I contribute full 18 to my 401k thinking I am letting my money grow untaxed for such a long time. However, looking at how 401k is taxed when I pull the money out, it does not sound like a great deal because it is taxed like regular income. As oppose to that if I had invested in a mutual fund and put it for long time, my income would be taxed as a long term investment which is flat out 15%.

  • Does it not make sense to invest in mutual fund because not only my money is there to be used whenever I want to without having to wait till I am 65 but also because it is taxed at a much lower tax bracket than 401k?
  • 1
    I'm sure someone will answer with more depth but mutual funds kick off other taxable events through your holding period, and you don't know what taxes will look like that far in the future. Maybe long term capital gains aren't treated differently 20 years from now...
    – quid
    Commented Aug 30, 2016 at 1:49
  • You should absolutely be tactical as to which account should hold different asset classes. Single stocks that you intend to hold for a long time are candidates for placing in taxable accounts.
    – user662852
    Commented Aug 30, 2016 at 4:25
  • 8
    Nobody has mentioned that the "main assumption" tied to a 401K is that your income is going to be lower in retirement than while you are working. Thus, your effective tax rate is going to be lower if you pay taxes on the income during retirement versus paying taxes on that income while you are at your prime earning age. While the examples assuming the same tax rates still show advantages to retirement accounts, those examples don't reflect the entire picture.
    – Dunk
    Commented Aug 30, 2016 at 16:11
  • 2
    @Dunk I think this is important but I think it helps to look at it this way: the money you set aside in the qualified account now will be taxed at the highest rate that applies. When you take the distribution, the expectation is that it will be your primary income so the will be taxed at the lowest rate (0%) first, then and then up depending on the amount. This is true even if your total income is the same in retirement. If you are expecting to have a lot of other income (like from non-qualified investments), then the Roth option might be better.
    – JimmyJames
    Commented Aug 30, 2016 at 17:21
  • Make sure you are considering the differences between Roth 401k and Traditional 401k. They aren't the same in regards to taxation!
    – davmp
    Commented Aug 31, 2016 at 0:24

11 Answers 11


Your analysis is not comparing apples to apples which is why it looks like investing money in a non-qualified account is better than a 401k (traditional or Roth).

For the non-qual you are using post tax dollars (money that has already been taxed). Now on top of that original tax you are also going to pay capital gains tax for any growth plus dividend rates for any dividends it throws off.

For the 401k, let's assume for the moment that $10,000 is invested in a traditional and that the marginal tax rate is always 20%. And for growth let's assume 10x. With a traditional your money will grow to $100,000 and then the IRS gets $20,000 as you pull the money out. The result is a net 80,000 for you.

For a Roth 401k, it is taxed first so only $8,000 gets invested. This then grows by the same multiplier to $80,000. (Until you consider changing tax rates the Roth and traditional give the same growth of money).

Considering the non-qual option, like with the Roth we only have $8,000 to invest. However in this case you will not realize the full 10x growth as you will have to pay taxes on $72,000. These are taxes that the 401ks (and also IRAs) do not pay.

There are other reasons to consider non-qual over maxing out your 401k. Liquidity, quality of investments, and fees being some of those. But the capital gains rate vs. ordinary income rate is not one, as the money in the non-qual still has to go through that ordinary income tax first before it is available to even invest.

  • 6
    Huh. With the non-qualified account, tax cuts into your growth twice, once when it reduces your initial investment and once when it gets taken out of your gains. I didn't realize until now that those factors are multiplicative with each other. It's a lot like the effect of more frequent interest compounding, except negative. Commented Aug 30, 2016 at 16:29
  • 1
    The other consideration with the non-qualified option is that you may also have to pay taxes on dividends or bond payments on a yearly basis effectively lowering the growth rate.
    – JimmyJames
    Commented Aug 30, 2016 at 17:11
  • 1
    @user2357112 There are edge cases where it's possible you would pay more taxes with a 401k than a non-qualified plan, but they're very much edge cases - primarily where you pay little tax on contributions but pay a lot of taxes when you're retired. Nearly nobody has that situation - almost always it's the reverse - and it has to be very extreme (like 10% marginal rate now and 33% marginal rate then) for it to happen.
    – Joe
    Commented Aug 30, 2016 at 18:35
  • 1
    Joe - there was a time that a company pension would potentially replace 75 to 80% of one's final income. It wouldn't take very much of a 401(k) balance to put you right over your last marginal rate. But I agree with you 100% that case is pretty rare. Commented Aug 30, 2016 at 19:46
  • 1
    @Joe if you are in a situation like you describe, a Roth contribution (supported by more and more 401k plans, or using a Roth IRA) would then be considerably better than either the traditional 401k or a non-qualified savings account. A Roth account may be better or worse than a traditional, but is always better than a taxable account unless you have a net loss.
    – Evan
    Commented Aug 31, 2016 at 15:44

