The Case Against Maxing Out Your 401(k)

Should you max out your 401(k) contribution?Most every personal finance blog I have ever read recommends maxing out your 401(k) contribution. They tell you to “just do it” – contribute as much as you can, as early as you can.

I couldn’t disagree more.

Forced savings

I believe most bloggers (and many financial planners and low-quality investment advisors) recommend maximizing 401(k) contributions as a way to enforce a savings discipline. They believe that without automatic deductions, people won’t save at all.

Our readership tends to be more disciplined and intelligent than the average personal finance blog readers, so I don’t think they need such a brute force recommendation. For our clients and readers, we emphasize transparency, rational decision-making and the use of mathematical tools. We recognize how important it is that you feel comfortable with your own finances.

(I included one mathematical tool at the bottom of this post to help you decide whether it’s wiser to save in a tax-deferred account or a taxable account. The quality of the investment choices matters a surprising amount in that calculation.)

Most people should establish and fund savings vehicles in this order:

  1. Establish an emergency fund of six months of living expenses
  2. Contribute to your 401(k), but only up to the company match
  3. Establish saving and investing vehicles for your other goals, like buying a house and saving for your kids’ education
  4. Contribute more to your retirement – but only choose the vehicle (IRA or 401(k) or taxable account) after you weigh the investment choices, tax benefits, fees and liquidity.

Rainy Day Fund

The most important step you can take toward establishing a healthy financial life is to fund an emergency account. Our clients are already more financially aware than most people. But even among our clients, there is likely to be a considerable number who haven’t taken this important first step.

A study by Annamaria Lusardi found 25% of people making more than $75,000 a year didn’t have three months of living expenses in an emergency account. (69% of people aged 18-29 didn’t have an account; 51% of people ages 30-44 didn’t have one.) Why? Young people overestimate their tolerance for risk, which may lead them to take risks with their rainy day money.

I suggest young people have an account containing six months’ worth of living expenses. You need more if you have family members likely to call on you for help. Establishing a rainy day fund is only the beginning of developing enough liquidity. A rainy day fund will cover some of your unanticipated expenses – but as you save for other goals, keep in mind that at any time, you may need to liquidate other accounts to handle emergencies too large to be covered by your rainy day fund, or multiple emergencies. Ideally your rainy day fund should be kept in an extremely low risk vehicle like a money market fund.

401(k) Up To The Employer Match

A 401(k) retirement plan with a matching contribution from your employer is an incredible benefit. It immediately doubles your money, so whenever possible you should contribute the maximum amount your employer matches. The big question is: Should you contribute up to the maximum allowed each year, which is currently $17,500?

The answer is, not until you have enough liquidity in your other accounts. Once you contribute money to your 401(k) plan, you cannot withdraw it without a sizeable penalty. That means a 401(k) plan is an awful way to save to buy a house or fund your kids’ education.  Most people do not consider liquidity when choosing the appropriate investment vehicle to employ. It is every bit as important as minimizing taxes, especially when you need money for unforeseen events in the future. A rainy day fund is a great start, but it is unlikely to cover all your future cash needs like family emergencies, unplanned health care costs, a wedding or cash needed to fund your living expenses while you bootstrap a startup.

The bottom line: Don’t contribute beyond your 401(k) match until you have enough money set aside for your other, likely higher priority needs.

Other Savings Goals

How much liquidity do you need? That’s a function of your other financial goals and how confident you are that your rainy day fund will cover any unforeseen issue.  The answer is highly personal and depends on your goals. For further perspective on this issue, you might enjoy our blog posts about buying a house and funding your kids’ education.

If you need money in the short term for something like paying the taxes due on the exercise of your options then you are probably best served putting the money in an extremely low risk vehicle like a money market account. We highly encourage you to avoid taking too much principal risk in this kind of situation.

If you have a longer time horizon, then a low-fee investment account with high-quality, passive investments (like that offered by Wealthfront) is a good choice.

Save More For Retirement

After you have enough liquidity, then consider investing more for retirement. Now, the decision you face is whether to use an IRA, a 401(k) or a taxable account. It may surprise you that a taxable account is even on the table. We’ll show you the calculations in a moment.

