Can a Taxable Account Beat a 401(k)?

Being advised to max out your 401(k)is Personal Finance 101. But is that universally solid guidance?

Tax-sheltered retirement plans offer the convenience of automatic investments and tax breaks—pretax contributions and tax-deferred compounding for traditional 401(k)s and tax-free compounding and withdrawals for Roth contributions.

But the availability and quality of the 401(k) are also important considerations.

Some workers don’t have access to an employer-provided retirement plan, and 401(k) quality can be uneven. High administrative costs, meager employer matching contributions, and costly investment lineups can detract from 401(k)s’ tax-saving features.

Meanwhile, the tax efficiency for investors’ nonretirement accounts has improved over the years.

Broad market equity exchange-traded funds have dramatically reduced the tax drag for taxable accountholders, effectively simulating the tax deferral that comes with investing in a 401(k). And many robo-advisors use other techniques to reduce the tax drag on investors’ taxable accounts—specifically, selling losing positions to offset gainers elsewhere in investors’ portfolios. That can reduce the capital gains taxes on positions when they’re eventually liquidated.

Even as investing in a taxable account has grown more attractive, it’s a given that investors should put enough in a 401(k)—even a poor one—to earn matching contributions. If the 401(k) plan is weak and they have additional retirement assets to invest, they should opt for an IRA in lieu of steering more money to the poor 401(k) plan. Income limits apply to IRA contributions, but anyone can invest in a Roth IRA through the “backdoor,” provided they have earned income to cover the contribution amount.

Multiple Factors Determine Whether a Taxable Account Can Beat a 401(k)

But what if they have additional retirement assets to invest? Once the IRA is fully funded, would those dollars be better off in a weak 401(k) or in a brokerage account held outside a tax-sheltered account?

The answer here, as with so many financial questions, depends on a couple of key factors, especially the following:

1. 401(k) plan quality: How bad is the plan? Does it have high administrative costs and subpar and/or expensive investment options? Or is it simply that the lineup includes some lackluster funds that are past their prime? Comparing your plan to others can help you make that assessment.

2. The quality and tax efficiency of the investments in the taxable accounts: Investing in a taxable account will rarely be the better option unless you can invest in securities that make few ongoing distributions of income, capital gains, or both. The good news is that investors can opt for a brokerage platform that offers a good array of low-cost, tax-efficient options—namely, index-tracking ETFs and municipal-bond funds.

3. The investor’s tax bracket at the time of the contributions: Being able to make pretax contributions—as is the case with traditional 401(k)s—will be more valuable to the investor who’s in a high tax bracket at the time of that contribution than it will be to the person who’s in a lower tax bracket.

4. The tax bracket at the time of withdrawals: Withdrawals from taxable accounts receive more favorable (and flexible) tax treatment than withdrawals from traditional 401(k)s. Investors pulling from their taxable accounts will owe capital gains taxes, whereas money coming out of a traditional 401(k) is taxed at the investor’s ordinary income tax rate, which is higher. Moreover, because the 401(k) money has never been taxed, investors owe taxes on the entire withdrawal, not just the appreciation; taxable-account investors, by contrast, will only owe tax on their gains. Finally, 401(k) assets are subject to required minimum distributions at age 73. For investors who expect to be in a high tax bracket upon retirement, having assets in a taxable account—and enjoying more favorable taxation on the distributions—will be particularly beneficial. (Of course, Roth 401(k) withdrawals are more favorable still: Roth 401(k) assets can be rolled over to a Roth IRA to avoid RMDs. Better still, qualified withdrawals from Roth 401(k)s and IRAs are tax-free.)

Taxable Account vs. 401(k) Takeaways

Investors would do well to weigh their own personal tax situations—both current and future—as well as the quality of their 401(k)s when determining which account types to fund. Investors can also benefit from tax diversification—splitting assets across accounts with varying tax treatment, whether tax-deferred, taxable, or Roth—when saving for retirement.

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This article was provided to The Associated Press by Morningstar. For more personal finance content, go to https://www.morningstar.com/personal-finance

Christine Benz is Morningstar’s director of personal finance and retirement planning.