the accounts you will pay federal taxes as follows:

401(k): $126,302.56

After tax Accounts: $0

So let’s be clear, having a 401(k) without corporate matching results in paying $98.329.15 MORE over the lifetime of your investment. YOU DO NOT SAVE ON TAXES with a 401(k), it’s a myth. As a matter of fact, even assuming you drop in tax brackets after retirement (like in this scenario), they still come back with a vengeance.

In this scenario, on top of all, your after-tax accounts will last a few more years as you can withdraw less. The assumption was that the $70,000 starting budget after retirement included funds for paying taxes.

Scenario 2: Contribute 8% + 3% match to 401(k) without corporate matching versus investing in SPY

In this scenario the numbers start looking different. Not from a tax perspective though. You will pay more taxes. Even more than in the last scenario since you’ll have more in the end (don’t worry, not enough to be effected by the estate tax).

Based on the same assumption above, you will

by age 59.5 have invested: $313,997.74 (your own contributions plus matching dollars)
Have an account balance of: $1,088,501.83
Paid: $213,231.15 in federal income tax (nothing changed here)

After tax account:
by age 59.5 have invested: $228,362.00
Have an account balance of: $791,637.69
Paid: $245,143.68 in federal income tax (again, nothing changed here)

You will still pay $98.329.15 MORE in taxes till the age of 77 but after that the story changes.

The big difference with scenario one is that your 401(k) will last 13 years longer as in the previous scenario. In scenario 1 it only lasted till age 77, in this scenario, you’re funded till 90.

This is greate, but again, not from a tax perspective. This also means the government will gladly take 13 years more tax dollars (at the 22% tax rate)


Scenario 3: Aim for the best of both worlds.

Scenario 2 shows, that 3% corporate matching makes a big difference in balances. The tax situation (if you hate giving it to uncle Sam) get’s even worse.

What about the third option. Walk away from the 401(k) and corporate matching. Instead build up the self discipline to award yourself that 3% dollar match in invest  the 11% of your salary into after tax accounts yourself.

Dollar and cents, this doesn’t make sense but if you were one to invest in 401(k) to reduce taxes, guess what: you’re already on the wrong side of logic.

Walking away from 3% matching does get you two important benefits the 401(k) doesn’t offer:

-You will pay a lot less taxes (contributing 11%, about $195,000 less till the age of 90).

-You get the freedom to do with your investments what you want and when you want it (and within bounds, without paying taxes).

Personally I don’t mind paying my fair share of taxes and would probably still opt for corporate matching, but I know, that doesn’t apply to all. Furthermore, that Freedom certainly has a nice ring to it.

Of course, there is the argument that without having it automatically put in a 401(k) it would get spend. I worry about that attitude. If you don’t have the self discipline today, to manage your money AND you’re deferring any effort in building that self discipline (by tricking yourself with automating), How well will you fair in retirement when you do have to manage it.

Okay, so let me know where I screwed up in the math on all of this. I dropped the table with all the data here : 401k vs after-tax Accounts data 

Good luck reaching your financial goals.


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About Maarten van Lier

Maarten came to this country with a suitcase and a diploma. He created a financial plan and goal to become a millionaire in 10 years. He successfully turned his financial goals into reality, wrote a book about it and now blogs actively in hope of inspiring other to do the same.

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17 thoughts on “The Myth of 401(k) Tax Breaks

    • Maarten van Lier Post author

      I wish I had. I for a long time maxed out my 401(k). Had I invested the non-matched funds in after tax account, I’d be in better position today and pay less taxes going forward. I would definitely put whatever in the 401(k) to get the 6% match. That’s a good matching program

      • BusyMom

        Okay, I need to think about this. Still learning everything. Why is every single personal finance blog out there talking about maximizing 401(k)?
        Will spend some time with a spreadsheet and google this weekend and report back!