IRA vs. 401(k)

If your 401(k) charges big fees and only offers mutual funds as your investment vehicles then you want to avoid your 401(k) for anything other than the amount that is matched. Repeated academic research has shown that actively managed mutual funds on average underperform index funds by 2.1% per year.

IRAs typically provide access to much lower cost investment options than employer 401(k) plans, but your ability to deduct your contribution to a traditional IRA may be limited by your income, whether you are covered by an employer’s plan, or both. If you earn about $100,000 per year as a single person ($175,000 as a married person) and you have participated in your company’s 401(k), you can’t deduct your contribution. If you earn less than about $100,000, you may be able to take partial or full deductions even if you participate in your employer’s plan.*

Most likely, your income is above that 100,000 mark, so you won’t be able to deduct contributions to an IRA if you participated in your 401(k) to get the aforementioned matching payment. If your company doesn’t have a 401(k) plan, then you can get a deduction for the amount your contribute to an IRA. The new tax law effectively limits annual contributions to an IRA (either Roth or Traditional) to $5,500 per year for people up to 50 years old and $6,500 per year for people over 50.

If you plan on not participating in your company 401(k) plan, be sure the “Retirement Plan” box is not checked on Line 13 of your W2. Your contribution to your IRA will not be tax deductible if it is.  As with most issues related to taxes, please be sure to consult your tax advisor to make sure you don’t exceed the appropriate contribution and deduction limits.

401(k) vs. taxable account

If you want to set aside money for retirement beyond your matched 401(k) contribution and the IRA limit, then you need to run a calculation to determine if you should put more in your 401(k) or invest it in a taxable account. The choice between a 401(k) and an IRA seems clear: Given that both have tax benefits, the superior investment choices found in typical IRAs make it the better choice.

The question of whether you go on to save in a 401(k) or a taxable account is more difficult. Will the tax benefits of the 401(k) outweigh the better quality investments in a taxable account?

Wealthfront’s investment team developed a couple of formulas to look at the question. We were surprised to discover that a 2% underperformance of actively managed mutual funds (the level academic research has demonstrated) is basically the equivalent of the tax savings in a 401(k). If the advisory fee is the same in each, then a taxable account should be a better choice. Why would you lock your money up in a 401(k) if you’ll earn about as much money in a taxable account?

The after-tax value of  $1 invested in a 401(k) plan with active mutual funds in 20 years =

$1
×
( 1 + portfolio return – advisory fee – underperformance )20
×
( 1 – ordinary income tax rate )

The portfolio return represents the gross return you should earn for your particular risk tolerance. The advisory fee is the fee charged by your 401(k) administrator. Underperformance is the performance penalty you pay for only having access to inferior investment products like actively managed mutual funds. This formula assumes your returns compound tax-free and then are taxed at your ordinary income tax rate when you withdraw the funds.

The after-tax value of  $1 invested in a low-cost passive taxable account in 20 years =

$1
×
( 1 – ordinary income tax rate )
×
( 1 + portfolio return × ( 1 – portfolio tax rate ) – advisory fee )20

Because you cannot contribute your income tax free to a taxable account, we assume that you first pay taxes at ordinary income rates before your invest. The portfolio return should be the same for the taxable account as for the 401(k); the advisory fee is the fee charged by financial advisor. Income earned each year in a taxable account is taxed before it is reinvested. Assuming you invest in index funds/ETFs then almost all the appreciation will be in the form of long-term capital gains, which are now taxed at 35% including state taxes. The dividends earned on your index funds will be taxed at 35% including state taxes. Therefore your portfolio tax rate will be only 35%. There is no underperformance because we assume you have access to the best investment products.

If you try to equate the ultimate value on the two accounts, the equations simplify down to the following:

portfolio return – underperformance =
portfolio return × (1 – portfolio tax rate)

Test Case

If you assume a portfolio return of 6%, then the two accounts generate roughly the same value if the underperformance of the investments offered in the 401(k) is 2.1%. Coincidentally, 2.1% is the difference Robert Arnott found to be the average difference in annual performance between actively managed mutual funds and index funds in his seminal research on the subject. 401(k)s become a more attractive investment vehicle as the number of index funds offered increase. That being said, the expected value of the 401(k) needs to be significantly greater than the taxable account to overcome the taxable account’s superior liquidity.

