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Too much in Tax Advantaged Accounts?

It’s a common refrain, I decreased my contribution to my 401K or IRA for fear of having too much in Tax Advantaged Accounts. This fear is driven by the ten percent withdrawal penalty that comes with a 401K or IRA, but the question is whether this fear is rational. Can you have too high a percentage of investments in Tax Advantaged Accounts?

Liquidity

So let’s get this out of the way first. To some extent yes. If you need the cash to pay a bill next week, then a 401K is probably not the place to have all your cash parked. It would make a terrible Emergency Account except for perhaps the 401K loan option. Even with that loan option I would recommend a pass since:

  • If you lose your job or transfer your loan typically becomes due immediately.
  • You likely cannot continue to contribute new money missing out on things like matches.
  • You lose out on compounding of the savings

A Roth has slightly less issues here since you can withdrawal the principal without penalty for contributions or after 5 years for any backdoor contributions. Still I would recommend not using your ROTH as an emergency fund as tax advantaged space is valuable. You don’t want to lose some of that space by withdrawing for an emergency.

So on the face of it Tax Advantaged Accounts are poor choices for Emergency accounts.  The last 3-5% of your account should not be in tax advantaged accounts. But what about your investments beyond the emergency accounts?

The Penalty

The tax code states that withdrawing your money from a 401k or your earnings from a Roth before 59.5 will, under certain circumstances, result in a penalty of 10% of the withdrawal amount. This is the reason so many people shy away from pushing too high a percentage of investments into Tax Advantaged Accounts. But is it a reasonable fear? Well I won’t make you wait any longer for the answer, no it is not.

Lets take a hypothetical person who has 18K a year pretax to save. They have a choice, deposit all 18K into a 401k and pay tax later, or pay tax now plus pay tax on future earnings to invest in a taxable account. The key here is plus tax on future earnings. The 401k not only defers taxes, but eliminates capital gains on earnings. (Note the outcome of 401K versus Roth IRA is the same given the same tax rates at investment or withdrawal. As such I will use a 401K for this example). So lets assume that the market returns 7% a year, capital gains is 15%, and this person pays an effective tax rate of 28% whether they pay it now or when they withdrawal from the 401k. Now lets assume the person is forced to pay the 10% penalty, a worse case as we will see later, to withdrawal the funds. Lets map that out over a 25 year timeframe:

Taxable Account
Year
401K
Deposit Principal interest – taxes Deposit Principal interest Return after 10% Penalty
$12,960 $12,960 $771 0 $18,000 $18,000 $1,260
$12,960 $26,691 $1,588 1 $18,000 $37,260 $2,608
$12,960 $41,239 $2,454 2 $18,000 $57,868 $4,051
$12,960 $56,653 $3,371 3 $18,000 $79,919 $5,594
$12,960 $72,984 $4,343 4 $18,000 $103,513 $7,246 $64,178
$12,960 $90,286 $5,372 5 $18,000 $128,759 $9,013 $79,831
$12,960 $108,618 $6,463 6 $18,000 $155,772 $10,904 $96,579
$12,960 $128,041 $7,618 7 $18,000 $184,676 $12,927 $114,499
$12,960 $148,620 $8,843 8 $18,000 $215,604 $15,092 $133,674
$12,960 $170,423 $10,140 9 $18,000 $248,696 $17,409 $154,192
$12,960 $193,523 $11,515 10 $18,000 $284,105 $19,887 $176,145
$12,960 $217,997 $12,971 11 $18,000 $321,992 $22,539 $199,635
$12,960 $243,928 $14,514 12 $18,000 $362,532 $25,377 $224,770
$12,960 $271,402 $16,148 13 $18,000 $405,909 $28,414 $251,663
$12,960 $300,510 $17,880 14 $18,000 $452,322 $31,663 $280,440
$12,960 $331,351 $19,715 15 $18,000 $501,985 $35,139 $311,231
$12,960 $364,026 $21,660 16 $18,000 $555,124 $38,859 $344,177
$12,960 $398,645 $23,719 17 $18,000 $611,983 $42,839 $379,429
$12,960 $435,325 $25,902 18 $18,000 $672,821 $47,097 $417,149
$12,960 $474,187 $28,214 19 $18,000 $737,919 $51,654 $457,510
$12,960 $515,361 $30,664 20 $18,000 $807,573 $56,530 $500,695
$12,960 $558,985 $33,260 21 $18,000 $882,103 $61,747 $546,904
$12,960 $605,204 $36,010 22 $18,000 $961,851 $67,330 $596,347
$12,960 $654,174 $38,923 23 $18,000 $1,047,180 $73,303 $649,252
$12,960 $706,057 $42,010 24 $18,000 $1,138,483 $79,694 $705,859
$12,960 $761,028 $45,281 25 $18,000 $1,236,176 $86,532 $766,429

No Need to Limit Tax Advantaged Accounts

The result, perhaps rather surprisingly, is that after 25 years, investing in the 401k and paying the 10% penalty beats the taxable account! Yes, you read that right. The much hyped penalty does not outweigh the value of the tax advantaged account in many common situations. In the immortal words of Myth Busters, the myth of having too much in a Tax Advantaged Account is busted. If we assume anything amounting to a longer time horizon, a higher rate of return, a taxable account not limiting taxation to capital gains rate, or a lower later tax rates for your investments then the tax advantaged accounts win hands down.  Many of these are likely to occur.

