401(k) vs. Taxable Account: Choosing the Right Vehicle for Retirement Investing
When it comes to saving for retirement, choosing the right investment account can be just as important as the investments themselves. For many, the two primary options are a 401(k) plan and a taxable investment account. Each has its own advantages and disadvantages, and understanding these differences can help you make a more informed decision.
What is a 401(k) Plan?
A 401(k) is a retirement savings plan sponsored by an employer. It allows employees to save a portion of their paycheck before taxes are deducted. Here are some of the key features of a 401(k):
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Tax Benefits: Contributions to a traditional 401(k) are made with pre-tax dollars, reducing your taxable income for the year. This can result in significant tax savings, especially for high earners. Roth 401(k) plans, on the other hand, allow you to contribute after-tax dollars, but withdrawals in retirement are tax-free.
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Employer Match: Many employers offer a matching contribution to employees’ 401(k) plans, effectively providing “free money” for your retirement. It’s common for employers to match a percentage of your contributions, up to a certain limit.
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Contribution Limits: The IRS sets annual contribution limits, which for 2023 are $22,500 (or $30,000 if you’re age 50 or older). This allows for substantial retirement savings, particularly when combined with the employer match.
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Investment Options: 401(k) plans typically offer a limited selection of investment options, often selected by the plan administrator. While they usually include a diversified selection of mutual funds, you might have fewer choices compared to a taxable account.
- Withdrawal Restrictions: Withdrawals from a 401(k) before retirement age (59½) generally result in penalties, and you must start withdrawing at age 73 due to Required Minimum Distributions (RMDs).
What is a Taxable Account?
A taxable investment account, also known as a brokerage account, allows you to invest in a wide variety of assets such as stocks, bonds, ETFs, and mutual funds without the tax advantages of retirement accounts. Here are some of its features:
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Flexibility: There are no restrictions on how much you can contribute each year, and you can withdraw your money at any time without penalties. This makes taxable accounts more flexible for short-term needs as well as long-term growth.
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Investment Choices: Unlike a 401(k), a taxable account provides access to a broader spectrum of investment options. You can tailor your portfolio to your precise risk tolerance and investment goals.
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Taxation: While you don’t receive upfront tax benefits, you will be taxed on dividends, interest, and capital gains in the year they are realized. However, you can offset capital gains with capital losses and benefit from lower long-term capital gains tax rates for investments held for over a year.
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No RMDs: You are not required to withdraw funds from a taxable account at any age, providing deeper control over your withdrawals and tax implications in retirement.
- Investment Strategy: Taxable accounts allow for strategies like tax-loss harvesting to optimize your tax situation, which isn’t as easily executed within a 401(k).
Comparing the Two: Pros and Cons
401(k) Pros:
- Tax-deferred growth
- Employer matching contributions
- High annual contribution limits
- Potential tax deductions
401(k) Cons:
- Limited investment options
- Withdrawal restrictions and penalties
- Required Minimum Distributions (RMDs)
Taxable Account Pros:
- Flexible contribution and withdrawal structure
- Broad investment options
- Ability to use tax strategies to optimize return
- No RMDs
Taxable Account Cons:
- No tax deferral on earnings
- Potentially higher taxes on dividends and capital gains
- No employer match perks
Which is Right for You?
The best choice depends largely on your financial situation, goals, and preferences. For many, maxing out a 401(k) to take advantage of employer matching is a foundational step in retirement planning. If you have additional funds after contributing to your 401(k), a taxable account can provide flexibility and additional growth potential.
For younger investors or those in lower tax brackets, a Roth 401(k) combined with a taxable account may be appealing, as it allows for tax-free growth and withdrawal options later in life. Conversely, those in higher tax brackets or nearing retirement might prioritize the tax benefits of a traditional 401(k).
Ultimately, integrating both accounts into your retirement strategy may yield the best outcome. By understanding each account’s features, advantages, and potential drawbacks, you can make smarter investment decisions today that will set your financial future on a path toward success.
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At 2:14 you say: "[Your 401k distribution] doesn't get taxed at the lower tax rates or gradually as your normal income tax does. It goes right to the marginal tax rate and you pay that top rate."
What??? According to Investopedia: "distributions from traditional 401(k) and traditional IRA accounts are taxed on an incremental basis, with steadily higher rates for progressively higher tiers of income." I don't think I can trust tax advice from you anymore…
Imagine you do a great job saving and utilizing 401k doing so…and at the age of 65, you and your wife retire with 4 Million in it.
Then, at 67, you die of cancer and your wife follows suit 4 years later.
