What is a good reason to NOT max out a 401k?

It is commonly given financial advice that one should always max out a 401k before moving on to other investment vehicles. Even assuming 0% company matching, the reasons given for maxing out are that you are putting in money pre-tax, letting it grow tax-free, and only getting taxed once you withdraw in retirement.

I've read some contrarian opinions that point out the following flaws in the "max out your 401k" philosophy:

• If your tax rate is higher when you retire than when you contribute (because you make more or because the govt raises income tax rates), then you are actually paying more tax.
• You cannot tax-deduct capital losses that occur in your 401k account.
• You only pay capital gains tax on capital gains in a regular brokerage account, whereas you pay income tax (higher) on capital gains in a 401k

These are all good points. However, I think they work better theoretically than in practice. Let's take each one in turn:

Tax rate might be higher when you retire:
I don't really buy this one. There are two possibilities here:

• Tax bracket: This is likely to be lower because you are retired, hence there is a good chance you are not pulling in big income since you are no long salaried.
• Overall tax rates: Unpredictable. If taxes overall increase, chances are that being in a lower tax bracket will counteract this. If push comes to shove and taxes are just way too high when you want to withdraw, you can always suck it up, move to a no-income-tax-state for one year, and withdraw there to further push the odds in your favor. Also make sure to bring in no other income in that one year.

With careful planning, I do not see how the probability of taxes being higher at retirement than at contribution is likely. The one exception is if you are so rich that you can't help but be taxed highly and perhaps pay an estate tax when you are at retirement age. But this thread does not apply to people who have to worry about estate taxes, so let's ignore that possibility. This thread is for the everyman.

Cannot tax-deduct capital losses
This is a fair argument. However, if one's strategy is long-term investing in funds rather than individual stocks, it is unlikely that this would be a major concern over a 30-40 year period.

Paying capital gains vs. income tax at withdrawal
I did the math, and even assuming that the capital gains tax is only 5% when you withdraw and your income tax remained steady at 35% throughout, you will come out ahead using the 401k rather than the brokerage account. This assumes no exorbitant realized capital losses throughout the investment period.

Okay, so there is a basic review of the issues. Can anyone help me find some holes in my own argument? I am trying to think about this rationally but all roads point to "max out 401k". Also, for the sake of simplicity, let's assume a Roth account is not an option.

If you're saving for a big purchase, like a house.



Ambulance Chaser said:

If you're saving for a big purchase, like a house.

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You can borrow against your 401k (essentially an interest-free loan) for the down payment on a primary residence, so I don't think this applies. However, I can see how an upcoming non-residential major purchase could make maxing out a 401k unattractive.

You have debt to pay like student loans, car loans, credit cards, etc. Also you need to be able to have a decent cash balance on hand in case some large emergency purchase comes up like a car repair.

You need your whole salary now.

You expect to die soon.

You believe inflation in the future will actually make your 401k investments worth less in the future (even after investing) than they would be worth now without investing.

You have an investment that you want to do now (or at least before you plan to withdraw your 401k) that you believe is better than investing in your 401k (even though your investment will be taxed [possibly] and your 401k earnings won't be)

You have access to investment opportunities that will far exceed the growth potential of the typical mutual fund or that will lower the volatility of your overall portfolio, i.e a hedge fund that plays in infrastructure rather than equity or if you have access to a privately owned company that will soon IPO/be bought out.

Choice of consumption now vs. when you are old.

Your personal IRA charges far less fees and has more investment choices than the 401K.

Young people may rationally expect to have higher taxes in retirement than they do at present. I am in this boat and choose to max out my TFSA (canadian version of Roth IRA) instead of RRSP for this very reason. I cant think of a time a 401k type deferral vehicle is better than a fully taxable account, however. This is assuming someone has already made the savings-consumption decision and wants to save.

Edit: point above is very good too



SVS said:

Your personal IRA charges far less fees and has more investment choices than the 401K.

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Debatable. Many 401k plans have 10bp fee funds, which is as low as it gets. Also, if your employer provides a 401K, how much you can contribute to an IRA is further limited I believe. But yes IRAs have a better selection of investments, if you are inclined to pick securities.

asdf said:

Young people may rationally expect to have higher taxes in retirement than they do at present. I am in this boat and choose to max out my TFSA (canadian version of Roth IRA) instead of RRSP for this very reason. I cant think of a time a 401k type deferral vehicle is better than a fully taxable account, however. This is assuming someone has already made the savings-consumption decision and wants to save.
Edit: point above is very good too

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Why would you expect to have higher taxes when you are not receiving a salary? The only way that is true is if you are taking your 401K withdrawals when you still have a job and are making big income - in which case I ask, what is the point of taking the withdrawals?



Troll2 said:

Why would you expect to have higher taxes when you are not receiving a salary? The only way that is true is if you are taking your 401K withdrawals when you still have a job and are making big income - in which case I ask, what is the point of taking the withdrawals?

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Pensions, old age benefits, RRSP withdrawals, taxable account gains, taxable account distributions/dividends. I'm certain I will "make" more money in retirement than I make now.

Another way to look at it is from the perspective of alternatives: Say I eventually plan on maxing out both a TFSA and RRSP, over time. It makes more sense to make TFSA contributions now and RRSP contributions later (at/near peak earnings).

You think the money will have greater utility now than when/if you retire.



Troll2 said:

Debatable. Many 401k plans have 10bp fee funds, which is as low as it gets. Also, if your employer provides a 401K, how much you can contribute to an IRA is further limited I believe. But yes IRAs have a better selection of investments, if you are inclined to pick securities.
Why would you expect to have higher taxes when you are not receiving a salary? The only way that is true is if you are taking your 401K withdrawals when you still have a job and are making big income - in which case I ask, what is the point of taking the withdrawals?

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It depends on how well you use deductibles currently to lower your effective tax rate. I can think of several situations in which someone who earns most of their income through passive investments or possibly capital gains will be taxed more heavily once their negatively geared properties are paid off or they transfer all stock holdings into fixed income assets.

Don't forget that at an AGI or around 180k for a married couple IRAs lose their tax deductible status, i.e. you are contributing to your IRA with post-tax dollars. 401s still retain their pre-tax contribution status. Since we're talking top marginal rates here, if your AGI is 180k or over, that's major savings.

don't forget that if you have an employer sponsored 401k, maxing out your 401k is roughly 3X as much as maxing out an IRA so its not really comparable.

Tax arguments are usually bunk since they forget all of the taxes you would pay on gains along the way.

One reason I would suggest if you were in an income range where it makes sense is to do this:
1. Contribute to 401k to the extent of employer match (since it is free money you can't have without contributions). If there is no match, skip step 2.
2. Max a Roth IRA--there are good advantages to paying taxes on it now and never again and if your income goes up, you won't be able to contribute to this anymore so its nice to get money here when you can (and having both pre-tax and post-tax accounts helps hedge against future tax rate changes).
3. Go back to your 401k with any additional retirement investments you want to make up to the 401k max.
4. If you want to keep investing, its time to move into taxable accounts.

Of course this adds up to something like 22-23k plus the employer match which ends up being a lot of money for someone who is still within the Roth IRA income bracket....so it is doubtful you will max out step 3 if you are eligible to max out step 2 (and honestly, that might be oversaving).