We can do better?

But wait, there is more. Who is to say you have to pay the penalty? There are a few different ways to get around paying the early withdrawal penalty.

Roll a 401K to a Roth

One is to roll the 401k value to a Roth IRA. After a 5 year waiting period you can withdrawal this cash without penalty, though you do have to pay taxes when you make the roll. All well and good if you can wait 5 years for the cash. The benefit being of course that you can choose your timing to minimize your tax bill.  You can even do this a little bit each year as a sort of ladder.   This could lead to paying a tax rate less than the rate applied to the earnings used in the taxable account.  Combining a lower tax rate at withdrawal and avoiding the penalty puts the tax advantaged accounts far ahead.

Rule 72(t)

Another is rule 72(t).  This rule allows you to  take equal payments from your 401k until you are 59.5 or have been doing so for 5 years, whichever is longer. There are a couple of different methods for calculating these withdrawal amounts.

  • One is amortizing the account over your life expectancy (essentially fixed yearly). This has the highest yearly payout rate.
  • The second is a required minimum distribution table similar to what you use over 70 (this results in a variable withdrawal rate). This has the lowest yearly payout rate.
  • Finally the annuitization option remains, which uses an annuity factor to determine equivalent payments. This is somewhere between the first 2 but relatively fixed.

Ultimately Rule 72(t)’s equal payments option is a fairly complex calculations I would recommend consulting a tax expert before pursuing. Honestly the biggest flaw here is once you choose a plan you are essentially locked in. You can change a calculation method once during the period, but you are locked into equal withdrawals regardless of needing more or less money.

Some Exceptions

There are also some exceptions to the penalty for purchasing a house, education expenses, or excessive medical needs. These are very particular exceptions so YMMV. More information can be found here.

Conclusions

The point of this twisting winding post is to highlight that you should almost always max your Tax Advantaged Accounts immediately after your Emergency Fund. I highlighted 401K and Roth but the same holds true for Traditional IRAs. Even HSA’s have their own withdrawal loopholes. As such you should never be afraid to have too high a percentage of investments in Tax Advantaged Accounts. I would recommend diversifying amongst the different types to provide safety in case laws change. I might also recommend having extra non retirement funds on hand when immediately entering retirement. But otherwise I would not bat an eye at putting every investment dollar beyond my Emergency fun in a 401K/ROTH combination.

Do you max your tax advantaged space?

I am not a tax professional or financial advisor. Full Time Finance is for entertainment purposes only. You and you alone are responsible for your financial choices.

18 Comments

  1. I am very lucky in this respect in that my job offers a 457 plan instead of a 401(k). The two are functionally almost exactly the same, except that with a 457 you can access the money penalty-free as soon as you leave the job. I’ve been maxing this out since as soon as I had access! If I can load it up as much as possible, then I will have a bridge between when I hit FI and when I am old enough to pull money out of more traditional retirement accounts.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 14, 2017

      A 457 is a great deal. Something to consider in your case is to double up. Get some side income and open a 401k with that income contributing another 18K.

  2. Dan
    Dan June 14, 2017

    The problem with Rule 72t is that it can only be invoked if you separate “from service during or after the year the employee reaches age 55” or age 50 for law enforcement and firemen. If you are thinking about early retirement, Rule 72t doesn’t help you.

    I do max out my 401k but disagree that it is a universal rule. If you want to buy a house, money in your 401k will not help you. If your 401k charges high fees, you may want to invest in a low fee taxable account. 401k’s typically have limited choices of investments so that is another reason. You can harvest tax losses out of your taxable account that will reduce your tax bill.

    This is my 25th year out of college. For most of that period, I have had access to 401k plans. I would say it is only in the last 15 years that I maxed out my 401k contributions. Prior to that, I would contribute enough to max out the employer match and then increased my contribution by 1% each year concurrent with my annual pay raise.

    • FullTimeFinance
      FullTimeFinance June 14, 2017

      Hi Dan, I believe your confusing different exceptions within 72t. The rule of fifty five waives the penalty if you separate from service at or beyond 55 (72(t)(2)(A)(v),
      72(t)(10)). Separately 72t (72(t)(2)(A)(iv)) does allow, regardless of age, withdrawal of funds in equal periodic amounts based on life expectancy. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions There are actually about 20 different exceptions under 72t.