We encourage you to plug your own assumptions into the formulas above to see what’s best for you. We’re delighted to answer any questions you might have if you send us an email to support@wealthfront.

The Bottom Line

401(k)s have become the de facto savings vehicle of choice for the masses. They shouldn’t be. The high fees and poor investment choices and poor liquidity can detract from the usefulness of 401(k)s. As always, we encourage you to think critically.

Liquidity and the costs of accounts should play a big role in your decisions about how much to set aside in tax-deferred accounts. You never know what curveballs life will throw at you. Knowing you have enough liquidity to deal with stressful times is worth a lot. Actually having the liquidity on hand when the needs arise is even more valuable.

 

*[Please note that the author is using these salary numbers as a rough guide for the purposes of illustration and explanation. Individuals must read and interpret IRS documentation to best determine their own situation and status. The previous link is provided for the reader's convenience and can be updated by the IRS at any time and without our knowledge. Please notify us if this link no longer functions or needs updating.]

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30 Responses to “The Case Against Maxing Out Your 401(k)”

  1. AC January 24, 2013 at 10:07 pm #

    Based on your experience, is it the norm for VC backed companies to not offer 401k matching?

    I work for a VC backed company which does not match employee 401k contributions. When pressed on the topic, the mgt. team has cited data from our VC investors that none of their portfolio companies provide 401k matching as stock options are the incentive for wealth creation. Given the points noted in this article about liquidity and the IRA vs 401k benefits, it would seem that most startup employees would be best served by foregoing 401k’s in favor of IRA and taxable accounts. This is counter to the notion that employees should automatically max out their 401ks every year.

    Thanks for another enlightening post!

    • Andy Rachleff January 25, 2013 at 8:09 am #

      It is my experience that VC backed startups do not match 401(k) contributions until the company is very mature (almost public to publicly traded). Based on the math we did for this article I would agree that most employees at VC backed companies who do not receive a match and who are only offered mutual funds in their 401(k) plan should not even contribute to their 401(k). However, if your plan offers index funds it might make sense for you to contribute if you are willing to forego the liquidity.

  2. Aleks January 26, 2013 at 9:10 pm #

    Apologies if I’m misreading the article, but it seems to suggest that traditional IRA contributions aren’t deductible at all if you’re covered by an employer’s retirement plan. In fact, if you make less than $59,000 (single) or $95,000 (married), your contributions to a traditional IRA are tax-deductible, even if you are covered by an employer’s plan.

    Additionally, I’m surprised to see that you didn’t mention Roth IRAs. Since the post-tax contribution limit for Roth IRAs is the same as the pre-tax contribution limit for traditional IRAs, the amount of money you can shield from taxes is effectively higher in a Roth; for someone who has the resources to max out their retirement accounts, many people would say that Roth IRAs are preferable for that reason. Your coverage by an employer retirement plan has no bearing on your ability to contribute to a Roth; if you are above the income limit, you simply make non-deductible contributions to a traditional IRA and immediately roll them over to a Roth.

    Yet another benefit of Roth IRA contributions is that they are effectively as liquid as taxable accounts, since you can withdraw your contributions at any time without penalty. The opportunity cost of doing so is high, but certainly not higher than not putting money in a tax-advantaged account in the first place!

    All that said, I count myself lucky that my 401(k) options are actually better than anything I could get privately. Institutional shares are the way to go :)

    • Andy Rachleff January 27, 2013 at 4:13 pm #

      If you participate in an employer plan, you can only deduct your contributions to an IRA if you are below a certain income limit. Readers who are interested in learning more specifics should check out the IRS’ detailed information. You might also find this link helpful.

      We addressed your points about Roth IRAs vs Traditional IRAs in a previous post called When a Roth 401(k) trumps a Traditional 401(k)

      We agree that 401(k)s can be superior to taxable accounts if your employer offers high quality, low cost investment options like index funds and low cost target date funds. Unfortunately few employers do.

  3. David Raccah January 29, 2013 at 10:29 pm #

    Hello Mr. Rachleff,

    I do not specifically disagree with you as much as I disagree with the approach – LOL! You see the best saving system out there is inertia :-) The more difficult we make systems of saving to change the better it is for individuals. Why, because we SUCK at saving and you have made the cardinal sin of very smart people – you forget that other people are not as smart and motivated in all areas as you are.