        • Maarten van Lier Post author

          I think most blogs talk about maxing out 401(k)s because it is assumed most people don’t have to discipline or knowledge to invest it themselves. Inherently there is nothing wrong with maxing out the 401(k) as long as you don’t mind paying the taxes in retirement.

          Under current tax law the 401(k) distribution is taxed as regular income (10%/12%/22%/22%/32%/35)

          Under current tax law stock gains result in long term capital gains (0%/15%/20%). If you can budget within the 12% tax bracket (i.e all I need $77,400 a year) you will pay 0% long term capital gains. If all your money will come from stock sales you’ll pay $0 in federal tax (barring any tax on dividends).

          The difference over the lifetime of your retirement can mean thousands if not hundreds of thousands in taxes.

          • BusyMom

            I see what you meant, but don’t you start off with a smaller amount if it is an after tax investment? Suppose I am in a high tax bracket, say 32%. If I put that in 401(k), I have $100. For other investments, I would start off with $68. When will I recover that? That is the what I don’t get.

          • Maarten van Lier Post author

            The premise of this article is the choice of putting 10% of your salary in pre or 10% in your post tax accounts. You can think of it at a 401(k) or Roth 401(k). You contribute the same percentage, with different tax consequences.

            Naturally, if you choose to invest less in your after tax account (68 instead of 100), you’ll have less by the time you retire.

            But if, for argument’s sake, we run the numbers: In the following scenario: Starting age 30, Starting Salary $60,000.00, annual raise 3%, death at 90
            -401(k) contribution 11%,
            At age 59, you’ll have $1,088,501.00.

            -After tax contribution 11% minus the tax-break you pass up
            At age 59 you’ll have $954,460.45

            You will have $134,041 LESS at time of retirement.

            with the 401(k) account, you will pay a total of $492,645.00 in taxes till the age of 90
            With an after tax account, you will pay $296,964.00 in taxes till the age of 90

            You will pay $195,681 more taxes with a 401(k), so in a sense, yes even by choosing to contribute less in your after tax (68 instead of 100).

            It doesn’t change the tax payment narrative after retirement. With an after tax-account, You’ll pay 0% (if you stay in the 12% bracket). With the 401(k) distributions you’ll pay taxes till the day you die, vastly out-costing the tax-break you enjoyed pre-retirement.

            The bigger question becomes, if you choose/are-only-able to invest the remaining dollars (the 68, instead of 100), will there be enough at retirement age to last till death. In the case of an 11% contribution, yes, anything less than 10%; ehhh, it would depend on other factors (like SSN)

            (all of this applies to federal tax, and assumes starting retirement in 12% bracket)

  • Ron Cameron

    This is right in my wheelhouse, but I’m struggling to understand where the math is coming from. I’ve read through this several times and something isn’t clicking for me. Is it possible that you’re not taking into consideration the yearly taxation of the growth of the non-retirement account? For example: Year 1, $1000 grows to $1100 but you pay $20 in taxes so you end up with $1080. Now instead of $1100 growing it’s $1080, and so on. I know the taxation of capital gains vs IRA distributions is different, but I still can’t see the massive gap you’re referring to. If anything, invest it into a Roth 401k (if available) and you overcome any benefits from investing outside a 401k.

    On a side note, planning for tax considerations in 10+ years is super difficult due to things changing. Of course, I don’t recommend NOT planning either 🙂

    • Maarten van Lier Post author

      Roth IRA would indeed be better, but has more limited funding possibilities (unless it’s a Roth 401(k), which I’m not sure all employers provide).

      There are no taxes on yearly growth (unrealized gains) in an after-tax investment account (other than dividends). You only pay capital gains taxes when you sell your shares. If you can live within the 12% tax bracket (That is, if after retirement your majority of income is capital gains and remains below 77K) you will pay 0% tax.

      As far as planning based on taxation for the long-term should it’s not gauranteed but its the best we have. The tax code is changing for 2018 but that’s the first overhaul was 31 years ago.