Imagine what would happen to those let's say 3.8 million if they were inherited by your two high earning children who happened to be in their late 30s. How much of those 3.8 million would uncle Sam take in following 10 years?
With brockerage account, uncle Sam would not get a penny
I think there should be a major overhaul of the retirement system. Any retirement plan should NEVER be taxed, it's money to help you in your golden years and every penny counts. I do not agree that the government should be tapping into retirement funds. I hope there is a law change before I retire, because paying taxes on a fixed income is so unethical.
Wow. I just learned something super valuable. I did not realize the marginal tax rate on 401k withdrawals and what that meant! That’s a huge difference I’m my tax liability in retirement from what I had been calculating. Thanks for this super valuable piece of info!
Another important downside of taxable accounts is how they are treated in bankruptcy. When you go bankrupt, all of your assets in a 401k are for the most part safe. Assets kept in a taxable account may need to be liquidated to pay off debts before you can get them discharged
I max out my 401k with no match. I don’t like the investment options. I’m thinking of just a taxable account and not have to jumó through hoops or worry about taxes in the future
Could you convert 401K to traditional IRA allow you to pay income tax based on tiered tax bracket rates instead paying all at the top tax bracket?
Do you have to wait a year and a day for each contribution? For example, if I purchased $100 of xyz and then two weeks later, purchased more, is it one date, or does each purchase have its own date? Hope this makes sense….
Both me and my wife have maxed out contributions to our work 401k's including 50+ age catch up contributions with great tax advantages. So 3 years ago, I invested $500,000 cash from savings which was earning nearly nothing and an additional $250,000 about halfway down the Covid-19 crash in an S&P indexed fund in a taxable brokerage account. Thought it would be set it and forget it, but getting big tax bills as it grew from $750,000 invested to just topping one million. Hoping the taxes calm down as the contributions convert from short term to long term. I am paying the tax bills out of checking which will allow for max fund growth, but I have been spoiled by our tax-defered 401k's and having to pay taxes when I haven't sold any shares really really sucks. Also how can I maximize writing off a 2018 $50,000 loss in this investment? Can I only write off $3,000 per year and how often?
2:12 that's completely wrong. Retirement withdrawals from a traditional 401k are taxed as ordinary income, not just at marginal tax rate. It's pooled together with all your other taxable sources of income. If all your income is the 401k distribution, it's taxed "gradually" as you called it, not at the marginal tax rate.
Thanks man that was every question I had
I have an LLC that I do a match. Contribution with employees. Can I do that with these kinda accounts?
I like that, "think of it as a complement to what you already have." Exactly! Why not have a 401K while also utilizing an independent/taxable account. Great vid!
that's why stocks, especially that don't pay dividends, like berkshire hathaway, are essentially tax sheltered. Why would I want to hold that in a 401k and pay Marginal tax rates when I sell it nd not have access to it until retirement, then keep it in a taxable account and only pay Long Term Capital Gains. 401k for the most part is a sham. High Fees, and more taxes. Don't get me wrong, it has its place, but it's not as amazing as they make it out to be.
So say I'm taxed at 15% rate on capital gains. if I buy a stock for $300, and a year later sell it for $400, I only pay a capital gains tax on $100? So $15?
With individual accounts you’re taxed twice assuming the money originally came from your paycheck or other reported income and not illegal unreported income. First you pay income tax when you get your paycheck. Then you pay the capital gains tax for long term trades when you sell. With 401ks, you only pay tax once. If your long term capital gains tax is above 10%, that’s higher than the withdrawal penalty. Therefore it would seem it makes more sense to contribute to a roth IRA and then take the penalty if you ever need to withdraw instead of a personal account. Also I have never heard of 401k withdrawals being taxed fully at the marginal rate…are you sure that’s correct?
Mutual fund with great returns and around 30 percent turnover rate or do I invest in an Index fund in a taxable account for about 5 years or so?
Btw, this is a very good video
You forgot to mention one thing, and that is the dividend from the taxable account if you own any dividend paying stock. The qualified dividends are taxed at 15% as well (the same rate as long term capital gain)
Good vid!
Great vid thanks
Dustin, question concerning my 401k. I'm still 13 years from retirement so I have time.
If I rollover my traditional 401k over to a traditional IRA after I retire then do a Roth Conversion will i still be taxed at the highest marginal rate once I withdraw portions of money out of the traditiinal IRA to the Roth IRA?
Do you have to pay taxes on dividend payments/ drip plan on a taxable account every year or only if you sell a position?
Wow! This was a fantastic video! Thanks Dustin!