BLUF: Income taxes will most likely rise in the future but 401k pre-tax investing net of taxes in this scenario still lasts longer than a brokerage account. Withdrawal needs in retirement would need to be high and taxation at or exceeding historical highs in the future for a brokerage account to catch up to a 401k.
Why I wrote this article
Pre-tax investing has always sounds like a great idea to me. I get to avoid paying paying Uncle Sam taxes from a high tax bracket now, let the money grow tax free and then pay income taxes from lower brackets in the future (because you will be drawing less from those accounts).
Then I listened to a podcast. I listened to an Afford Anything podcast with this guy Ed Slott who published a new book “The New Retirement Savings Timebomb.” Sounds big and scary, right? Well, Ed sure sold it that way. His premise is that tax rates are historically low now and are sure to go up in the future. Additionally, the (marginal) tax rates in the past have been as high as 90%. The horror! As such his advice was that young people should be putting 100% of their money into a Roth, NOT be doing any pre-tax investing.
That made my ears perk up. Anytime I hear personal finance advice that flies contrary to what I had thought I like to investigate it. This all sounded eerily like a scare tactic to sell his book but because I honestly never did the math of which accounts perform better with taxes factored in, I couldn’t be sure. In this post we’ll follow the hypothetical lives of two married couples to see how the Traditional 401k vs. Brokerage / Roth 401k could play out over a lifetime. Note that this entire post will use a married filing jointly example but the principles still apply to those in other filing situations.
Let’s talk taxes
This discussion requires a solid foundation in how the US tax system works so lets make sure that everyone is on the same page there. I know, talking taxes sounds about as exciting as going to the dentist. I’ll keep it brief!
How a progressive tax system works
In the United States we have a progressive tax system. The income that you earn starts out being taxed at a low rate and the taxation increases as you make more money. Each chunk of income that is taxed at a different rate is referred to as a tax bracket. $0 to $19,900 is a bracket of income that is taxed at the 10% rate in 2021 for married couples filing their taxes jointly. The next dollars you earn from $19,901 to $81,050 are taxed at 12% and so on.
These tax brackets are indexed to inflation from a law passed in 1984 meaning that the dollar amounts typically go up every year.
How taxes are calculated
The most common mistake people make is thinking that the highest tax bracket that their money “touches” is the rate that ALL their money is taxed at. For example, if a couple makes $200,000 they think that their taxation is $200,000 * 24% = $48,000 which is wrong. This leads people to try and do silly things just to stay out of the next highest tax bracket when it doesn’t make much of a difference.
The table below shows how your taxes are actually calculated. If a couple makes $200,000 a year, the first thing that comes off the top is their $25,100 standard deduction. This is free income that is untaxed leaving the couple with $174,900 that is subject to taxation. Each bracket of income is then taxed at each tax rate and added up to a total tax. As you can see only the income above $172,750 is taxed at 24%. $2,150*24% = $516.
Take all those individual tax bracket amounts and sum them up and you get the total taxes that you owe. In this case $30,017 on an income of $200,000.
Marginal Tax Rate vs. Effective Tax Rate
The highest tax bracket that your money touches is called your marginal tax rate. In the previous example for a couple making $200k, that’s 24%. Since that is the marginal tax rate is thrown around sometimes people freak out and mentally use that number to calculate what they think they’re going to own.
In reality, what you actually owe in the end and what you should care about is your effective tax rate. This is the percentage of tax that you actually paid on the taxable income that you earned.
For example, this couple ended up owing $30,017 on an income of $200,000. $30,017/$200,000 = 15% effective tax rate. Sounds a lot better than 24%, doesn’t it? The problem is that marginal tax rates to figure out by glancing at a table while you need to calculate your effective tax rate taking a number of things about your tax situation into account. For that reason the marginal tax rate number will often be used in discussion. Now that you know what it means don’t let that trip you up!
