This article will teach you why it may be a good idea to stop contributing to your 401K to build more wealth and be more tax efficient. For the past 20 years I’ve been enamored with retirement accounts. I have an IRA, a 401K and a Roth IRA, all of which I’ve contributed to throughout the years. I’ve jumped through hoops to be as efficient as possible with my taxes, and I’ve even been able to have no federal income tax liability for the past several years. I’ve finally realized though that retirement accounts have some serious drawbacks that a normal taxable brokerage account doesn’t have. I’m planning to stop contributing to my 401K and IRAs due to these drawbacks, or at least greatly reduce my contributions. I encourage you to check out the book Paying the Piper: 7 Tax Traps Hidden in Your 401k & IRA…and Strategies For Planning Your Escape.
I discovered this while planning my early retirement. I contemplated continuing to work for an extra 5 to 10 years in order to maximize my Roth contributions by putting $31,000 into our Roth accounts each year ($6,000 per IRA and $19,000 in my 401K). I decided recently to switch from traditional accounts to Roth accounts because of our rental property income in retirement and the changes to how inherited IRAs are now treated.
This past week I’ve researched the differences between Roth, Traditional, and taxable accounts and I wanted to share why I think taxable accounts are often given little regard when they have distinct advantages over retirement accounts. It may make sense for you to stop contributing to your 401K or other retirement accounts after reading this.
Capital Gains Vs. Ordinary Income:
With 401K and IRAs when you take withdrawals they are taxed as ordinary income. If the assets were held outside of a retirement account they would have capital gains taxes. Long term capital gains for income at the 12% tax bracket or bellow is 0%.
Here’s an example: 3 married couples each have $2 million saved in investments. They did this by saving $1,340 a month every month for 30 years and having an 8% annualized return.
Couple A: Couple A invested in a traditional 401K plan. Over the years they received an average 15% tax break on their contributions resulting in $72,360 in lifetime tax savings.
In retirement they plan to withdrawal $105,050 each year to stay in the 12% Tax bracket.
- They pay 0% for the first $24,800 (standard deduction) = $0 tax
- 10% for the next $19,750 = $1,975 tax
- 12% for $19,751 to $80,250 = $7,259 tax
- Total tax = $9,234.
This will be their tax bill every single year. Over 20 years they will pay $184,680 in income taxes.
Couple B: Couple B invested in a Roth 401K plan. They received no tax breaks. Each year they want to withdrawal $105,050.
Taxes: They pay no taxes because the Roth grows tax free since it was funded with after tax money! Every year they pay $9,234 less in taxes than couple A. After 8 years they are ahead because they have offset the tax breaks couple A received. Now, I know the time value of money makes this break even point further out in the future, however very few people who get a tax break on their retirement contributions actually take that money and invest it. Over a 20 year period, accounting for the 8 years to reach the break even point this couple will pay a total of $110,808 less in taxes than couple A.
Couple A also has the risk that tax rates could increase by the time they hit retirement and during retirement. Currently tax rates are at historic lows and most likely due to our expanding debt and deficit will need to be greatly increased in the future.
Couple C: Couple C didn’t play the game. They bought growth stocks and growth stock mutual funds outside of retirement accounts in a taxable brokerage account. Because the stocks and stock funds they bought don’t issue dividends and they never trade stocks, only buy and hold, they have never paid any taxes on their holdings. Now in retirement they have a $2 million portfolio and also want to withdrawal $105,050 per year.
Because they have invested $482,000 total over the years, 24% of their withdrawals are not taxed because this is a return of capital. the GAIN is all that is taxed. To take out $105,050 only $79,838 is taxable.
After the standard deduction the total that is left is $55,038. Because this is under $80,250 Couple B is in the 12% tax bracket and because the assets have been held for over a year they qualify for long term capital gains tax rates. This rate is 0%.
Just like Couple B with the Roth accounts, couple C pays no taxes and hits a break even point on forgoing the tax deduction of traditional accounts after 8 years. Like couple A however couple C runs the risk of an increase in the capital gains tax rate over time.
Capital Gain and Capital Loss Harvesting:
These are pretty interesting concepts that if you are paying attention to can allow you to minimize your tax bill in retirement. These strategies are only available to taxable brokerage accounts and can not be done in retirement accounts.
