This morning I did a bit of an apples to oranges comparison of a 401(k) and a high yield savings account, showing that the two would meet two years and two months out given a set of probably unreasonable assumptions. It was apples to oranges because the risk involved in investing in the stock market simply isn’t anywhere near the risk involved in saving money in a high yield savings account . So, I took Anne’s suggestion  and compared a pre-tax account, in this case the 401(k) again, and a post-tax account.
Results? 401(k) never catches up. Despite starting with more money, $133 vs $100, 401(k) can never get over 25% the marginal tax rate + 10% penalty hit that it takes when you extract funds from it (not a loan, a straight up withdrawal). If you plan on pulling out your 401(k) funds to buy a house, don’t put them in there in the first place. Make the minimum contribution to get your match, then put the rest somewhere else.
- Better is defined as the approach that ends up with the most amount of gain.
- You are in the 25% marginal tax bracket.
- Both accounts return 11% a year, or 0.8735% each month, compounded monthly.
- There is no 401(k) contribution match by your employer. An employer match will bring in the breakeven point and raise the value of the 401(k).
The chart below plots the growth of the brokerage account versus the 401(k) account. The value shown is the final extracted value, but growth is based on the non-extracted value. For example, with the 401(k), it’s the pre-tax dollar amount that is being compounded but the graph is showing that value reduced by 35% (25% tax, 10% penalty). The brokerage account line is growing based on its unrealized gains but the value shown is the realized gain, minus long term or short term capital gains. If you’ll notice the little hitch in the purple line at around month 12, that’s because the brokerage account tax rate fell from 25% (short term capital gains) to 15% (long term capital gains).
If you’re interested in the Excel spreadsheet I played with to reach these simplistic conclusions, I’ve made them available here . Please check it out and let me know if you see any mistakes I may have made.