Should I Max Out My 401K?

With a goal of maximizing after tax returns, does it make sense to invest the maximum amount in a 401K or take this money after tax and invest in a taxable account.

Investing in a 401K with pre-tax dollars should have advantages over investing post tax dollars in a taxable account. One advantage is that gains in taxable accounts are subject to capital gains taxes. Another potential advantage is if the 401K distribution tax rate is lower than the current tax rate.

The disadvantages of 401Ks have to do with higher fees and underperformance of the limited investment options 401K plans typically offer.

According to the Center for American Progess, 401K plan administrative fees and investment expenses can total around 1% annually(1). 401K investment options vary by plan, but actively managed funds typically underperform passively managed funds. In 2015, Morningstar published a study showing that the average active U.S. large capitalization funds performance trailed the average passive performance by 0.82% annually(2). With 401K plans lasting 20 years or longer the compounded effect of fees and underperformance is impossible for the advantages of 401K plans to make up. For example, the account value lost, due to fees, is 18.2% over 20 years. The account value lost due to underperformance is 15.2% over 20 years. Combining these effects together gives a portfolio loss of 30.7% over 20 years. If your 401K plan offers low management fees and low expense investment options, stick with it. If not, contribute up to the employer match then look for a better investment option.

1)https://www.americanprogress.org/issues/economy/reports/2014/04/11/87503/fixing-the-drain-on-retirement-savings/

2)http://corporate.morningstar.com/US/documents/ResearchPapers/MorningstarActive-PassiveBarometerJune2015.pdf

Disclosure:

The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.

The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.

Performance data showing past performance results is no guarantee of future returns.