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.
- 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.
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.