There are 3 options (option 2 may not be available to you)

  • Traditional 401k
  • Roth 401k
  • Taxable investment account

When you invest 18,000 in a Traditional 401k, you don't pay taxes on the 18k the year you invest, but you pay taxes as you withdraw. There's a Required Minimum Distribution required after age 70. If your income is low enough, you won't pay taxes on your withdrawals. Otherwise, you pay as if it is income. However, you don't pay payroll tax (Social Security / Medicare) on the withdrawals. You pay no tax until you withdraw.

When you invest 18,000 in a Roth 401k, you pay income tax on the 18,000 in the year it's invested, but you pay nothing after that.

When you invest 18,000 in a taxable investment account, you pay income tax on that 18,000 in the year it's invested, you pay tax on dividends (even if they're re-invested), and then you pay capital gains tax when you withdraw.

But remember, tax rules and tax rates are only good so long as Congress doesn't change the applicable laws.

  • 1
    You don't pay payroll tax on the withdrawals because you pay it on the contributions... Only the income tax is deferred.
    – littleadv
    Commented Aug 30, 2016 at 4:21
  • 9
    It is incorrect to present 401k and "mutual funds" as alternatives. 401ks are just accounts, while mutual funds are investment vehicles. You can buy mutual funds in a 401k. I think what you mean by "mutual funds" is actually "taxable investment account".
    – BrenBarn
    Commented Aug 30, 2016 at 4:21

Before anything, I see that no one mentioned the one thing about 401(k) accounts that's just shy of magic - The matching deposit. In 2015, 42% of companies offered a dollar for dollar match on deposits. Can't beat that. (Note - to respond to Xalorous' comment, the $18K OP deposits can be nearly any percent of his income. The typical match is 'up to' 6% of gross income. If that's the case, the 401(k) deposits are doubled. But say he makes $100K. The $18K deposit will see a $6K match. This adds a layer of complexity to the answer that I preferred to avoid, as I show with no match at all, and no change in tax brackets, the deferral alone shows value to the investor.)

On to the main answer -

Let's pull out a spreadsheet -

enter image description here

We start with $10,000, and assume the 25% bracket. This gives a choice of $10,000 in the 401(k) or $7500 in the taxable account. Next, let 20 years pass, with 10% return each year. The 401(k) sees the full 10% and after 20 years, $67K. The taxable account owner waits to get the 15% cap gain rate and adjusts portfolio, thus seeing an 8.5% return each year and carrying no ongoing gains. After 20 years of 8.5% returns, he has $38K net. The 401(k) owner on withdrawal pays the 25% tax and has $50K, still more than 25% more money that the taxable account. Because transactions within the account were all tax deferred.

EDIT - With respect to davmp's comment, I'll offer the other extreme -

enter image description here

In his comment, he (rightly) objected that I chose to trade every year, although I did assign the long term 15% cap gain rate, he felt the annual trade was my attempt to game the analysis. Above, I offer his extreme case, a 10% return each year, no trade, no dividend. Just a cap gain at the end. The 401(k) still wins. I also left the tax (on the 401(k)) at withdrawal at 25%, when in fact, much, if not all will be taxed at 15% or lower, which would put the net at $57K or 30% above the taxable account final withdrawal.

The next issue I'd bring up is that the 401(k) is taken out at the top (marginal) tax rate, e.g. a single filer with taxable income over $37,650 (in 2016) would save 25% on that 401(k) deduction. Of course if the deduction pulls you under that line, I'd go Roth or taxable. But, withdrawals start at zero. Today, a single retiree has a standard deduction ($4050) and exemption ($6300) for a total $10,350 "zero bracket" with the next $9275 taxed at 10%. This points to needing $500K in pre tax accounts before withdrawals each year would get you past the 10% bracket. (This comes from the suggestion of using 4% as an annual withdrawal rate).