For capital gain harvesting you strategically sell investments that you have held for over a year to the point where you fill up the 12% tax bracket each year. If couple C earned a total of $60,000 in a given year, they would have $44,800 of room in the tax bracket to harvest gains. By selling assets with this amount of gains and immediately rebuying the same assets, they would pay NO TAXES, and increase their basis by $44,800 meaning that basis would never be taxed. This works really well for a couple transitioning into retirement. If they are working part time and have reduced their expenses substantially they could almost double this amount of capital gain harvesting per year. By the time they get to full retirement close to 75% to 80% of their nest egg could be basis. This is a great defense against potential future increases in the capital gains tax.
For capital loss harvesting you sell an asset that has dropped in value to offset the sale of an asset that has increased in value. This is more valuable during retirement than while building the nest egg up. With a diversified portfolio you may have some stocks or mutual funds that are losers, at least in the short term. When selling shares to live off of the proceeds mix some of these losers with winners. If you paid $10,000 for a stock that is now worth $5,000 and $10,000 for a stock that is now worth $20,000, you can sell both assets, and the 5,000 loss offsets $5,000 of the gain in the other stock, for a total gain position of only $5,000.
With tax loss harvesting you can not buy shares within 30 days that are virtually identical, so use tax loss harvesting to diversify your investments. Tax loss harvesting can also be used while building your nest egg. You can deduct up to $3,000 of capital losses per year against your W2 income. Take the loss, save whatever your tax rate is on $3,000, and re-balance into a different asset.
If you want to take advantage of the capital gains tax harvesting and capital loss tax harvesting stop contributing to your 401K and IRA accounts and go with a taxable brokerage account.
What if each couple wanted to retire early? Say at 45?
Couple A: Couple A is limited to whats called an SEPP or standard equal periodic payment plan. This plan is based off of current interest rates and their life expectancy. The IRS has 3 methods of determining an SEPP.
Method 1 Required Minimum Distribution: With the RMD calculation you divide the previous year end balance by the current remaining life expectancy of the account owner.
- Age 45: $2,000,000 / Life expectancy of 38.8 years = $51,546
Each year a new calculation has to be made for the new year end balance and the new age of the account owner. This method has an extremely conservative withdrawal rate, which essentially assumes that your account will never grow at all. This withdrawal is under half what couple A wanted.
Method 2: Fixed Amortization Method: This is my favorite method because it is simple, requiring no new calculations each year. This method takes the ending balance of the account and amortizes it based on 120% of the midterm interest rate and the life expectancy of the account holder. When setting up the SEPP 120% of the midterm rate is the maximum interest rate that can be chosen, the account holder can choose to use a lower interest rate, and thus receive a lower payment if desired.
- Age 45 a $2,000,000 balance amortized with a 0.54% rate over 38.8 years = $57,204
This is a little better, but still comes up much too short.
Method 3: Fixed Annuitization Method: The Fixed Annuity Method takes the age of the account holder and applies an annuity factor to it, then uses the 120% of the midterm rate to figure out the payment. The results for this method are very similar to the fixed amortization method. Once again, this calculation is only done once and the same amount of money is withdrawn every year. Bankrate has an excellent calculator for this method here.
- Age 45 $2,000,000 balance = $57,273 per year
As you can see none of these options are great. What’s worse is that you can not change an SEPP once started and it has to continue until you are 59 1/2 or for 5 years, whichever is longer, and you can’t add any money to the plan that is being used.
Bottom line: Couple A is getting half the money they want and has their hands tied. Alternatively they can access more money but would have to pay an additional 10% penalty on top of the tax they are already paying.
Couple B: Couple B can withdrawal excess Roth contributions at any time, but the gains have to stay put or else they can be penalized with a 10% tax. With $482,000 in contributions they can withdrawal their desired $105,050 per year for 4 years and then $62,000 in the 5th year with no problems.
In that 5th year they could set up a SEPP, which would have the same rules as couple A. Most likely withdrawing around 5% of the total per year the account in year 5 would be about what it was when they started. Couple B can withdrawal the same amounts, as couple A did, so $57,273 per year, however this $57,273 is fully untaxed, whereas couple A would have had to pay $3,501 in federal income taxes. Although couple B was able to avoid taking an SEPP for almost 5 years, they still will be bound by it until they hit 59 1/2.