  • Mrs. Groovy

    Ahhhh! My head is swimming with these numbers but I get the theory. Holy crap, young people need to see this post. And that’s an excellent point about deferring self-discipline and automation.

    • Maarten van Lier Post author

      I know, there is a lot of math there. The way it drove home for me was when I converted 40K from my 401(k) to my Roth IRA. I’ve been retired almost 4 years and basically have paid no federal tax based on stock sales because I live within the current 15% tax bracket (taxes incurred by dividends, were offset by deductibles).

      I touch my 401(k) and suddenly I’m taxed again (as you would if you took out money from your 401(k) after 59.5). Made me think, and subsequently draw some conclusions.

  • FullTimeFinance

    The only scenario where your arguement is true is the one where the after market withdrawals pay 0 percent capital gains. Otherwise the 401k comes out ahead. Paying the ordinary income tax on the investment or the ordinary Income tax on the result is a wash at the same tax rate. Why, because you get the return on the taxable amount of the after tax which nets them out. The 401k benefit is it avoids the additional cap gains while after tax except tax advantaged does not. Given cap gains start at 77k a year at 15 percent it depends on what you expect in 401k output. It also depends on your inputs and future tax law. If your currently in the bracket over 77k then your current tax rate is greater then it will be if it’s under 77 k in retirement, giving you tax relief based on a bracket reduction. If your over 77 k in retirement cap gains kicks in and you save 15 percent. Now if you start under 77 k and stay there you might have a point.

    • FullTimeFinance

      Keep in mind this assumes you invest the portion of the 401k that would otherwise be taxed going into an after tax account, which adds to your investing principal. If you invest in a 401k to have more cash to party then all bets are off.

      • Maarten van Lier Post author

        Absolutely, one should be disciplined to invest the remainder. Which is probably why 401(k)s (despite their taxation) are still the best option for most people. I do worry about those that don’t have that discipline. Once their 401(k) becomes available for distribution there is no-one or nothing in place to stop them partying on.

    • Maarten van Lier Post author

      I think I agree (mostly) on your first comment. Although, I still have the feeling you you may be better off even if you need more than 77K a year.

      After retirement you pay regular income on the entire distribution from your 401(k). So if you withdraw 90K from your 401(k) because that is what you need you will fall within the higher than 12% bracket (new 2018 bracket).

      If you withdraw 90K from your after-tax account, chances are you are still within the 12% bracket as your income is only the capital gains. If your investments quadrupled over time, only 67,500 would be capital gains/income. I’m pretty sure you would still pay 0%

      Once you’re financial annual needs do exceed capital gains of 77K you would fall in pretty much the same tax brackets.

      This is kind of where the second part of the story around 401(k) bugs me. The other line your fed is, you’ll live on less when in retirement and therefor will most likely be in a lower tax bracket.

  • Mr. Groovy

    “The often touted reason of, paying less taxes when contributing to a 401(k), is a myth!”

    Say it ain’t so! Sadly, I’m afraid you’re right, my friend. I ran an experiment a few years ago to see which was better, the Roth or the 401(k). Turns out, at least in my shoddy experiment, that there was no tax advantage to the 401(k). Anyway, before I even conducted this experiment, I put more money into my brokerage account than my Roth and 401(k). It was only later in my investing career that I stopped putting money into our brokerage account and started to max out my 401(k). I can’t tell you why I did this, I just did. And thank God I did. Half of my portfolio is now in my brokerage account. And now I have access to a lot of tax-free capital gains if I need them. Great freakin’ post, Maarten. Thank you.

    • Maarten van Lier Post author

      Thx, good thing you went half the other way. I did too but just not enough, hence the Roth IRA conversion ladder today.

      Sadly it seems like another example of “I want it now. I’ll take some credit (tax break) today” and pay it off later. Not being fully aware of how much that later may cost you.

      While researching this, I learned about the Roth 401(k). Never heard of it before but it seems more attractive to me.