Last - the tax discussion has 2 major points in time, deposit and withdrawal, of course. But, the answers here all ignore all the time in between.

In between, you see that for any number of reasons, you'll drop from the 25% bracket to 15% that year. That's the time to convert a bit of money to Roth and 'top off' the 15% bracket. It can happen due to job loss, marriage with new spouse either not working or having lower income, new baby, house purchase, etc.

Or in-between, a disability put you out of work. That permits you to take money out with no penalty, and little chance of paying even the 25% that you paid going in. This, from personal experience with a family member, funded a 401(k) with 28% money. Then divorced and disabled, able to take the $10K/yr to supplement worker's comp (non taxed) income.

  • You mentioned the match, but ran the numbers without it.
    – Xalorous
    Commented Aug 30, 2016 at 19:39
  • Multiply the 401(k) column by the match impact. If $18k was 6% of OPs income, the match would literally double that column. When I looked at our last statements, 1/3 of our balance was due to company match. Including this in the spreadsheet would add a layer of complexity and would actually require knowing the percent that actually got matched. The mention of the match was meant to be anecdotal since no one else mentioned it Commented Aug 30, 2016 at 19:43
  • 1
    Sorry, but I don't buy your speadsheet. There is no reason that a taxable account has to suffer a 1.5% earning penalty every year of 20 years. For example, I could pick a basket of individual growth stocks and get no divi and hold for 20 years. At the same 10% return, this would get me $50,456.25 in portfolio value at the end of the 20 years -- same as the 401k. Agree that I would pay cap gains on that, but I'm not limited by any gov't limitations to how much I can put away so while the 401k could only start with 18,000 I could put more than that in the taxable.
    – davmp
    Commented Aug 31, 2016 at 0:18
  • No problem. The assumptions I make are clear. One can use any set of assumptions they wish, including a single purchase buy and hold, with one sale at withdrawal time. Better still, the taxable account can assume a zero cap gain and stepped up basis on death of the owner, the 401(k) can't do that. Commented Aug 31, 2016 at 1:25
  • @davmp - I added a snapshot to reflect your scenario. Let me know if I misrepresented your position. Commented Aug 31, 2016 at 14:24

When you are investing for 40 years, you will have taxable events before retirement. You'll need to pay tax along the way, which will eat away at your gains.

For example, in your taxable account, any dividends and capital gain distributions will need taxes paid each year. In your 401(k) or IRA, these are not taxable until retirement.

In addition, what happens if you want to change investments before retirement? In your taxable account, taxes on the capital gains will be due at that time, but in a retirement account, you can change investments anytime you like without having to pay taxes early.

Finally, when you do pull money out of your 401(k) at retirement, it will be taxed at whatever your tax rate is at retirement. After you retire, your income will probably be lower than when you were working, so your tax rate might be less.


when you contribute to a 401k, you get to invest pre-tax money. that means part of it (e.g. 25%) is money you would otherwise have to pay in taxes (deferred money) and the rest (e.g. 75%) is money you could otherwise invest (base money). growth in the 401k is essentially tax free because the taxes on the growth of the base money are paid for by the growth in the deferred portion. that is of course assuming the same marginal tax rate both now and when you withdraw the money. if your marginal tax rate is lower in retirement than it is now, you would save even more money using a traditional 401k or ira.

an alternative is to invest in a roth account (401k or ira). in which case the money goes in after tax and the growth is untaxed. this would be advantageous if you expect to have a higher marginal tax rate during retirement. moreover, it reduces tax risk, which could give you peace of mind considering u.s. marginal tax rates were over 90% in the 1940's. a roth could also be advantageous if you hit the contribution limits since the contributions are after-tax and therefore more valuable. lastly, contributions to a roth account can be withdrawn at any time tax and penalty free. however, the growth in a roth account is basically stuck there until you turn 60. unlike a traditional ira/401k where you can take early retirement with a SEPP plan.

