Why Invincible 20-Somethings Should Max Out Their 401-k’s

The benefits & loopholes of a 401k and why you’d be silly to invest anywhere else

Photo by Austin Distel on Unsplash

I come across more than a few young people that think retirement savings are for chumps and money is better saved in a checking account. The rationale is hardly ever the same. For some it is the reduction in income that they are unwilling to take. For others it is the far-off, inconceivable notion of retirement that leads them astray. And for the last couple — who’s program administrators clearly didn’t read the teachings of Richard Thaler — it is the power of the default that keeps them from setting up a 401k. Regardless of motive, the outcome is the same: increased tax liability, decreased financial security and lower savings. In this article, I’m going to dive into exactly why this is the case and why every investor should be focused on maxing out their retirement accounts before saving in traditional accounts.

The Tax Benefits

The tax benefits are far and away the biggest biggest benefit of retirement accounts. By investing within retirement accounts rather than traditional accounts, you have the potential to vastly minimize your tax liability. We’re not talking about small savings; were talking about massive savings. Let me illustrate with a simple example:

Sara contributes $8,000 ($10,000 pre-tax — more on this later) to a Roth 401k at age 25. Assuming 9% returns, Sara will have over $250,000 come the age of 65. She can spend this money whenever she chooses and doesn’t have to pay any taxes on the gains. In other words, by using a tax-advantaged retirement account, Sara paid only $2,000 in taxes on what amounts to $250,000 in income. A 0.8% tax rate.

Now there is a bit of nuance here: I’m not taking into account the opportunity cost of what that $2,000 could have earned if not paid in taxes. Nuance aside though, this example starts to explain the true power of tax-advantaged savings accounts. In a traditional investment account, you’d also have to pay tax on that $242,000 of capital gains and dividends. This could amount to tens of thousands of dollars in additional taxes.

Getting more into the details, there are two primary types of retirement accounts: IRAs & 401ks/403bs. Each of these has 2 flavors: Roth & Traditional. Those getting a bit more creative may may also consider their HSA a third type as it converts to a psuedo-401k at the age of 65. For Roth accounts, post-tax money is contributed and gains are untaxed. For traditional accounts, pre-tax money is contributed and income taxes are levied on withdraws. In both cases, the account is only taxed once rather than twice (when earned and on capital gains) with typical income. This small difference can mean huge taxation differences down the line.

The Financial Security

There is something to be said about having a nest egg to catch you if you find yourself in bad circumstances. However, this is typically easier said than done. Living below your means is easy to preach but hard to practice when temptations are constantly calling your name. Then, if you do manage to build up savings, that new car or boat or house all the sudden starts to look more and more appealing. The problem with savings, or at least our struggle with it, has to do with opportunity cost. Why sock away $100 where it will give you zero happiness when you can buy a fancy dinner with it that will give you loads of happiness?

Savings are hard because they’re so easy to tap for fleeting wants. This is precisely where retirement accounts can be beneficial. Because the withdraw rules are relatively strict and money can’t be withdrawn on a whim, it is a powerful tool to limit compulsive expenditures in a way that traditional savings are not. In this way, they can help you to be more diligent about your budget and financial goals.

The Myth of “locking away money until you’re 59 1/2”

My mom once told me it is unilaterally a bad idea to withdraw from your retirement account before reaching retirement age. In her words, I would be “stealing money from my future self”. Don’t get me wrong, I love my mom, but I thought her advice on this was ill-thought out and irrational. While I saw the rationale behind her advice, I found that it didn’t apply to one group of people: those trying to game the system. She of all people should have known I fit into that group.

For those trying to game the system, maxing out 401k & IRA contributions is just the start. Where the games continue for the more creative is trying to get money out before the typical age of 59.5. While this shouldn’t be attempted by the average person just trying to save a little for retirement, it is a powerful tool to be aware of for those who regularly max out all of their retirement accounts and, consequently, have less in non-retirement savings to tap into. To explain what I mean by this and why one may consider this, let me explain with a simple example:

Joe is 50 years old with 16 astrobucks in investments/cash and 200 astrobucks in various retirement accounts. If Joe want to stop working his day job and take up painting (salary: 1 astrobuck/yr) while maintain his current standard of living (3 astrobucks/yr), he will need to supplement his income with his investments. Now the issue here is that, his current savings and investments will only last him 8 years (assuming no growth) which isn’t enough to take him to the minimum age of penalty-free withraws of 55. Out of money and options, he decides to take a early 401k withdraws from these to cover those last few years and the IRS charges him a 10% penalty and income taxes.