Couple C: Couple C can take as much money out as they want, and as long as they are in the 12% or lower bracket they will owe no tax on the capital gains. They can take money out and add as much new money in in any year without penalties or hoops to jump through. With 24% of their money as basis withdrawing $105,050 would have no taxes owed.
- $25,215 is return of capital
- $24,800 fills the standard deduction
- The remaining $55,035 is way under the $80,250 upper level of the 12% tax brackets, so long term capital gains are taxed at 0%.
Earned Income Vs. Unearned Income:
Earned income, as in W2 jobs are not the best way to make money. You have to pay Social Security taxes or self employment taxes and your earnings are based off of trading your time for money. The best way to make money is through unearned income, such as rental real estate, which has highly favorable tax treatment. The problem is that you can not contribute to retirement accounts with unearned income. Your rental income can not fund a 401K or an IRA, but it can fund a taxable brokerage account.
Not having to jump through the hoop of “source of income” is a major advantage for using a taxable brokerage account. If you want to leave your W2 job you have no choice but to stop contributing to your 401K and your IRA.
For a long time I’ve thought about how much money my compounded retirement accounts that I never pull any money from will be worth when I die. If I live to be 100 and continue my savings rate, work to 55, and earn 10% returns I will have $302 million to pass to my heirs! What a great gift right?
Well no, it’s actually a terrible, horrible, stupidly planned gift. Retirement accounts are not immune to the inheritance tax. Let’s say I did have $302 million in retirement accounts and no other assets to pass on when I die, and Mrs. C. and I die at the same time. We would have $11.58 million each as an exemption so total taxes would be levied on roughly $279 million. Estates with over $1 million taxable are taxed at $345,800 for the first $1 million and 40% for anything over that. That’s roughly $112 million being given to taxes through poor planing. It is also highly likely that in the future estate taxes will be greatly increased.
What if instead of putting all my money in retirement accounts that I can’t touch until I’m 60 and letting it grow until I die, I invested all the money in taxable brokerage accounts? Also what if I gave it away in the present instead of in 65 years? The best time to give away assets is before they appreciate.
We can give $15,000 per person per year without cutting into our lifetime inheritance exemption. Since this math is all based off of investing $31,000 per year (2 maxed Roth IRAs and 1 maxed 401K), instead of investing it in MY accounts, I invest it between my children, grandchildren, and great grandchildren’s accounts? And I can use money that doesn’t come from a W2 job to do it!
Doing this will save $112 million on MY estate taxes, but since a good chunk of these gifts would be to grandchildren and great grandchildren with much longer time horizons I am also savings hundreds of millions of dollars in estate taxes for my children and grandchildren by keeping the money in taxable accounts and giving it away before my death.
What if instead of earning 10% I earned 12%? I would have $1 billion at my death. The estate taxes on that would be $400 million!
Giving away the assets before they appreciate is something you can’t do with a retirement accounts, since you can’t access it until 59 1/2. Even then, most people want to hold onto their wealth until they die. This is extremely inefficient from a tax prospective. Another benefit to this strategy that I talked about earlier is that I can pass on this $31,000 every year and it can be from any income source. It can be from my rental income or capital gains from flipping a house, I don’t have to work a W2 job forever to fill up the Roth IRA.
Then my children and grandchildren who do have W2 jobs can essentially transfer these gifts into their Roth IRA accounts. If I give each child $7,750 a year they can directly but $6,000 into their Roth IRAs in the year I give the gift and spend the remaining $1,150 but offset it by increasing their 401K contributions to account for this.
Ability To Diversify Investments Further:
In 401K and IRA accounts your investment options are severely limited. With a 401K your company may only offer a dozen mutual funds to choose from. In an IRA you can choose virtually any mutual funds or individual stocks. But what about real estate, or royalty streams, or even precious metals? Although you can establish what’s called a “self directed IRA” that can invest in these products, it comes with a lot of extra rules and extra fees. Keeping your wealth in a taxable account allows you to have a larger diversity of investments.
As an example, a few years ago on Royalty Exchange the rights to several of the songs on Sesame Street came up for sale. These songs generated just over $108,000 in royalties per year and sold for $540,000! That’s a 20% yearly return! The royalty stream has 64 more years remaining on it.
