For years we have been advising clients to establish and make the maximum contribution to a Safe Harbor 401(k) Profit Sharing plan. Of course this advice is always tailored to each client’s specific circumstances. Most of our clients have heard this advice enough times from several different sources, that they readily agree to get on board. Recently, however, we were asked to speak at a dental society meeting to a group of 40 dentists and decided to quantify the effects of having a 401k or not.
Some of the general benefits of having a 401k include:
- The ability to setup an automatic savings plan (this is like “auto-flossing” while you sleep).
- The ability to get a current-year tax deduction at a time when we reasonably think you’re in your high earning and therefore high tax bracket years.
- The ability to allow the money to grow tax-deferred, meaning no tax on the income from the investments from year to year, allowing your money to grow unrestrained by taxes
So how does this actually play out in real dollars? To answer this question let’s compare two doctors, Dr. F and Dr. W. They are both 35 years old when they start. Dr. W follows the advice to open and contribute to a 401k plan and invests $71,500 per year into the plan ($53k max for Dr., $18,500 for spouse); Dr. F ignores the advice and decides instead to invest the $71,500 in a taxable account that will give him more control over his money during his working years (i.e. the ability to spend it). Some other facts include:
- They are both in a 35% tax bracket; they are in a 25% tax bracket in retirement
- They both earn a flat 8% investment return, and inflation = 3%
- They both stop working and contributing at age 65; at that time they both start withdrawing $120,000 per year from the account (in today’s dollars; this grows of course with inflation)
What are the big differences? Investor F had to pay taxes on the money at 35% this year and so he had less to invest. Investor F also had to pay taxes on his investment gains at 35%. Investor W didn’t pay any of those taxes, but paid taxes (at the lower 25% rate) upon withdrawing the money. Most importantly, we want to know how much money they both have at age 65? And how long will their money last? And should they be concerned about signing the Giving Pledge (givingpledge.org)?
Here are the cold, hard numbers:
|Dr. W||Dr. F|
|Portfolio value at age 65||$11,965,652||$4,887,730|
|Portfolio value at age 95||$59,323,099||$0|
|When do they run out of money?||Never||Age 89|
What advice would PFG give these two doctors?
Advice to Dr. W: stay the course. Sign up for the “Giving Pledge” (https://givingpledge.org/)
Advice to Dr. F: to quote a good friend of mine who died just short of his 90th birthday, “If you get a chance to die in your 70s, take it.”