another alternative is to invest the money in a normal taxed account. the advantage of this approach is that the money is available to you whenever you need it rather than waiting until you retire. also, investment losses can be deducted from earned income (e.g. 15-25%), while gains can be taxed at the long term capital gains rate (e.g. 0-15%). the upshot being that even if you make money over the course of several years, you can actually realize negative taxes by taking gains and losses in different tax years. finally, when you decide to retire you might end up paying 0% taxes on your long term capital gains if your income is low enough (currently ~50k$/yr for a single person). the biggest limitation of this strategy is that losses are limited to 3k$ per year. also, this strategy works best when you invest in individual stocks rather than mutual funds, increasing volatility (aka risk). lastly, this makes filing your taxes more complicated since you need to report every purchase and sale and watch out for the "wash sale" rules.

side note: you should contribute enough to get all the 401k matching your employer offers. even if you cash out the whole account when you want the money, the matching (typically 50%-200%) should exceed the 10% early withdrawal penalty.


If you put it in a normal account it is (1) taxed as ordinary income now and then (2) any growth is taxed again at the capital gains rate. Additionally, (3) any dividends will be taxed each year. If you put it in a 401(k), you will only be taxed once, at the ordinary income rate.

Mathematically, if you start with X and have a regular tax rate of t and capital gains rate of g and your investments return r and there are n years to retirement, then your total wealth if you put it in a mutual fund (ignoring annual taxes on dividends) will be

X*[(1-t)*(1+r)^n - g*((1+r)^n-1)]

While if you used a 401(k) it would simply be


The whole g term (along with any annual taxes on dividends) is gone in the second case and that's potentially a lot of taxes. The 401(k) is much better in terms of total wealth unless tax rates dramatically rise between now and when you retire so that the t in the second case is much higher than in the first. This is virtually never the case for people retiring now. Of course, what tax rates the future holds, we do not know.

  • 1
    Gains are taxed only on withdrawal
    – Xalorous
    Commented Aug 30, 2016 at 18:52
  • @Xalorous If you are referring to capital gains tax in a brokerage account, then gains are taxed each time there is a sale. In my math above I have assumed the investments are never sold until they are withdrawn at retirement, so what I have written should be what you were expecting. Let me know if I misunderstood your comment.
    – farnsy
    Commented Aug 30, 2016 at 19:26

Don't forget inflation.

With a Roth 401k (or IRA), you don't pay any taxes on inflationary or real gains. You pay taxes at the beginning and then no more taxes (unless you invest money after you distributed from it).

With a regular, taxable investment account (not a 401k or IRA), you pay taxes on the initial amount. And then you pay taxes on the gains, both inflationary and real. So you effectively pay taxes on the inflated principal twice. Once at initial earning and once when it shows up as inflationary gains. I'll give an example later.

With a traditional 401k (or IRA), you pay no taxes on the initial amount. You pay taxes on the distributed amount. That includes taxes on gains, but it only taxes them once, not twice. All the taxes are paid at distribution time.

Here's a semirealistic example. This is not a real example with real numbers, but the numbers shouldn't be ridiculously off. They could happen. I'm going to ignore variation and pretend that all the numbers will be the same each year so as to simplify the math.

So you pay a 25% marginal tax rate and want to invest $12,000 plus any tax savings.

Roth: $12,000 principal
Traditional IRA (Trad): $16,000 principal with $4000 in tax savings
Taxable Investment Account (TIA): $12,000 principal

Let's assume that you make an 8% rate of return and inflation is 3%. Both numbers are possible, although higher and lower numbers have occurred in the past. That gives you returns of $960 for the Roth and TIA cases and a return of $1280 for the Trad case. Pay no annual taxes on the Roth or Trad cases. Pay 25% marginal tax on the TIA case, that's $240.

Balances after one year:

Roth: $12,960
Trad: $17,280
TIA: $12,720

Inflation decreases the value of the Roth and TIA cases by $360 in the Roth and TIA cases. And by $480 in the Trad case.

Ten years of inflationary gains (cumulative):

Roth: $5354
Trad: $7138
TIA: $4872

Net buildup (including inflationary gains):

Roth: $25,907
Trad: $34,543
TIA: $23,168

Real value (minus inflation to maintain spending power):

Roth: $20,554
Trad: $27,405
TIA: $18,109

Now take out $3000 per year, after taxes. That's $3000 in the the Roth and TIA cases, as you already paid the taxes. In the Trad case, that's $4000 because you have to pay 25% tax which will cost $1000.