    Everyone has something to add to society, but not everyone is good at saving money – that is the VERY SAD truth. The automatic enrollment law of 2005 has made more people save money. True, they may be saving money in a crummy plan. But, to tell people to not save money in the brain dead manner – and instead use a time tested system like asset location is 100% reasonable as long as they are as smart and passionate as you are.

    Look at the saving rates and balances in 401K – they are at their highest point – of all time! Sure, I am no Pollyanna – the market may well be far to over heated right now. But who cares? By forcing folks to save in 401Ks and making anything in 401k actions as hard as possible (joke), we have allowed people to stay the course and reset to an even higher point. Sure, that was done not only by gains but by new contributions and again, I do not argue with your approach – what I worry is the actions of people who have kids, life, and work to worry about.

    If everyone was as passionate as you and I am in this space – we would not need to worry about any of this. Instead we have to worry about things like fiduciary versus brokers, we have to worry about how to invest instead of just how much to invest.

    In closing – your plan is battle tested and back-tested, but is it human tested? Can a human do this without using a service like yours? Ideas like this remind me of Ric Edeleman’s many good books, which go to town on why managed mutual funds are a bad option and why institutional funds are better, for those in the know they are not available to the average man. So, sure he explains that ETF work as well, but not before exalting the virtues of DFA. To me – inertia and the plain old 401K is better than nothing – which is what you will get otherwise, for most people.

    On an aside, Aleks – please be careful, backdoor Roth IRA only works when all your money is in a 401K and not in an anotehr (non-ROTH) IRA, which works for you as your 401K is solid. For the rest of the world who moves jobs and does a Rollover IRA, this becomes expensive quickly.

    My humble opinion,
    David

    • Andy Rachleff January 31, 2013 at 8:45 am #

      David,

      Thank you for your thoughtful post. We understand that some people require the discipline of contributing to a 401(k) plan to enforce a savings regimen and reference it in our post. We just don’t think that is true for the vast majority of our particular readers and clients. If you don’t need a 401(k) to ensure savings then it is not necessarily the best investment vehicle to use.

  4. Joe A January 30, 2013 at 11:06 am #

    Nice article. My 401k has two mutual funds with management fees below 0.05% (US Mid/Large cap) and about ten more funds with fees upwards of 0.2%. Should I be willing to pay higher management fees or more tax to diversify my portfolio with International and Small cap? Or is it probably not worth it?

    • Andy Rachleff January 31, 2013 at 8:42 am #

      Your goal when managing your portfolio should be to maximize your returns for your particular level of risk. If you look at the math, that is best accomplished by combining relatively uncorrelated asset classes. You should keep adding asset classes until they no longer increase your expected return for your particular risk (standard deviation). That’s the basis of the Wealthfront service which is explained in our investment methodology white paper. Therefore it is highly likely that it is worth it. We can’t offer our service to manage current 401(k) accounts (the only 401(k) accounts we support are rollover accounts), but we encourage you to use our recommended asset allocations that you will find by going through our questionnaire.

  5. Dan January 30, 2013 at 11:49 am #

    I may just be missing this in the article, but there is one other subtlety in the tax treatment that’s worth considering here.

    For the average person, income tax rates are likely to be lower during retirement than during working years because you won’t have all that much ordinary income from employment. This means that the marginal tax rate when you put money into a taxable account (in Eqn 2) may be significantly higher than the marginal tax rate you pay when taking money out of a 401k (in Eqn 3) when you probably wont have much other income. All things equal, this should increase the tax advantages of the 401k.

    I did a quick spreadsheet, trying to replicate the assumptions that got you to the 2.1% underperformance as the breakeven point. By my math, if your marginal tax rate at retirement is 10% lower than your , the underperformance breakeven point increases to around 2.8% (with some variance around your exact tax rate).

    It may still be a better economic choice to save in a taxable account given the better average performance, greater liquidity, and lower fees. That said, the tax savings are probably bigger than this analysis would suggest.