Taxes in the future
We do need to recognize that income taxes around 2020 are quite low. If no laws change, on January 1st, 2026 taxes brackets will reset from the Tax Cuts and Jobs Act (TCJA) of 2017 expiring with the following changes:
- 12% tax rate goes back up to 15%
- 22% tax rate goes back up to 25%
- 24% tax rate goes back up to 28%[2]
Outside of that there is speculation that taxation increase will be required to pay for the massive money printing to recover from the pandemic. Going back to Ed Slotts’ comments when he said taxes have been as high as 90+%. He’s not wrong, but the comment is misleading and scary for the average person. In 1944 at the tail end of WW2, taxes for the highest (marginal) tax bracket were 94%![3] What he doesn’t mention is that it was for income exceeding $3 million in 2021 dollars. Allow me to get out my tiny violin for you if you’re crushing the game like that. The lowest bracket was 23% (still high) on up to ~$30k in 2021 dollars.[3]
Investment Account Taxation
To make sure that we’re on the same page with how taxation works with retirement and brokerage accounts lets review the topic.
Pre-Tax Accounts: 401k Investment Taxation
Using a 401k investment account means the money comes out of your paycheck tax free and reduces your taxable income. When you reach 59.5 years of age and withdraw the money it’s taxed as ordinary income just like a W2 paycheck today. Until you withdraw that money it’s allowed to grow tax free inside the 401k account. The near term benefit is that you save that money AND it reduces your tax bill.
The argument Ed Slott makes is that income taxes now are pretty low and they’ll be much higher in the future. You should pay those taxes today and put the money into a Roth 401k post-tax.
Post-Tax Accounts: Brokerage account & Roth 401k Investment Taxation
In this example I’m using a brokerage account because it’s accessible to many and allows you to contribute at least as much as the traditional 401k so we can compare apples to apples.
Brokerage Account:
A brokerage account is not a retirement account. Anyone can open one and the money simply goes in after all normal payroll taxes have been removed. You can then buy stocks, bonds and other alternative assets with those funds. If you sell assets within a year of buying them they’re called short term capital gains and are taxed as ordinary income. If you hold them for longer than a year then they’re taxed at a special, lower rate.
The 0% tax bracket is large enough that many couples in retirement can sell long term gains and pay no taxes. Unqualified dividends and bond interest is taxed differently but using your standard deduction that can be wiped away. The example below shows how a couple could withdraw $100,000 from a brokerage account in a year and pay $0 in tax.
Roth 401k:
Contributions to a Roth 401k have ordinary income taxes taken out of it first and then the money goes in after tax. The advantage is that when you withdraw the money there’s no tax to pay!
Case Study: 401k Fanatics vs. The Brokerage Buyers (or Roth 401k)
To see how a lifetime of saving, investing, withdrawals and taxation happens in an apples to apples comparison I give you the following scenario.
Overview
To make this fair they both have the same exact gross income and very high expenses (they aren’t good savers) every year. The 401k Fanatics max out their pre-tax 401k at $39k/yr and then are left with $0. The Brokerage Buyers followed Ed Slotts advice and paid the taxes first and contributed everything to a post-tax account. Because of that they are taxed more heavily on their income and have a smaller amount of post tax dollars to put into their brokerage account per year – $30,378.
401k Fanatics:
Below is what a typical year looks like for the 401k Fanatics.
Brokerage Buyers:
Below is what a typical year looks like for the Brokerage Buyers. With no pre-tax contributions they pay more in taxes up front and therefore have less money to invest in their brokerage account each year ($30,378) compared with the $39k/yr of the 401k Fanatics.
Assumptions:
- Tax brackets – both couples incomes are taxed at 2021 tax levels through the accumulation phase. In the withdrawal phase we’ll vary the tax rates to see what happens.
- Investments – both couples invest in the same low cost VTSAX index funds monthly. $3,250/mo for the 401k fanatics ($39,000/12) and $2,531.50/mo for the Brokerage Buyers ($30,378/12).
- Investment returns – both couples get 7% average annual returns compounded monthly.
- Brokerage account taxes – since income needs of the Brokerage Buyer couple are within the 2021 capital gains 0% bracket it is assumed that they pay no taxes upon withdrawal. For this reason the brokerage account is interchangeable with a Roth 401k for tax reasons in this example. They all pay $0 in tax when withdrawing. Any dividend or bond income is expected to be small enough to fall within the standard deduction.
- Inflation – we’re going to use 2021 dollars all the way though the example. Expenses will rise with inflation but it is assumed to impact both couples the same.
