Did we just find another $500k?

A recent discussion with my wife about 529 savings plan kicked off a more detail discussion about our utilization of 401k plans. I realized I was sitting on a hidden goldmine that I haven’t been fully utilizing. It’s time to make some changes. 

 

My wife happened to read a piece somewhere on the projected astronomical increase of college tuition. Apparently, by the time our kids start college the yearly cost of college tuition will be somewhere in the order of $75k per year in about 18 years time….. yep you read that right!

I’m not terribly concerned about that expense. I expect we’ll fund a significant portion of our kids tuition expense ourselves (if my wife has her way, we’ll be funding all of it!) .  Our passive dividend income will be kicking off significantly above my planned $50k/yr in 5 years at that point, hopefully even north of $100k/yr.  Nonetheless, it would still be great if we could find a more tax effective way to fund it.

It was in that spirit that we started doing some investigation and stumbled upon 529 plans, which essentially allow you to obtain a tax deduction (against state taxes in certain states) for contributions that are made for your kids college education and spending.

Unfortunately, the great state that I reside in doesn’t offer any kind of tax deduction for 529 plans. That got me thinking whether I should be making more effective use of a 401k vehicle to do our college saving for our kids and work out some way to effectively pull it out via a 72t equal withdrawal. By the time our kids start college, I’d be nearing my 50′s anyway, at which point I’d hope that we’d be all set on a financially free lifestyle.

In any case, as I started kicking around this idea even more, I was stunned at how ineffectively our current 401k’s are being utilized.

Our 401k allocation today

Today, my wife and I both contribute to our 401k to the extent of our match, which means we are roughly pouring in approximately $15k in our 401k’s collectively. The maximum individual tax free threshold for a 401k is approximately $17,500 annually, or $35k for the both of us.

That effectively means we could probably put in another $20k before maxing out our 401k taxable contributions.  I also recently found out that employer contributions do not count towards the individual tax thresholds for the 401k. So the $15k that our employers are kicking into the pot is just literally free money and doesn’t count to these limits at all.

Continuing with this theme a little further, I started to look at our marginal tax rates, which I think came in at somewhere like 33 % for federal taxation. I dug into our state tax laws and discovered that the 401k contribution is about the only thing that is an allowable pre tax deduction as far as our state income tax laws go. We pay an effective state income tax of somewhere close to 7%.

Bottom line, any pre tax dollar that we can eke out contributes to an effective tax saving of almost 40%. Given the money is pre-tax, I believe that you are also able to effectively shelter social security and medicare tax from that income. What that means is you don’t pay the 6.5% social security tax and the 1.45% medicare tax that are normally payable on earnings. That’s one of the reasons dividends are so tax effective, given all these taxes are avoided.

Layering that in, that takes the effective saving on the dollar to close 50% on any “pretax money” that we are able to shelter.  If you reason that there is approximately $20k extra that we can tip into the 401k money jar, that’s about $10k per year that we we’d be saving in taxes annually! Ouch!

The interesting thing about this observation is that $10k annually that we are unlocking that would have otherwise have just been lost to the government. There is no other effective tool that I know of, or deduction that I’m aware of apart from standard childcare and health care FSA’s where we could have unlocked so much extra cash.

Of course, not everyone is going to have the extra cash sitting around to fully max out their 401k. But just say you did. What’s your opportunity cost of tapping our your 401k vs investing on your own?

Let’s say the $20k that we could invest to max out of 401k’s is instead deployed in taxable accounts. After taxes, we’d be left with almost $10k to make investments with these funds. Even if you assume  you can earn a more effective investment return on those fund, perhaps double the return of a 401k, which is a big assumption, it’s extremely hard to come out ahead of taking the full tax deduction.

It’s possible, of course, but you’d need to be a phenomenally good investor and outperform the market over a very long period of time. Possible… but bloody hard mate! Let me illustrate.