Do that for five years and the new balances are

Roth: $9931
Trad: $13,241
TIA: $5973

The TIA will run out in the 8th year. The Roth and Trad will both run out in the 9th year.

So to summarize. The Traditional IRA initially grows the most. The TIA grows the least. The TIA is tax-advantaged over the Traditional IRA at that point, but it still runs out first. The Roth IRA grows about the same as the Traditional after taxes are included.

Note that I left out the matching contribution from a 401k. That would help both those options. I assumed that the marginal tax rate would be 25% on the Traditional IRA distributions. It might be only 15%, which would increase the advantage of the Traditional IRA. I assumed that the 15% rate on capital returns would still be true for the entire period. If that is increased, the TIA option gets a lot worse.

Inflation could be higher or lower. As stated earlier, the TIA account is hit the worst by inflation.


You raise a good point about the higher marginal rates for 401(k) but things will be different, in retirement, than they are for you now.

First off you are going to have a "boat load" of money. Like probably a multi-millionaire. Also your ability to invest will (probably) increase greater than the maximum allowable to invest. For this money you might choose to invest in real estate, debt payoff, or non-qualified mutual funds.

So fast forward to retirement time. You have a few million in your 401(k), you own your house and car(s) outright and maybe a couple of rental properties. For one your expenses are much lower. You don't have to invest, pay social security taxes, or service debt. Clothing, gas, dry cleaning are all lower as well.

You will draw some income off of non-qualified plans. This might include rental real estate, business income, or equity investments. You can also draw social security income. For most of us social security will provide sustenance living. Enough for food, medical, transportation, etc. Add in some non-qualified income and the fact that you are debt free, or nearly so, and you might not need to draw on your 401(k).

Plus if you do need to withdraw you can cherry pick when and what amount you withdraw. Compare that to now, your employer pays you your salary. Most of us do not have the ability to defer our compensation. With a 401(k) you can!

For example lets say you want a new car where you need to withdraw from your 401K to pay for it.

In retirement you can withdraw the full amount and pay cash. Part of this money will be taxed at the lowest rate, part at higher rates. (Car price dependent.)

In retirement you can take a low interest or free loan and only withdraw enough to make the payments this year. Presumably this will be at the lowest rate.

Now you only have one choice: Using your top marginal rate to pay for the car. It doesn't matter if you have a loan or not.

  • "you can cherry pick when and what amount you withdraw" Only until the OP turns 70.5 in which year, Required Minimum Distributions kick in, just as they do for Traditional IRAs. Commented Aug 30, 2016 at 14:46
  • Obviously, but the amount is insignificant in comparison to the assets held. For example, at age 77, you have to withdraw 118K if you have 2.5mil. While 118 is a lot of money, it is small in comparison to likely earnings on the amount held.
    – Pete B.
    Commented Aug 30, 2016 at 14:48
  • Regarding debt payoff, best advice is to put enough in 401(k) to capture full matching from employer, pay your expenses and bills, fund your emergency fund, then anything left pay against the highest interest rate debt. As debts are paid off, their monthly payments go into this pay-down amount. Then when debts are paid, increase contributions in a balance of 401(k) and IRA up to the maximum retirement savings. What's leftover is usable for wealth building, luxuries, vacations, whatever. The goal is to not pay people to use their money, but instead to make your money work for you.
    – Xalorous
    Commented Aug 30, 2016 at 19:37

Be sure to consider the difference between Roth 401K and standard 401K. The Roth 401K is taxed as income then put into your account. So the money you put into the Roth 401K is taxed as income for the current year, however, any interest you accumulate over the years is not taxed when you withdraw the money.

So to break it down:

  • Standard 401K: income + interest taxed as it is withdrawn.
  • Roth 401K: income taxed at current rate, no taxes upon withdrawal. Interest is tax free.

You may also want to look into Self Directed 401K, which can be either standard or Roth. Check if your employer supports this type of account. But if you're self employed or 1099 it may be a good option.


This is an excellent topic as it impacts so many in so many different ways. Here are some thoughts on how the accounts are used which is almost as important as the as calculating the income or tax.