    • Andy Rachleff January 31, 2013 at 8:48 am #

      Dan,

      We don’t write our blog for the average person. Our readers tend to be young and work in the technology business. Assuming they are successful we think it is unlikely their tax rate will go down when they ultimately withdraw money from their tax deferred retirement accounts. In that case our assumptions are valid. I completely agree with your conclusion if your marginal tax rate is likely to be lower on retirement.

      • Dan January 31, 2013 at 5:03 pm #

        I’m not sure that response makes sense:

        1. Even young, technology people (of which I am one) have a better than average chance of being retired when they’re 70+ and making mandatory withdrawals from a 401k (http://www.nytimes.com/2012/10/11/booming/11question-booming.html?_r=0).

        2. But even if you never retire, maxing out your 401k may still make sense if you’re reasonably risk averse. After all, if your marginal tax rate is just as high when you’re in your 70s and 80s as it is when you’re a young tech professional, then you’ve probably saved a small fortune for retirement. If that’s the case your slightly inefficient decision to max out your 401k just isn’t that big a deal in terms of your total financial health. If, on the other hand, you don’t end up being so financially successful, either by choice or by bad luck, then you’re tax rate during retirement will be low and you’ll probably really need that extra money that you’ve socked away in your 401k.

        Particularly for people who work in a fast-changing and high-risk industry like ours, a little bit of risk aversion probably makes a lot of sense. In short, I’m not sure that the advice you’ve given here makes even for the relatively narrow demographic group at whom you target it.

        • Andy Rachleff February 1, 2013 at 9:35 am #

          Risk is not the issue. The math displayed in the post assumes the same investment risk profile for a taxable or 401(k) account.

          The major point of the post is you should consider liquidity when deciding where to invest for retirement. If the amount of value generated after tax by each account is close then the taxable account should be your preference because you can access the money at any time. Your tax deferred account needs to earn significantly more to make up for the liquidity premium you deserve.

          • Dan February 1, 2013 at 10:10 am #

            Yes, you’ve assumed the same investment risk profile in both cases, but you’ve assumed a risk neutral profile that just cares about maximizing expected returns. My point is that if you change the assumed risk profile to one that is more risk averse, the 401k starts to look more attractive because it provides a better financial outcome in the cases where ones other source of income aren’t that high.

            On the liquidity point, you’re absolutely correct. That’s the bigger issue here than underperformance I think.

      • Kevin March 17, 2013 at 8:59 am #

        Andy: I like the fact that this is an analysis for those planning on success. There are two other cases that support the thesis *not* to contribute to a 401K once financial success is achieved:

        Case 1: Modest financial success. Need to consider the differential tax rates at withdrawal. Assume both significant income from taxable assets and a highly appreciated 401K. The distributions from 401K/IRA are taxed at the top marginal rate (36% today and probably going higher). This contrasts to the much lower 24% capital gains rate (inclusive of 4% Obamacare surcharge).

        Case 2: Exemplary financial success. In this case assets are sufficient that there is no need for post retirement income from IRA/401K accounts at all. Instead estate planning issues come into play. This is where required minimum distributions really hurt. These distributions are taxed at the highest rates and force the account to be diminished over time leaving less to pass on tax-free. Way better to have these build up in a taxable growth fund not being taxed at all (as long as you don’t sell the appreciated asset) and able to be passed to heirs and charity tax free.

  6. Michael Plater II April 17, 2013 at 7:52 am #

    This type of analysis was exactly what I was looking for, thanks. Though am I right in assuming that it does not take into account reinvesting the savings from the taxable account deductions? I guess if you’re maxing out your 401K anyway then the refund doesn’t matter, though what if you’re not?

    • Andy Rachleff April 17, 2013 at 10:38 am #

      it does take into account reinvesting.

  7. Michael Plater II April 17, 2013 at 7:54 am #

    Sorry I meant “non-taxable account deductions” in my last comment.

  8. Aaron Sneeman April 29, 2013 at 3:51 pm #

    I see you suggest funding a college fund (e.g., 529) before the additional retirement savings. What about the fact that you can’t borrow money for retirement but you can for college?

    • Andy Rachleff April 29, 2013 at 5:08 pm #

      If you don’t get a match and choose not to participate in a 401k plan then you are relatively indifferent between 529 and IRA contributions. I prioritized your college fund over your IRA because you are likely to need the money for your kids’ college before you need money for retirement.