      I agree saving for a major purchase is a separate issue.

      • Dan
        Dan June 15, 2017

        Thanks for pointing that out. I didn’t realize there were multiple subsections under 72t that covered withdrawal scenarios from 401k and IRA accounts. I was confusing different subparagraphs of 72t when I wrote my comment..

        72(t)(2)(A)(iv) is a series of substantially equal periodic payments (SOSEPP)
        72(t)(2)(A)(v) is separation from service on or after age 55

        My reading also discovered:

        72(t)(2)(A)(iii) – disability at any age which allows for penalty free withdrawals
        72(t)(2)(B) – qualified medical expenses can be paid for with penalty free withdrawals

        There are also several subsections dealing with early withdrawal from IRAs.

        This has been one of the most helpful blog posts I have ever read. I guess the reply comment is technically what spurred my further investigation into the topic.

        • fulltimefinance@fulltimefinance.com
          [email protected] June 16, 2017

          Thanks Dan, I’m glad it was helpful

  3. SMM
    SMM June 14, 2017

    I plan to max out my 401k in the next couple of years. Why not show reduced income for tax purposes have my gains be tax free ? Seems like a win win situation. I also just view it as a payment to myself first before paying anyone else. I do contribute once in a while to after tax account, but those are not a priority.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 15, 2017

      Exactly. Deffering and waiving taxes are beautiful things.

  4. Rich @ pennyandrich.com
    Rich @ pennyandrich.com June 15, 2017

    I agree with this, especially for those in high tax brackets. Future withdrawals and income during retirement are all unknowns. One can plan for them, but there are many uncertain variables (health, regulation, portfolio performance, market environment, etc). In contrast, the tax savings on 401k contributions is immediate and significant.

    FTF, quick question. I’ve been considering using a muni bond fund as a sort of savings account, for money I’m not quite ready to invest and for an emergency fund. Distributions are around 4% annually and, in theory, are state and federal tax free. Do you see any pros and cons to this? The fund is basically a closed end ETF and would be liquid. I’d need to space out contributions to avoid paying too much in brokerage fees, but the distributions could be reinvested without commission. Anyway, curious about what you think as you’re clarity on bonds is more advanced than most blogs I’ve read. Thanks!

    • fulltimefinance@fulltimefinance.com
      [email protected] June 15, 2017

      Rich, Before anything you’d want to ensure your invest horizon and goals are in line with a bond fund. I’m assuming they are here. There are a few things to look out for. The state originating the bonds defines state exemption, so ensure the holdings are all for your state. Also you will still be subject to capital gains tax, likely as part of the distribution. Find out how much of the income is cap gains distribution and what is the typical holding length of those distributions. That should be published on the funds disclosure. Those define your tax exposure. Take the result after tax and compare it to the alternatives to see which investment is better.

  5. Mustard Seed Money
    Mustard Seed Money June 15, 2017

    After I paid off my house I started to max out my tax advantaged accounts. I’m sure in hindsight that I probably would have way more if I had paid it all off. But at the time the psychological benefits of paying off the house made more sense. So I am torn as it’s a great feeling paying off the house but I know I’d probably be that much closer to FIRE based off how the market has responded over the last couple of years.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 16, 2017

      Sometimes psychology trumps math.

  6. Mr. Hammocker
    Mr. Hammocker June 18, 2017

    As long as the emergency fund is sufficient, I think it is great to max out tax advantaged retirement accounts. As you mentioned, there are liquidity concerns. But if the money is for retirement this should not be a concern. Excellent idea on the 401k to Roth IRA conversion. Thanks for the post.

  7. Dave
    Dave June 19, 2017

    Thanks for providing such great information in this post. For the purposes of liquidity, we are working on adding more to our taxable accounts. We still max our 403b and IRA, but we are making monthly contributions to our brokerage accounts. Also, I am planning on reaching fire at age 52. We want to draw down our taxable accounts for 8-10 years before we start taking money from our 403b or IRA.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 19, 2017

      That’s a great position to be in and a great plan. The longer those retirement funds remain untouched the better off you’ll be.

  8. Shane
    Shane June 19, 2017

    Here is something I’ve been wondering, what if I do a 72T, can I also do Roth conversions and 10% penalty withdrawals to deplete the account early essentially erasing the fact that I can’t stop until 59 1/2?

    • fulltimefinance@fulltimefinance.com
      [email protected] June 19, 2017

      Hi Shane, once you’ve started a equal periodic payments plan under 72t the IRS deems the account locked for any other withdrawal. Pulling by another means would initiate the penalty for all funds withdrawn under the rule. There are exceptions made if the market causes the funds to be exhausted.

  9. Investing analysis! Certainly wouldn’t recommend relying on a 401K as an emergency fund or pulling money out, but good to know it would kill you in the long-run.

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