Now as you can tell by the story, Joe is in a pretty unique scenario trying to retire at 50 with plentiful retirement funds. This is, as far as I can think of, the only group group that may be an exception to my mom’s earlier advice. To clarify: only those who have ample funds in their retirement accounts to not worry about maintaining their standard of living indefinitely should attempt early withdraws for a non-essential purpose. With that out of the way, let me talk about how Joe could have, hypothetically, withdrawn from his retirement accounts without incurring that 10% penalty.

1. A 401k loan : This one is my personal favorite workaround. This is partly because I find it the most clever but mostly because my mom also told me to never do this as well. 401k loan rules stipulate that you make take a maximum of a $50k in loans out from your 401k in a 12 month period. The loan is structured such that your 401k loans to you and you pay back your 401k over the course of 5 years or less. This is unilaterally disparaged by financial advisors but actually acts as an ideal tool in Joes case. Joe could take out a 401k loan, use some of that loaned money to live off of (remember this is an untaxed $50k) and some to make the first two years of loan payments. When the two years are done and Joe runs out of money, Joe can withdraw penalty free from his 401k (he’s now 55) to pay off the remainder of the loan. This may be a bit hard to wrap your head around but think of your retirement accounts and personal savings as two distinct entities until you reach the age of 55. (withdrawing penalty-fee at 55 is, itself, another exception that can be taken if you formally retire from your job between 55 & 60)
2. Early Withdraw Exceptions — There are variety of exceptions that can qualify you for early withdraw of retirement savings penalty free. If you rack up large medical bills or you’re looking to buy your first house, you can withdraw money from your retirement accounts penalty free. Again this typically isn’t recommended but, in my opinion, wrongly so. Assuming you are contributing ample funds to your retirement accounts and you’re not worried about actually having enough money in retirement, it can actually be in your best interest to, say, save for and pay with a Roth IRA to fund your home down payment (or at least $10,000 of it). In many cases, It makes sense to always build your nest egg within your retirement accounts before saving any money outside of retirement accounts. Many large expenses like homes and medical bills can, under certain circumstances, allow you to withdraw early from your retirement accounts without penalty. In essence, retirement accounts are a lot less restrictive than you may have believed. This means that it can often be more advantageous to contribute an extra $500 a month to a retirement account for that home you were looking to buy rather than saving and investing in a normal account.
3. SEPP — for those who’d like to retire early: If you max out your HSA, IRA, & 401k from the age of 21, it doesn’t take long for the money snowball to get out of control. By 50, you could expect to have about $3 million in retirement savings (assuming only individual/no spouse contributions, no employer contributions, and a 9% return). That’d be plenty to retire on but you’re still not of an age to be eligible for penalty free withdraws. This is where SEPP payments come in. SEPP is another exception to the withdraw penalty guidelines that allow you to take early “substantially equal payments” without penalty. Essentially, you follow a few SEPP equations that give you an annual withdraw rate. You can then withdraw that money penalty free (though not tax free so this should only be done with a traditional retirement account) in “substantially equal payments” over the course of anywhere from 5 years to however many years it takes you to reach retirement age. The main tradeoff is these payments cannot — technically should not — be stopped and prevent you from further contributing to your account. This can be a powerful tool though for those looking to retire before hitting formal retirement age.

TLDR: After A Safety Net, Save Only In Retirement Accounts

Retirement accounts are far more powerful than most believe but do also have their caveats. Numerous tax advantages mean saving within them is extremely advantageous and loopholes mean they’re not nearly as restrictive as many believe. There are clear limitations though: many high earners will quickly hit contribution limits on these accounts and the money can’t quite be accessed for all needs. These drawbacks mean you should never quite save all of you money within them; maybe a number 80% makes more sense. Given a safety net and meager traditional savings though, it could hardly make more sense to save money within retirement accounts and watch them snowball all that much faster devoid taxation and temptation.