A lot of people don't realize just how much using a 401K can be worth. Consider someone who gets a match on his 401K savings. Say the employer will match you 100% of your first $5,000 you put into the 401K. That's basically the equivalent of earning a guaranteed 100% return on the first $5,000 you save each year. You're not going to get that kind of return anywhere else. It boggles my mind to think about how many people don't contribute enough to their 401Ks to get their full match each year. That's like leaving part of your salary on the table, and it's not even salary that you have to negotiate hard for.
Is a 401k Worth it?
Many doctors, however, don't get any kind of a match, and if they do, it's their own money they're matching with anyway. How much is a 401K worth then? Let's run the numbers.
There are two significant tax benefits to a 401K, and one potential downside — high expenses and fees. Let's see if we can't quantify each of these in turn.
#1 Tax Benefit of a 401k: The Tax-Deferral
Example — The California Doc with High State Tax
You get to save money at your marginal tax rate when you contribute to a 401K. Let's consider a married physician couple with a taxable income of $350,000. Let's say she puts $30K into the 401K. For 2019, they're in the 32% tax bracket. Just for fun, let's say she lives in California, with an 9.3% state tax. So she is now saving money at 41.3%. So, by putting $30K in, she saves $30K*0.413= $12,390 in taxes.
Let's say they pull that money out 30 years later. In fact, maybe they move to Vegas to retire and so also eliminate state income tax. Are they going to have to pay 41.3% tax on that money? Unlikely. Assuming no other income, the first $24,400 they pull out that year comes out tax-free thanks to the standard deduction. The next $19,050 comes out at 10% tax. The next $58,350 comes out at 12% tax. So let's say she pulls out $100K from her 401K that year. At what rate does that money actually get taxed in retirement?
| Bracket | Income | Tax Due | |
| 0% | $24,400 | $0 | |
| 10% | $19,050 | $1,901 | |
| 12% | $56,550 | $7,800 | |
| Total | 9.70% | 100,000 | $9,701 |
It gets taxed at 9.7%. Saving at 41.3% and pulling money out at 9.7% is a winning formula. That's precisely like getting an extra 31.6% return on your investment. You're not going to get that anywhere else. Now, your own percentage might be a little higher, or a little lower, but so what. Even if my numbers are off by a figure by 50% you're still looking at a guaranteed, instantaneous, automatic return of 17%. Where else can you find returns like that? You can't. Even if they stayed in California, it would still be dramatic savings.
#2 Tax Benefit of a 401k: Tax-Free Growth
If our physician investor had decided to invest in a taxable account instead of a 401K, she would have lost that instantaneous 33.6% return we discussed above. But in addition to that, she would have lost the benefit of her investment not being taxed as it grows. Every time an investment is bought and sold in a taxable account, you have to pay capital gains taxes. Not so in a 401K. Also, every month, quarter, or year, an investment throws off dividends. These are also taxed outside a 401K. Having assets in a 401K allows even a diehard buy-and-hold investor to avoid the costs of rebalancing. A more active investor might save thousands.
But let's just consider the value of having untaxed reinvested dividends. Let's say our investment grows at 8% a year; let's say 2% of that is a dividend taxed at 18.8%. So in the taxable account, that means the investment grows at 7.624%, while in the 401K it grows at 8%. After 30 years, a $30,000 investment in the taxable account is worth $277,710.53, or about $24K less than the $301,879.71 it would be worth in the 401K. Now, this additional gain would be taxed when withdrawn from the 401K, of course, as we saw above at about 12.5%, so we'll subtract out ~$3000. Even so, avoiding that tax as the money grows results in an additional 7.6% return for the 401K investor.
An active investor may realize a much larger benefit, while a careful buy and hold investor who would have invested very tax-efficiently and tax-loss harvested aggressively may realize a smaller benefit, but this is a reasonable approximation for the average investor. So adding 7.6% onto 29.8%, and we're up to an automatic, instantaneous, guaranteed 37.4% return just for contributing to the 401K. Alas, this will be reduced a bit due to our current 401K system.
What About Those High Expenses and Fees of a 401K?
You can do all you can to minimize high expenses and fees but it is a rare 401K that doesn't have additional costs when compared to an IRA at a low-cost institution such as Vanguard. Even a careful investor could easily pay 0.5% more a year in investment expenses in his 401K. Sure, if he changes jobs he can roll that money out to an IRA, and obviously he can do that at retirement, but even so, these additional costs and fees (and sometimes poor investment choices) are sure to take their toll.
Let's assume a 0.5% drag on his returns. Take our physician investor investing for 30 years at 8% (actually 7.5% due to costs) in his 401K. That'll reduce his returns by about 13.1%. So subtract that out from the 37.4% in benefit we found above, and that still leaves a 24.3% instantaneous guaranteed return for contributing to the 401K.
But what if the fees, expenses, and investment choices of your 401K REALLY sucked, you didn't get a match, and you didn't expect to either be able to change the 401K or roll money out of it for decades. At what level of expenses should the 401K benefits be abandoned in favor of a taxable account?
Well, given our assumptions, we see that 13.1% of that 37.4% in benefits was erased by additional fees and expenses of 0.5% per year. Increase those fees to 1.5% a year and you'll have erased all the 401K tax benefits and then some. Certainly, at 2% expenses, you'll be better off in a taxable account. But it is a pretty rotten 401K that doesn't have at least some investment choices with expenses under 1%. My own 401K, while it has a few pesky minor fees, at least offers a total stock market index fund from Schwab at 0.07%. That's pretty comparable to what I'd get in an IRA.
Plus, it is getting to be more and more unusual for any employee, physician or non-physician, to stay with the same employer for his entire career. You might change jobs (allowing a rollover) or the 401K expenses might improve after a few years. You could even lobby for an index fund to be added to the offerings. So even if your 401K expenses are pretty high now, you might want to think twice before passing up that tax break. And if you have a good 401K, thank your employer.
What do you think? Do you disagree with my conclusions? Has investing in a 401k been worth it to you? Comment below!
