You don’t always save money by putting your investments into a 401(k).

When you invest money inside a 401(k), you don’t have to pay taxes on any returns earned by your investments. But you also have to pay a fee to your 401(k) provider.

  • If you buy and hold index funds in a taxable account, you don’t have to pay any capital gains tax on price increases until you sell.
  • In a 401(k), the annual fee adds up every year and may eventually exceed the tax savings.

So the taxes cap out at the capital gains tax rate (15% or 20% depending on your tax bracket),1 whereas the expenses of a 401(k) continue to accumulate.

However, in a taxable account, you do still have to pay taxes on dividends (and bond payouts) every year, and those taxes might cost you more than the 401(k) fees.2

Below is a calculator to determine how many years before the 401(k) fees exceed the tax savings, if ever.

employer matching (%)
total investment return including dividends (nominal) (%)
dividend yield (%)
401(k) fee (%)
capital gains tax rate (%)
income tax rate today (%)
income tax rate in retirement (%)

A 401(k) falls behind a taxable account after:

This calculator assumes you buy index funds and hold them forever. If you trade stocks within a taxable account, you have to pay taxes every time you make a trade.

Something else to consider: If you quit your job, your old employer’s 401(k) provider will let you roll your 401(k) into an IRA. You don’t have to pay any fees on an IRA.3 So even if the 401(k) fees exceed the tax benefits after (say) 30 years, that’s not a problem if you expect to quit your job after less than 30 years. Realistically, few people stay at one job for so long that the 401(k) fees exceed the tax savings.

(If you change jobs, usually you can roll your old 401(k) into your new 401(k), but I wouldn’t do that because it means you have to keep paying 401(k) fees. It’s almost always better to roll your old 401(k) into an IRA.)

Notes

  1. The capital gains tax will always be less than 15%/20% of your account value (depending on which tax bracket you’re in), but it converges on 15%/20% as the value approaches infinity.

    Example: If you invest $100 in an index fund and you sell when the price reaches $101, you have to pay 20% of $1 (assuming you’re in the 20% tax bracket), which is only 0.2% of the total value. If you sell when the price reaches $1 million, you have to pay 20% of $999,900, which is 19.998% of the total value. ↩

  2. H/T Ben Kuhn for raising this possibility. I’m sure someone somewhere had considered it before him, but I’ve never seen anyone else bring it up, and standard financial advice ignores it. ↩

  3. Other than ETF/mutual fund fees, but you have to pay those no matter what. ↩