Here is a quick question to consider: which retiree would you rather be?  Assume that both accounts hold identical investments and that each retiree spends the same amount each year.

  • Retiree A has a $5 million account to fund retirement
  • Retiree B has a $4 million account to fund retirement

We suspect that most people might prefer to be “Retiree A.”  But, wait….

  • Let’s assume that “Retiree A’s” $5 million account is a traditional 401k (or, IRA).
  • Let’s assume that “Retiree B’s” $4 million account is a traditional brokerage account and that it has cost basis of $3.5 million. Cost basis means that Retiree B paid $3.5 million for the securities; thus, this account has an embedded gain of $500,000.

People often forget that they have not yet paid taxes on their 401ks.  (Taxes on a traditional 401k are paid when distributions are made from the account and are paid at ordinary income tax rates.)

For the sake of a simple example, let’s look at the maximum amount each retiree could go spend immediately – in other words, let’s assume that each retiree “cashed in” their entire account on day one of retirement.

  • Retiree A would cash out $5 million. He could likely owe about 45% in Federal and state taxes (the 401k distribution would place him in the highest bracket). Thus, he’d pay about $2.25 million in taxes, and he’d be able to spend $2,750,000.
  • Retiree B would cash out $4 million. She could likely owe a maximum of about 25% in Federal and state taxes (capital gains).  But, that would only apply to the gain on the securities!  Thus, the $500,000 gain might trigger about $125,000 in taxes. Thus, she’d have $3.875 million left to spend!

Without question, saving into a 401k is a great thing to do for many reasons:

  • Tax savings in the years that you make contributions (pre-tax contributions)
  • The opportunity for employer matching
  • Tax deferral on the interest, dividends and growth of the account
  • Systematic and disciplined way to dollar-cost-average your investments

While your Traditional IRA will be subject to Required Minimum Distributions, having a mix of Traditional IRA, Roth IRA, and Brokerage accounts during retirement affords you maximum flexibility to manage your taxes and cash flow needs. While we encourage clients to utilize (and typically maximize) their 401k opportunity, it’s also important to fund a traditional brokerage account when planning for retirement. Doing so provides the flexibility to access money from an account that is not subject to full (ordinary) income taxes in retirement.