401k account – Achieve Market returns

I ran a couple of scenarios to test this out further. Lets assume you’re invested in a basic 401k fund that tracks the market in terms of performance. This would be my strategy, I’m not looking for any extra outperformance, just consistent returns from the market with the aim of capital preservation.

Based on our situation above, we can afford to plonk an extra $20k per year in our 401k, tax sheltered, before we max out our 401k tax threshold of $17,500 each.

Over the long term, equity markets have returned approximately 10%. The last 3-4 years have been dynamite in my 401k. I’ve been average 18% returns per annum. But these type returns are just not possible over a long basis on US equities.  So I’m sticking with 10%.

By my calculations, the future value of $20,000 invested annually for 20 years at 10% will be close to $1.2M. So our extra contributions in our 401k could be expected to accure $1.2M  over 20 years. That’s a pretty handy sum.

Taxable account – Market Return

But of course, we could potentially still invest the increased money that we would put into the 401k into our taxable accounts. It’s just that we’d have much less to put in to start with. Only 1/2 the money after tax vs our 401k contribution. Starting with 50% of the initial contribution puts you behind the eight ball though. You need huge returns to catch up to a “pre tax contribution”. The return to get a starting  $1ok investment anywhere near $20k is pretty steep, and you need a long period of time.

It’s very hard for an individual investor to outperform the market over many years. Typically, as portfolios go up in value, investors tend to own more and more stocks to diversify the risk of any single position. Eventually, you find yourself owning your own managed fund. That’s not necessarily a bad thing, but it makes your returns revert back to the mean.

You become the index, which means it’s hard for you to consistently outperform it. This is particularly so if you don’t have a focus on total return performance. As a dividend investor, my focus is on a sustainable dividend income. While I’ve outperformed the index over a period of time, that’s not my focus and I don’t expect multidecade outperformance by a wide margin.

Given this, my expectation of returns in my taxable account would be a long term return of 10%.

The future value in 20 years time of $10,000 invested annually for 20 years at 10% would be $572k. That’s almost $600k less in a taxable account over 20 years versus what we’d get if we deployed that money in a 401k.

I’ve probably understated the 401k investment scenario because you can bet your life that 401k tax free thresholds will increase over 20 years, which will mean that we could invest more than $20k annually into our 401k over the years.

Taxable account- Superstar investor return

Now of course, you could still come out ahead of the 401k if you happened to be a consistently good, rockstar investor and significantly outperform the index. Now I’m no Buffet, but I’ve probably achieved close to a 12.5% total return over the last decade, close to a 5% outperformance over the index. Let’s assume I could get that type of outperformance over the long term and can earn a 15% return in my taxable account vs the index’s 10% return.

So the future value of $10,000 invested annually for 20 years at 15% would be close to an investment value of $1.02M. That’s pretty close, not quite what the value  of the 401k investment account would be, but it’s assuming a lot about the future and my ability to significantly outperform the market, none of which is certain or all that easy to achieve

But what about early FI?

One of the big reasons that I’ve been reluctant to put more more into my 401k is that I don’t want to wait to have access to my funds till I’m 60, without penalty. That’s a long time to wait and much can change in that time frame, I need the flexibility to get to these funds a little earlier.

The thing that occurred to me though, is that we’ve already built up a significant dividend cushion in our taxable accounts. This is only going to keep ballooning with the annual increases in dividend payments. I can still afford to have a more tax effective structure in place, save on what we are paying the tax man today and still get to our end goal of financial independence.

It may delay the build up of the dividend stream in my taxable account a few years, but who cares? We should have more that enough to cover our needs in just a few years. In addition, we’ll be sheltering a huge annual tax obligation more effectively that what we have been doing to date. That’s a trade off that makes a lot of sense to me.

What did I learn and what will I do?

The biggest mistake that we made was not getting fully versed around the intricacies of the 401k and running the numbers on what the options would look like for us in terms of tax deferral and capital appreciation.

