Assumptions:
- Annual contributions are $18,000 each year (these contributions increase slightly).
- Money is invested in the same portfolio through 401K and Investments.
- Returns are based on the actual past 15 year returns for DOW Jones Index.
- Each row assumes complete withdrawal from the 401K or from Investment.
- You contribute pre-tax money to 401K so during the year of contribution, you will save tax on the contributed amount. Money in Investments is post-tax.
- Your employer does not match your contribution.
- Tax rate is 22% for the entire period of evaluation.
- Long Term Capital Gains Tax is 20%.
- Total Tax Payable for 401K includes: Tax Savings on Contribution + Tax Penalty at 10% up to age 59 ½ years + Tax on withdrawal of total amount.
- Tax Payable when Investment is liquidated is on the capital gains and not on total withdrawal.
Table: Comparing Traditional Investment with 401K
| Age | Annual Contribution | Simulated YoY Returns | Cumulative Investment | 401K – Total Tax Payable | 401K – Net Withdrawal | Equity – Tax Payable (@20% on CG) | Equity – Net Withdrawal | 401K v/s Investment | |
| 30 | 18,000 | 11% | 19,984 | 2,435 | 17,549 | 397 | 19,587 | (2,038) | |
| 31 | 18,000 | 6% | 40,084 | 8,867 | 31,217 | 817 | 39,267 | (8,050) | |
| 32 | 18,000 | 7% | 62,301 | 15,976 | 46,325 | 1,660 | 60,641 | (14,316) | |
| 33 | 18,000 | 27% | 101,581 | 28,546 | 73,035 | 5,916 | 95,665 | (22,630) | |
| 34 | 18,000 | 8% | 128,573 | 37,183 | 91,390 | 7,715 | 120,859 | (29,469) | |
| 35 | 18,000 | -2% | 143,305 | 41,897 | 101,407 | 7,061 | 136,244 | (34,837) | |
| 36 | 18,000 | 13% | 182,952 | 54,585 | 128,367 | 11,390 | 171,561 | (43,194) | |
| 37 | 18,000 | 25% | 251,350 | 76,472 | 174,878 | 21,470 | 229,880 | (55,002) | |
| 38 | 18,000 | -6% | 254,186 | 77,380 | 176,806 | 18,437 | 235,749 | (58,942) | |
| 39 | 18,000 | 22% | 332,992 | 102,598 | 230,395 | 30,598 | 302,394 | (71,999) | |
| 40 | 18,000 | -34% | 232,217 | 70,349 | 161,867 | 6,843 | 225,373 | (63,506) | |
| 41 | 18,000 | 19% | 297,307 | 91,178 | 206,129 | 16,261 | 281,046 | (74,917) | |
| 42 | 18,000 | 11% | 350,054 | 108,057 | 241,997 | 23,211 | 326,843 | (84,846) | |
| 43 | 18,000 | 6% | 388,408 | 120,330 | 268,077 | 27,282 | 361,126 | (93,049) | |
| 44 | 18,000 | 7% | 435,913 | 135,532 | 300,381 | 33,183 | 402,730 | (102,350) | |
| 45 | 18,000 | 27% | 574,200 | 179,784 | 394,416 | 57,240 | 516,960 | (122,544) | |
| 46 | 18,000 | 8% | 636,733 | 199,795 | 436,938 | 66,147 | 570,586 | (133,648) | |
| 47 | 18,000 | -2% | 640,132 | 200,882 | 439,250 | 63,226 | 576,906 | (137,656) | |
| 48 | 18,000 | 13% | 746,454 | 234,905 | 511,549 | 80,891 | 665,563 | (154,014) | |
| 49 | 18,000 | 25% | 956,179 | 302,017 | 654,162 | 119,236 | 836,943 | (182,781) | |
| 50 | 18,000 | -6% | 919,333 | 290,226 | 629,106 | 108,267 | 811,066 | (181,960) | |
| 51 | 18,000 | 22% | 1,146,733 | 362,994 | 783,738 | 150,147 | 996,586 | (212,848) | |
| 52 | 18,000 | -34% | 770,587 | 242,628 | 527,959 | 71,317 | 699,270 | (171,310) | |
| 53 | 18,000 | 19% | 936,999 | 295,880 | 641,120 | 101,000 | 835,999 | (194,880) | |
| 54 | 18,000 | 11% | 1,060,240 | 335,317 | 724,923 | 122,048 | 938,192 | (213,269) | |
| 55 | 18,000 | 6% | 1,137,867 | 360,157 | 777,709 | 133,973 | 1,003,894 | (226,184) | |
| 56 | 18,000 | 7% | 1,239,783 | 392,771 | 847,012 | 150,757 | 1,089,026 | (242,014) | |
| 57 | 18,000 | 27% | 1,591,095 | 505,190 | 1,085,905 | 217,419 | 1,373,676 | (287,771) | |
| 58 | 18,000 | 8% | 1,730,099 | 549,672 | 1,180,427 | 241,620 | 1,488,479 | (308,052) | |
| 59 | 18,000 | -2% | 1,709,117 | 542,957 | 1,166,159 | 233,823 | 1,475,293 | (309,134) | |
| 60 | – | 13% | 1,938,480 | 426,466 | 1,512,014 | 279,696 | 1,658,784 | (146,770) | |
| 61 | – | 25% | 2,424,651 | 533,423 | 1,891,228 | 376,930 | 2,047,721 | (156,493) | |
| 62 | – | -6% | 2,288,143 | 503,391 | 1,784,752 | 349,629 | 1,938,514 | (153,763) | |
| 63 | – | 22% | 2,799,314 | 615,849 | 2,183,465 | 451,863 | 2,347,451 | (163,986) | |
| 64 | – | -34% | 1,852,026 | 407,446 | 1,444,580 | 262,405 | 1,589,621 | (145,041) | |
| 65 | – | 19% | 2,200,578 | 484,127 | 1,716,451 | 332,116 | 1,868,462 | (152,012) | |
| 66 | – | 11% | 2,443,081 | 537,478 | 1,905,603 | 380,616 | 2,062,465 | (156,862) | |
| 67 | – | 6% | 2,578,184 | 567,200 | 2,010,983 | 407,637 | 2,170,547 | (159,564) | |
| 68 | – | 7% | 2,765,360 | 608,379 | 2,156,981 | 445,072 | 2,320,288 | (163,307) | |
| 69 | – | 27% | 3,498,180 | 769,600 | 2,728,581 | 591,636 | 2,906,544 | (177,964) | |
| 70 | – | 8% | 3,761,243 | 827,474 | 2,933,770 | 644,249 | 3,116,995 | (183,225) | |
Observations:
- You need to contribute the amount that your employer would match for your 401K contribution, or else you will forfeit the money.
- After your retirement, you can withdraw the amount that would not attract any tax then your 401K will yield better returns compared to your investments. In this case, it would be no tax during investment and no tax at withdrawal which investments cannot beat. This is however not practical as you would need more than the minimum withdrawal to avoid tax.
- If there are years prior to your age of 59 ½ years, you cannot withdraw the contribution without attracting a penalty on the withdrawal. During such years, you would need to move your contributions to lower risk investments like bonds. Timing the falls is always a good move in hindsight and you will never be able to achieve that perfection.
