Welcome to part 2 of the big question of whether you can save too much in a 401k. I know what you’re thinking after last week’s email – “This is great and all, Dan. But I participate in a traditional 401k. How about covering that?!?” Well, fortunately Nick also broke this down for a traditional 401k, but he admits it is a more complex analysis here.
The big difference when looking at contributions to a traditional 401k vs a Roth 401k is contributions to the traditional 401k go in before taxes. So, we need to adjust our contribution amounts to reflect this difference. The assumption here is you are in a 24% tax bracket while working and also the same bracket in retirement. To make the tax-adjusted contribution so we can compare it to the $10,000 annual contribution we need to make the actual 401k contribution an amount of $13,158.
Side note – if you know with 100% certainty your tax rate in retirement will be identical to your rate while working, well, it makes no difference if you are saving in a traditional 401k or a Roth 401k. Here is where it gets complex. If this assumption is true, then the factor that makes a difference when considering the benefit of a traditional 401k is the difference between your tax rate when working and the tax rate when retired.
Here is where you need to take the time and read this article on Nick’s site because he has included a great chart illustrating the benefits. However, since I cannot share the chart easily here I wanted to share his conclusion and I’m going to quote him – “as your tax rate in retirement increases, the annual benefit of contributing to a traditional 401(k) decreases, relative to a taxable account.”
Nick goes on with his conclusions. He states the benefits of a traditional 401k get are completely nullified once your retirement tax rate gets too high. In his example and using the assumptions I mentioned earlier, this magic number is a retirement tax rate of 34%. Basically, with a retirement tax rate this high and avoiding paying the 24% tax rate when you were working, you simply traded paying a current 24% bill now to instead pay a tax bill at a 34% rate. Ughh. Bad deal, except for Uncle Sam.
So, where does this leave us? Well, if tax rates go up in retirement significantly then any gains you made in your traditional 401k could be completely wiped out. A similar argument could be made if capital gains rates go up for taxable accounts.
Ultimately, no one knows what will happen with tax rates in the future. The assumption/fear sale technique has always been rates will go up. This has been said for years and years. Somehow Congress and the White House have been able to push that down the road time and time again. There’s a whole new school of thought about Modern Money Theory that basically says – ah, don’t worry about it.
Getting back on where this leaves us. First, no matter current or future tax rates, it makes sense to max out your employer match. Beyond that point is where you need to start looking at things such as the internal expenses in your 401k plan and also things like – would I ever need some of this money before retirement? In those situations it may make sense to consider utilizing a low-cost buy and hold strategy in a taxable account.
One final thought on this whole consideration, including whether to go the Roth 401k or traditional 401k route vs a taxable account. First, a big benefit of participating in a 401k is the ease of use and staying disciplined with your investments. Your contributions automatically come out of your pay before you have a chance to touch (spend) it. Plus, you know if you liquidate it early you will be socked with a penalty as well as adding to your taxable income bill for the year. Putting the money automatically into a taxable account is not as direct and knowing you have readily accessible money can be very tempting for many people. Even if your 401k investment expenses are at or above the national average, it may be worth paying that additional expense to keep you disciplined and regulated with your retirement savings. As always, something to talk to your CFP® about.
I lied. One more final thought based on some feedback from last week’s article. And I admit I should have mentioned this before. This entire analysis assumes you are paying little to no fees to your financial advisor. I know I’m the outlier by charging a flat fee regardless of asset size. Most advisors charge a percentage of assets, which often starts at 1%. Once you add in the investment expenses this fee can double to 2%. You may also have additional indirect fees if your advisor is actively trading your account as those fees include trading expenses and taxes. Ultimately, this is just a reminder to be fully aware of the fees you pay your advisor and bring them into this consideration.