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?
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 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:
|Deposit||Principal||interest – taxes||Deposit||Principal||interest||Return after 10% Penalty|
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.
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.
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.
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 accounts based on tax 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.