The Roth is the best bang for the buck, once you have taken full advantage of employer matched 401K. Yes, you pay taxes upfront. All income earned isn't taxed (under current tax rules). This money can be passed on to family and can continue forever. Contributions can be funded past age 70.5. Once account is active for over 5 years, contributions can be withdrawn and used (ie: house down payment, college, medical bills), without any penalties. All income earned must be left in the account to avoid penalties. For younger workers, without an employer match this is idea given the income tax savings over the longer term and they are most likely in the lowest tax bracket.

The 401k is great for retirement, which is made better if employer matches contributions. This is like getting paid for retirement saving. These funds are "locked" up until age 59.5, with exceptions. All contributed funds and all earnings are "untaxed" until withdrawn. The idea here is that at the time contributions are added, you are at a higher tax rate then when you expect to withdrawn funds.

Trade Accounts, investments, as stated before are the used of taxed dollars. The biggest advantage of these are the liquidity.

  • A long time, but not forever. Say my 1 yr old grandchild inherits my Roth. And her RMD is based on her life expectancy, 90 or so. That's the life of the inherited IRA. Further beneficiaries don't get to recalculate. The only contrived way to get much longer is for the accounts to keep transferring via marriage and transferred as the younger spouse's account, never treated as inherited. Commented Aug 30, 2016 at 20:06
  • contributions can be withdrawn at any time, not only after 5 years Commented Aug 30, 2016 at 22:31

If you pay 20% tax now and none later or if you pay no tax now and 20% later, it doesn't make a difference. Mathematically, it's the same.

You have to guess about which tax rate (now vs later) will be higher for you in order for you to make the best choice. Predicting tax rates 40 years in advance is hard. Everybody pretends like they can do this accurately.

I would suggest going half and half.

If you have 20k and put half in pre-tax (10k in) and half in post-tax (only 8k in) you end up with 18k total in which is right in the middle of where you would be if you went with the whole 20k in either extreme. It would also leave you owing 2k in tax rather than the possible 4k in tax if you had gone with all pre-tax.

When you split down the middle, you are guaranteed to have 50% in the "right" side, the side with the best outcome.

Being guaranteed to be 50% on the right side is pretty good compared to maybe being 100% on the wrong side.

  • 1
    "If you pay 20% tax now and none later or if you pay no tax now and 20% later, it doesn't make a difference. Mathematically, it's the same." This is patently false. Assume you are deciding whether to put $10k into a 401k, or invest in a non-tax sheltered investment. The investment earns you an average of 5% over 30 years, with a 20% tax rate: Commented Aug 30, 2016 at 16:10
  • If you avoid the 401k, you have $10k to invest for 30 years = 10*(1+.04)^30 = $32k. Note that the growth rate each year is 4%, because 20% of earnings each year are cut off by taxes. If you use the 401k, you get the initial deduction, and all earnings are tax-deferred. So the initial investment is actually 10k/80% = 12.5k * (1+.05)^30 =54k *80% after-tax earnings = 43k. This results in improved earnings of about 30%, between the $32k earned without the 401k, vs the $43k earned with the 401k. Commented Aug 30, 2016 at 16:11
  • Also - while tax rates may change overall, there is a high likelihood that you will earn less in retirement than in your prime working years. Therefore your prime working years will place you in a higher tax bracket than during retirement. So even though tax rates may shift over the next 30 years, all else being equal it is quite likely that being in a lower income bracket in the future will decrease your future taxes. Commented Aug 30, 2016 at 16:14
  • @Grade'Eh'Bacon Gains taxes are only calculated when there is a gain. So if you invest, you pay capital gains tax when you sell or when you receive a dividend. Yes there are cases where activities within a mutual fund creates a taxable event, but in general, you don't pay taxes on investments until you sell, and then only on the gains. In a tax-deferred account, like a 401k, you pay taxes when you sell as well, but the contribution itself is pre-tax.
    – Xalorous
    Commented Aug 30, 2016 at 19:47
  • Retirement savings (by way of 401k) is a way to defer paying taxes now, when your tax rate is higher than when you retire, theoretically. You give up liquidity for a, theoretically, lower tax rate. Also, 100% yearly compounded at X% ROR and then pay 20% is far better than 80% yearly compounded at the same ROR. The longer the compounding period, the more dramatic the difference. It is exponentially better (quite literally).
    – Xalorous
    Commented Aug 30, 2016 at 19:51

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