I looked at the 401k as an investment account and evaluated it purely on that basis. And on that basis, it didn’t measure up. My investment choices were limited to about 10 funds, none of which had performed particularly well and none of which were particularly appealing, so I just chose the least bad, took my employer contribution and away we went.

That was a mistake and a 401k shouldn’t be evaluated that way. It should be evaluated as part of a tax shelter strategy. The investment options are secondary, you just want to make sure you get market return and achieve capital preservation with the lowest possible fee. Get an index fund with the lowest expense structure possible. It’s hard to really go wrong that way.

The other significant thing that dawned on me as we went through this is that the greater the income you make and the higher your tax rate, the more you have to be a rockstar investor to make taxable account investing make sense compared to maxing out your 401k.

Why do I say this? Consider if our tax rate was only 20%. That $20,000 that we could invest in our 401k which became $10,000 for us after tax would actually be more like $16,000 after tax if we only had a 20% tax rate. We wouldn’t need to earn as high a return on the $16k, with a hope of trying to “catch up” to the $20k compared to starting with just $10k (which is where we effectively are give our almost 50% effective marginal tax rate).

If for instance our marginal tax rate was only 20% instead of 45%, I’d only need to outperform my benchmark 401k fund by 2% to come out on top over 20 years. So instead of needing to earn a 15% return vs a 10%  index return, I’d just need to earn 12% to make taxable investing worthwhile.

Thus for folks earning a lower income. maxing out the 401k may not necessarily make sense if they can earn just a little more over the index consistently. Unfortunately, our barrier is much higher given our higher tax rate.

We’ve learnt a valuable lesson in 401k structuring over the last few days. Much better to have it in our mid 30′s than in our late 50′s. There is still time to correct without too much damage being done.

The first thing my wife and I are planning to do is to bump up our 401k contributions to max out our plans for next year! If all goes, we’ll be pulling out our kids college tuition from our tax sheltered 401k via 72t withdrawals when we eventually need it. Our brief investigation into savings plans for college unearthed some interesting insights that I never thought we’d get from the exercise.

How are you approaching your 401k allocation if you have one? Have I missed something in my thinking? Is maxing out your 401k really a goldmine?

Comments

  1. Jon says:

    Hi FI,
    One issue we have over here in the UK is the constant fiddling by government in taxation laws, rates etc which make it difficult to plan effectively. Only recently they changed the pension age from 50 to 55 (can’t access private pension funds until 55). Capital gain tax rates, income tax rates, child benefit rates – you name it, they have fiddled with it. Do you have the same issues in the US or is it fairly stable ?

    Reg, Jon

    • Integrator says:

      Hi Jon,
      Taxation rates are a moving feast here as well. The US doesn’t have a broad enough taxation base to support it’s spending needs, which is why the need to become the debt ceiling is becoming such an annual circus. Rates have moved up post the Bush era, and I could see them moving higher again. If anything, a movement upward in current tax rates will only make maxing out tax free shelters like a 401k more attractive.

      The thing is, I’m not sure that they can afford to tinker with the tax free status of retirement accounts too much. I don’t believe social security will be a viable option to support folks in my age bracket as we enter retirement in 30 years. Tax sheltered retirement plans need to continue as an incentive to encourage folks to be independent of social security. I just don’t know how many people fully appreciate how valuable the current day tax saving is from maxing out retirement accounts. I know my employer match was the more valuable hook for me.

      It’s entirely possible that there may be some “exit tax” when you attempt to redeem funds from your 401K or other tax free account down the road, but on a time value of money basis, I think sheltering tax today will more than make up for the possibility of needing to pay some exit tax on funds down the road.

  2. It’s kind of amazing that we both had the same post today. I also did a comparison on taxable vs tax sheltered investing.

    You’ve got a lot of good logic in here, and I’m following the savings you’re coming up with. But there is just one big wrench in the whole plan: What if your employer will not allow you to take withdraws out of your 401k plan early? Unfortunately that is the case for me.

