Coming Out Ahead with a 401(k)

[canyonwalker]

As I wrote about the contribution limits for 401(k)s rising in 2023 a few weeks ago I was reminded that a lot of people don't understand the benefit of 401(k)s. I mean, I think most American adults understand it at a high level: "Investing money in a 401(k) saves on taxes, so you have more money at the end." But understanding the details of how that works— and how much it benefits them— is squishy. I get it; the math¹ can seem intimidating. Even for many people well educated in math or engineering it's too much to figure out. That leads to a lot of people not participating in 401(k) programs when they should. For example, many of my colleagues. 😳

I'll walk you through the math with a simple illustration. This will show you how much you can gain by investing through a 401(k) instead of an ordinary account. I call it the Tax-Deferred Advantage.

Here are five basic assumptions for my example:

1. Let's suppose you invest your money in company XYZ, which enjoys stock price appreciation averaging 7% a year over the course of many years. To keep this example simple let's assume XYZ does not pay a dividend or distribution. This is a little unusual as most companies, over 80% of the names in the S&P 500 index, pay dividends; and virtually all mutual funds pay distributions. This assumption keeps the tax calculations simple.


2. Let's suppose your overall marginal tax bracket is 28%. This includes both federal and state/local taxes, so think of it as 22% federal plus 6% state/local, or 24% federal plus 4% state/local, etc.


3. You start with $10,000, pre-tax, to invest.


4. You "buy and hold" XYZ — no trading until you're ready to withdraw. (This also keeps the example simpler.)


5. We'll look at the totals after 20 years.

Case A: You invest via traditional investment account. You start by paying taxes on that $10k. Your investment in XYZ is thus $7,200 ($10k less 28% combined tax). Twenty years later your account value is $27,862. (This is $7.2k x 1.07^20.) When you withdraw the money you pay tax... but only on the gain of $20,662. Your net after taxes is $22,076.

Case B: You invest via a 401(k). You pay no taxes on the $10k up front because it's tax-deferred. All $10 goes into buying shares of XYZ company. Twenty years later it's worth $38,697. When you withdraw the money you pay taxes on the whole amount. After taxes you net $27,862.

So, how did we do? The 401(k) gave us 26% more money ($27,862 vs. $22,076) after 20 years. That's the Tax-Deferred Advantage!

And BTW, the advantage gets even bigger when you change some of the model's assumptions. For example, if your investment pays dividends or distributions, the advantage is even bigger. If your tax bracket is lower in retirement than your working years, the advantage is bigger, too. I'll show examples of these in a later blog as the math gets more complicated.

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1: Insert curmudgeonly math joke: "That's not even math, it's arithmetic. If it were math it'd have letters!"

Comments

[some_other_dave]

This reminds me of when you explained to me the tax benefits of owning real estate. I was nervous as hell about writing the biggest check I'd ever seen in my life, plus taking an immense loan, and you helped walk me through the actual monetary implications.

Thanks again for doing that!

[canyonwalker]

I'm glad you found that helpful.

I'm sure your lawyer had a part in helping you make that decision, though. 😅

[some_other_dave]

Considering she was kind of pushing me to take that step, yes you could say she did!