  9. Steven May 5, 2013 at 5:45 am #

    I like this detailed analysis and more so I liked that you have a “bottom:line”.

    “Don’t contribute beyond your 401(k) match until you have enough money set aside for your other, likely higher priority needs.”.

  10. seth May 15, 2013 at 10:47 am #

    I think you miss one point. How many people spend their entire career with one employer? Or even 10 years these days?

    It makes sense to max out the 401k (even with crappy invesment choices) because when you leave the company you have a good sum of money to roll over to an IRA with good cheap investment choices, and the tax deferred growth for many years.

    If you didn’t do the deferral max in the calendar year, you can’t make it up in future years. Use it or lose it.

    In short, don’t base your annual tax deferral on your current company’s 401k because odds are the money won’t be there very long.

    • Andy Rachleff May 15, 2013 at 4:22 pm #

      You make a very good point! But you should still worry about the loss of liquidity.

  11. Patricia June 13, 2013 at 10:44 pm #

    Here’s my problem with the 401K “forced savings” plan: My current effective tax rate is zero. How will my retirement tax rate be lower when I retire? So if my retirement tax rate cannot be lower than what I am being taxes now, why invest in a 401K at all?

  12. Anderson January 6, 2014 at 5:08 pm #

    This article seems to assume that all 401k contributions are pre-tax, traditional 401k contributions. I would love to see an update on this as it relates to Roth 401k contributions. For instance, I would think it would be best to contribute to your Roth 401k up to the company match, then max out a Roth IRA with somebody like Wealthfront or Vanguard because of the increased flexibility (at $5500/yr), then go back to max out the Roth 401k (up to $16,500 a year). This is assuming you have some index funds as investment choices or the ability to self-direct your investment and buy ETFs like I do in mine. Am I wrong on this?

    • Andy Rachleff January 6, 2014 at 6:18 pm #

      It only pays to go back and max out your Roth 401k if you don’t care about liquidity (you should) and you plan on leaving your company after only a couple of years and reinvest it with someone like Wealthfront. It is not a good assumption that you have the same ETFs available to you in a 401k, because few do. We explained why in Why Your 401(k) Plan Sucks (https://blog.wealthfront.com/401k-retirement-plan-fees/).

  13. haley January 9, 2014 at 10:48 am #

    The research you cite in support of the 2.1% underperformance of actively managed funds vs index funds is all about the tax inefficiency of mutual funds for taxable investors. It has no bearing whatsoever on tax deferred/exempt accounts such as 401(k)s and IRAs.

    Higher expense ratios and impaired liquidity that often accompany 401(k)s are important, but you are confusing the issue by bringing up irrelevant research.

    • Andy Rachleff January 9, 2014 at 11:30 am #

      I think you are mistaken. Taxes are not even considered in the research. That just adds to the advantage of passively managed funds vs. active.

  14. Viral January 27, 2014 at 8:35 am #

    Great article. Can you distill, with similar clarity/examples, the 529 college savings plan? It is hard to make a decision when one has to weigh mutual fund fees, performance versus potential state tax benefit of deduction. For e.g. if I invest $4,000 every year for the VA state sponsored 529 plan, is the tax savings of roughly $230 worth it? VA state 529 plan fees for advisor-sold funds exceed 0.75% whereas out of state funds (e.g. AK, UT, etc) have far lower expense ratios but similar returns. Please do alert us if there is practical research on this with numbers! Thank you.

  15. 401k Alternatives March 24, 2014 at 4:28 pm #

    I like this. I would just add that this is a great thing to think about. I’m not so much against the 401k as the fact that we just jump into, like you said, without any prior thought. “Just do it” is how everyone looks at it, but if you think about it, it shouldn’t be the first place you put your money.

    To make your number one priority a non-liquid, risky asset is a huge risk. I love that you mentioned having an emergency savings fund…if you think about things in a linear way that would be the first thing to build.

    However, because 401k dollars come out first it is usually the first thing people do, then if they have money they will put it in an emergency fund or a safe fund.

    Safety first, then you can move to risky assets with money you can afford to lose. Great post thanks.

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