I know a lot of people who save a very specific, but arbitrary amount. If you guessed $19,000 a year, you are right! Many professionals do great harm to themselves because they look at maxing their 401K as the end all be all of saving. Since the limit is $19,000, this is where they stop saving. Earning $100,000 a year that’s a 19% savings rate, but earning $300,000 a year it’s only a 6.3% savings rate. We should all be striving to save north of 25% of our income.
For people not covered by an employer plan the $6,000 IRA limit is even more dangerous. At under a third of the 401K limit people who “max their IRA” are typically woefully under investing.
This is another reason that taxable investment accounts are superior to retirement accounts. With no limit we are forced to decide for ourselves how much to invest.
The Advantages Of Retirement Accounts:
- Employer match: An employer match makes a 401K worth it every time. A standard match is $1 for $1 for the first 5% of your income. This is free money and is always worth getting.
- High earners who will retire to a low cost of living area, have no rental properties, and don’t plan to have over $22 million at their death. For this couple they get the large tax deduction while working, in retirement they fill up the standard deduction and 10% bracket with their withdrawals, and since their estate will be under the estate tax threshold they don’t have to worry about giving millions to the feds. They got a combined 50% state and federal discount on taxes while working, and received a generous employer match. Retirement accounts are the right path for these people. They should invest additional funds in a taxable investment account and real estate.
- The cookie jar is out of reach: Even though from many standpoints the taxable account is better for most people it presents a trap. It’s like keeping the cookie jar on the counter, every time you walk in the kitchen you will be tempted to grab a cookie. If it’s up on the top shelf and chained shut with a lock and you need a ladder and a bunch of tools to get it, you will forget the cookies are there. Having hundreds of thousands to millions of dollars sitting in an accessible account can be tempting to tap for vacations, home improvements, or other expenses and could leave you without any money by the time you get to retirement. To go this route it is imperative to treat it like a retirement account and leave it alone.
- Tax Certainty: For Roth accounts there is certainty in the taxes you will pay. 0%. Regardless of how much you take out per year your future tax rate will be 0%. This makes Roth accounts ideal for people who will have less than $22 million at death and are in a low tax bracket, or even a 0% tax bracket during their working years but expect income tax rates to be higher in the future.
- Lawsuit Protection: In most states your retirement accounts are out of reach from a lawsuit, a taxable brokerage account is not. If investing in taxable accounts you need an umbrella insurance policy. I think everyone should have an umbrella insurance policy. A $1 million policy should cost less than $500 a year (often less than $250 a year) and would cover the vast majority of lawsuits. The primary reason to have umbrella insurance is that the insurance company’s lawyers will fight hard to get bogus claims thrown out and to minimize any awards.
The Downside to Going With A Taxable Account:
The biggest downside is there is no employer match of course. The employer match is the best part of a retirement account, always get the match! Unfortunately I have never worked a job that offered an employer match. Always read the fine print. Many employer matches vest over a set number of years and they can take away their match if you leave before this time is up.
IF you choose to change investing strategies, say you want to sell a portion of your stocks to buy a royalty stream, you would incur capital gains for that year. As an example, if you bought that Sesame Street royalty stream, you would have had to sell $540,000 in the brokerage account. If at the time half of money was invested capital and half was gains, this would trigger $270,000 of capital gains that most of which would be taxed at 15% provided your W2 income already filled up the 12% tax bracket. Although this $40,000 tax hit may be worth it, it’s certainly a big step backwards.
Capital gains tax rates can change: Capital gains taxes are only so low because of the back to back Bush tax cuts and Trump tax cuts. The Democrat party wants to change the tax code to make capital gains taxes higher than earned income taxes. Capital gains tax rates have been as high as 35%! If the pendulum swings the other way and our 0% capital gains bracket shrinks or disappears, then being in a taxable account proves to not be a great option.
Dividend risk: Let’s say when you bought the mutual funds and growths stocks in your portfolio they didn’t have a dividend. flash forward 50 years and you have $100 million invested and now you are being issued an average 2% dividend per year? That’s $2 million! This would bring $361,000 in taxes! While this is still a small overall percentage of the yearly gain in value (At 10% would be gaining $10 million for the year, so $361,000 is 3.6% of that gain, reducing total growth to 9.6%.)
Retirement accounts, despite having some potential tax advantages are not always the best option for everyone. Study the pros and cons and decide for yourself whether you should stop contributing to your 401K or not. Perhaps the best solution is to invest in all 3 types of accounts, traditional, Roth, and taxable.