    • Integrator says:

      You raise an interesting point. It didn’t occur to me that my employers rules on the 401k could be more restrictive than that of the IRS, who actually provides for a “hardship” early withdrawal to fund tuition expenses of yourself or dependents. It’s something I’ve got to look into further.

      In the worst case, I figure I’ll just wait it out to the “post penalty” withdrawal period post 59.5 and then start withdrawing the money. I need to better understand how to more effectively get access to the distributions in a tax effective manner. I’ve read that it’s potentially good to covert to a Roth IRA over time when you are in between jobs or have a soft spot in your income. Otherwise, I figure that by the time I actually need access to the funds that there will be significant tax bracket inflation such that distributions can be pulled out at effective tax rates of close to 10-15%.

      That’s a significant windfall in my book!

  3. Roger H says:

    Hi,

    Social security and Medicare taxes are not affected by your 401k contributions.

    Your article does make me rethink my strategy regarding a Roth 401k vs a traditional 401k. I wasn’t factoring in state taxes when choosing the Roth

    Thanks,
    Roger

  4. Roger H says:

    Hi

    One more comment that a friend ran into regarding maxing the 401 k. You still need to contribute equal installments throughout the year. If you hit the IRS limit before your last paycheck, you will end up leaving some of the company match on the table.

    Good Luck
    Roger

    • Integrator says:

      Thanks for the comment around the social security and medicare taxes Roger. I couldn’t verify whether this was actually the case or not. The state tax deduction can be a very significant one, and something that’s easily overlooked.

      Agree on the need to properly optimize contributions to avoid not exceeding limits and getting the full match

  5. Erich says:

    It sounds like you’re saying that you are not taxed on 401k’s when withdrawn. That’s fantastic, in Canada we are taxed at our marginal tax rate when we withdraw the funds from an RRSP, so the tax-free gains are only tax-free until you start withdrawing them. They also have similar age restrictions and penalties for early withdrawal.

    So, my plan is to hold 50% of my retirement savings in a TFSA (post-tax savings, no withdrawal fees or taxes on gains or withdrawals). That way, if I am successful in my long-term aggressive savings, even if I’m making sufficient dividends to be in a higher tax bracket based on my annual income withdrawals, I will still fall within a lower tax bracket because 50% of my income is taken from a TFSA.

    Even if I’m not as successful as I hope, and my dividend income total put me in the same as my current tax bracket, if only 50% of it is taxable I would drop into a LOWER tax bracket than I am currently and have a similar benefit.

    • Integrator says:

      Erich,

      Unfortunately that’s not the case for withdrawals from the 401k, you are still taxed at marginal income rates that you happen to be in at the time of withdrawal!. My thinking was that the effective tax rates that you’d be paying at the time of withdrawal would be substantially below current taxation. Likely not 0%, but maybe an effective rate of 10% or so depending on where your income happens. Given I expect the bulk of my other income at retirement will be in concessionally taxed dividends, I expect the effective tax rate on 401k withdrawals to be much below what I’d be paying today.

  6. I think it’s a great strategy because you already have a sizeable dividend account. Besides that for FI I would do match then do after tax investing. Great post and I will probably do the same in the future.

    • Integrator says:

      Thanks EL. The significant thing that the dividend cushion allows is that it also pushes the amount that I can effectively take out a lower taxed rates in my 401k. I believe up to $72,500 in dividends can effectively be taken out tax free on an annual basis if you are married filing jointly. That leaves $17,850 annually to be pulled out of the 401k at 10% tax rates based on it being treated as wage like income. In my view, converting a 40% tax rate into something near 10% is not a bad outcome…. and $90k odd should be plenty to live off annually!

  7. San says:

    I googled around for the 72t withdrawals that you mentioned about early withdrawals for education. However, based on the information in IRS, early withdrawals for educations from 401k are not exempt from the 10% penalty.
    http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics—Tax-on-Early-Distributions
    Am I missing something?

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