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Saving For A House: 401(k) vs. High Yield Savings
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When it comes to saving for a house, is it better to contribute pre-tax into a 401(k) and withdrawing it (taking the 10% penalty) or contribute it post-tax into a high yield savings account? The trade off is that a 401(k) will grow more, start with a bigger pot, but take an extra 10% hit on the way out. A high yield savings account starts with a smaller balance, takes an earnings tax each year, but doesn’t face a 10% penalty at the end. According to my analysis, after three years of growth, contributing to a 401(k) comes out 6% ahead compared to a high yield savings account (my assumptions and an explanation of my analysis to follow). The break-even point is at around two years and two months.
What does this mean? If your sole concern is saving and earning the most to put down towards a house, with no consideration towards retirement, then contribute to your 401(k) if your target date is at least two years and two months into the future. I believe that to be short-sighted because retirement is far more important than whether you own or rent, but that’s a decision you have to make. *One other option to consider is that you can contribute to a 401(k) and then borrow from it at prime + 1-2%, so these are by no means the only two options you have.
Assumptions
- Better is defined as the approach that ends up with the most amount of short term gain, this analysis gives no consideration towards retirement goals, which I believe is far more important than buying a home.
- You are in the 25% marginal tax bracket.
- The 401(k) would return 11% a year, or 0.8735% each month, compounded monthly.
- The High Yield Savings would return 4.75% a year, or 0.3875% 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).
Explanation of Approach & Spreadsheet
I assumed that you would contribute $100 in the beginning of January (once) to your high yield savings account and you would contribute $133.33 to your 401(k), that’s the pre-tax equivalent of $100 if you are in the 25% marginal tax bracket.
Pretty Charts!
The chart below compares the growth between the high yield savings account and the 401(k). You’ll notice the dips at the end of each year in the HYS, that’s when income tax is levied on the interest earnings. The 401(k) line reflects the post-tax value of the 401(k) balance, that is after a 25%+10% reduction (25% marginal tax rate, 10% penalty). The 401(k) growth is calculated using its pre-tax value but the chart is charting it’s post-tax and post-penalty value. You can see that the lines intersect around the 2 year, 2 month point (X-axis 25 or 26), when income tax is levied on the HYS.
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.
{ 7 comments, please add your thoughts now! }
You’re not accounting for risk at all here. Sure, in an ideal scenario the 401k might come out ahead, but over a short-term time frame like 2-3 years the returns are volatile.
For example, the S&P 500 from 2002 to 2004 returned around -6%. Sure, you could get lucky like from 2005 to 2007 where it returned almost ~17%, but is that a risk you’re willing to take? Taking the average in this case isn’t realistic because you’re not using a long enough time span.
The reason 401ks work for retirement is because of the long time horizon. Trying to leverage that for a short-term gain is akin to trying to time the market. My money would go into either a High Yield savings, or a CD. Given that you’d have a time frame in mind for when you wanted the funds available, I’d most likely opt for the CD.
I agree with risky business. You are comparing apples to oranges. You shouldn’t compare a deposit account to a 401(k) invested in stocks–you should compare a stock portfolio held outside of a retirement account to one held within a retirement account.
I agree with risky business too, I merely wanted to show the math for those who were thinking about it. I outlined the assumptions too, that 11% return from the market would be up against a 4.75% high yield account, I think 11% return from the market each year over a two or three year span is unreasonable and risky business pulled out the historical data to prove it.
I wrote the post because I have friends who are considering this and even though I’ve tried to dissuade them from doing this for the retirement reasons, showing the ideal conditions having a horizon of 2 years is enough to dissuade most that this is a bad idea.
I still think you are conflating two concepts and by doing that, you are actually making the 401(k) approach look more attractive than it really is.
There are two issues. The first issue is, how much risk is acceptable for short-term savings? Most people agree that short-term savings should be invested with little risk.
The second, and totally independent, issue is whether it makes sense to put pretax money in a 401(k) knowing that you are going to need it in the short term and will incur penalties for early withdrawal. I think, if you run the numbers, it would be a long time before the small additional compounding due to the pretax growth would make up for the 10% hit.
So IMO, the first thing to do is to bust the myth that there’s any advantage to the 401(k) route vs. investing in stocks outside of a 401(k). And then the second step is to explain why investing in a risky portfolio is not a good idea for the short term.
at a base line, for your friends who are clearly not as proficient as you, you should probably be comparing similar investments. If you use 11% in the 401k, then use 11% for a taxable investment account, or vice versa. I agree with everyone else, that using 4% in one and 11% in the other doesn’t make any sense.
Anne, John: That is a good point about comparing two things of differing risk and one that I never brought up when it came to discussing this with my friends. I thought the 10% penalty would be enough of a deal breaker (it still is, it’s just not a deal breaker if everything goes swimmingly over the course of two years+2 months).
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