15 Years of Saving and Investing Later…
How have our good little saving and investing couples done? Quite well! They started later in life at 45 years old and are now 60 after saving for 15 years. The 401k Fanatics are millionaires in the two comma club while the Brokerage Buyers have accumulated a healthy $807k in their brokerage account.
Retirement time! Who wins?
After 15 years of investing the couples have retired. They’ve paid off their house and cars and now only need $80k/yr to support their lifestyle. Let’s see what happens when the 401k Fanatics have to pay ordinary income tax on those withdrawals while the Brokerage Buyers get to laugh in the face of the tax man all the way to the bank!
Income taxes rise to 2026 levels
What happens if congress does nothing, the tax rates reset higher and that continues into the future? See below for the 2026 tax rate impact on our 401k Fanatics.
Hey now, what happened? The 401k Fanatics were able to make that money last almost 7 years longer than the Brokerage Buyers despite them paying 0% tax. Why? Well with the progressive tax brackets the 401k Fanatics are still only paying a 9.62% effective tax rate. Projected far into the future the Brokerage Buyers will still never catch them.
Income taxes rise to scary “2036” levels
Okay, maybe you believe that taxes will get much higher. After all, the fed has been printing money faster than Leonardo DiCaprio in Catch me if you can. I’m calling them “2036” tax brackets. What then?
The lowest rate becomes 15%, then 20% and increasing up to 70%! Yikes! That would be pretty bad.
Surely that must have tipped the scaled in favor of the Brokerage Buyers paying 0% tax? Well, nope. The 401k Fanatics effective tax rate went up to 13.5% and still get 4 more years of money than the Brokerage Buyers. Even projected far into the future they would never catch them.
The obvious next question that I had to answer was how bad would future tax rates have to get for these two couples to run out of money at the same time? Well pretty horrifically bad – I believe the worst in history even topping 1944 WW2 levels when the first bracket, $0 – $30k (inflation adjusted) was 23%![3] I had to come up with a 22.11% effective tax rate to make then break even.
What does that look like for tax brackets? I played with some numbers to come up with one potential. I thought that the “Doomsday” naming was appropriate.
Conclusions:
The big takeaway from this for me is that you really need to focus on effective tax rates when thinking about taxes in the future. Pre-tax money will always grow faster initially by comparison because you can simply save more of it. If you have really poor 401k investment options with high expense ratios that would certainly narrow the gap over but it’s situation dependent on how close the outcome would be.
The other observation is that the more you need to consume, the more of a tax penalty you pay and the more you need to worry about tax rates. I can’t imagine a world where the rich and poor pay a flat tax so the lower incomes will likely be taxed less. The less you can live on, the less you’ll be taxed.
Early Retirement Considerations:
Winning is great, but you don’t win if you can’t retire early because you can’t access the money. If you have an early retirement plan you do need to balance 401k investing with post-tax investing because having more money in a 401k doesn’t matter if you can’t access it when you need it.
Most people saving 50+% of their income can max out a 401k and contribute a substantial amount to a Roth and a brokerage account. That said, everyone’s situation is different and you need to plan out your investments to have the money you need, in the right buckets, at the right time.
Action Steps:
- Make sure you are investing in a 401k to get your employer match. That’s a 100% ROI!
- If you’re just starting out consider trying to maximize those pre-tax buckets.
- After that consider Roth IRA contributions.
- Build that brokerage account. Have you considered putting some of your emergency fund in there?
- If you plan to retire early, take a look at the different buckets of money. How much do you need to get to 60 years old to access retirement accounts? A detailed post coming on this topic.
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Sources
- TaxPolicyCenter.Org. https://www.taxpolicycenter.org/statistics/historical-average-federal-tax-rates-all-households. Accessed 4/17/2021.
- FedTaxPlanners.com. How 2026 Sunset Laws will impact your tax cuts. https://fedtaxplanners.com/how-2026-sunset-laws-impact-your-tax-cuts/ Accessed 4/17/2021.
- Tax Foundation Tax Rate History. https://files.taxfoundation.org/legacy/docs/fed_individual_rate_history_nominal.pdf. Accessed 4/17/2021.
