The common advice for saving is always to max out your 401k and other tax-advantaged accounts. I am certainly not disagreeing with this for anybody just starting out on their savings journey or while in full swing of their high-income career. After all, a lower tax bill is nice. But what if you get this nagging feeling that you want to retire in a few years but well before age 59 ½? Anybody who can save enough to retire early, will likely hate having to pay a 10% early withdrawal penalty. Also, a 401k rollover takes time and can make you nervous if your 401k administrator still sends checks in the mail. You definitely need some money accessible immediately. But how bad is the impact of having a taxable brokerage account?
You have several options to avoid paying the 10% early withdrawal penalty but let’s look at the very simple and easy approach of just saving in an after-tax brokerage account for a few years instead of your 401k or IRA. Note that if you are getting an employer match on your savings, you absolutely should continue saving enough in your 401k to get the match. But let’s go through a basic example that simply compares the impact of after-tax savings and no withdrawal penalty with the tax-advantaged savings and a withdrawal penalty.
Scenario: Jane is 50 years old and wants to retire at age 55. So far, she has $300,000 saved in her 401k and wants to continue saving $20,000 per year. Since she can make catchup contributions in addition to the regular 401k contributions, she could save the entire $20,000 in her 401k. Assuming an 8% annual rate of return, her 300k balance will grow to $440,798 in 5 years and the additional 20 k savings per year will grow to $117,332.
Let’s assume Janes saves the $20,000 in a taxable account instead. Her tax bill will go up a bit so theoretically she could have more if she invested in a 401k. However, most people just set a savings target and then spend the rest. So Jane is determined to save the 20k in her taxable account even if that means a slightly higher tax bill on her take-home pay. She will receive some taxable dividends on her investments. Assuming a 4% dividend rate taxed at 15%, we lower her rate of return assumption to 7.96%. This really does not seem all that bad since she does not sell anything the first 5 years and does not incur taxable gains. So in this case, Jane will have her $440,798 401k balance and $117,220 in a taxable brokerage account. This is just barely lower than the tax-deferred savings.
Jane wants to withdraw $20,000 per year net to support some other income that she receives from either a profitable side job or an early pension. The standard deduction will be used up by her other income. That means her withdrawals will be taxable.
If Jane withdraws everything from her tax-advantaged account, she will have to pay income taxes since the money was not previously taxed. She also has to pay the 10% early withdrawal penalty. We assume a total tax rate of 22% (12% income and 10% penalty). This means that Jane has to withdraw $25,641 to get $20,000 after tax. If the remaining balance keeps growing at 8%, her account growth will look as follows:
|Age||Balance 401k||Withdraw after Tax||Net Withdrawal Amount||Tax||Growth on remaining balance|
|55||$ 558,130||$ 20,000||$ 25,641||$ 5,641||$ 42,599|
|56||$ 575,089||$ 20,000||$ 25,641||$ 5,641||$ 43,956|
|57||$ 593,403||$ 20,000||$ 25,641||$ 5,641||$ 45,421|
|58||$ 613,183||$ 20,000||$ 25,641||$ 5,641||$ 47,003|
|59||$ 634,546||$ 20,000||$ 25,641||$ 5,641||$ 48,712|
Her ending balance is $657,617by the time she can start withdrawing penalty free.
Since Jane has $117,220 in a taxable brokerage account, she will not have to pay an early withdrawal penalty as long as she withdraws from her taxable account. The money saved in this account is after-tax, so she only has to pay taxes on the dividend and capital gain portion of the withdrawal. Let’s just conservatively assume that 50% of her withdrawal amount is made up of capital gains and dividends and she will have to pay the 15% capital gains tax for this. With an average tax rate of 7.5% on her withdrawal amount and the remaining balance growing at 8%, her balance growth will look as follows:
|Age||Balance 401k||Balance After Tax||Withdraw after tax||Net Withdraw||Tax||Growth on 401k||Growth on After Tax|
|55||$ 440,798||$117,220||$ 20,000||$ 21,622||$ 1,622||$ 35,264||$ 9,378|
|56||$ 476,062||$104,976||$ 20,000||$ 21,622||$ 1,622||$ 38,085||$ 8,398|
|57||$ 514,147||$91,752||$ 20,000||$ 21,622||$ 1,622||$ 41,132||$ 7,340|
|58||$ 555,279||$77,471||$ 20,000||$ 21,622||$ 1,622||$ 44,422||$ 6,198|
|59||$ 599,701||$62,047||$ 20,000||$ 21,622||$ 1,622||$ 47,976||$ 4,964|
Her total ending balance is $693,066 by the time she can start withdrawing penalty free. This is over $35,000 more at the end of the 5 years than in the 401k-only scenario.
Probably not. If you are in a very high tax bracket during your working years, the deduction from your 401k contributions may offset the benefit of the penalty. If you are in the 22% tax bracket, a $20,000 deduction is worth $4,400. But that is only if you really save the extra money. Saving an additional $4,400 per year for 5 years, will get you an additional 25,813. Letting this amount grow for another 5 years, gets you to $37,927. This is only slightly better than the $35k difference for the after-tax savings example before.
So go ahead and use a taxable brokerage for some of your savings if you want especially if you are nearing your Financial Independence/ Early Retirement day. Having a taxable brokerage account gives you a lot of flexibility. It also helps calm your nerves while you wait for your 401k rollover check to be delivered to your Rollover IRA account.