"Was I Sold a 401k Fallacy?"

401k accounts are one of the most commonly available tools for retirement savings (there are many variations but that's not the point here).

Even when I meet with people who describe themselves as "financially hands off," they more often than not still contribute to their retirement accounts.

One of my clients, I'll call him Ted in this newsletter, is someone who diligently saved the maximum amount allowed from the very early years of his career.

By the time Ted was finally ready to retire, he had plenty saved for a comfortable retirement.

One day, in one of our regular meetings, it felt like Ted really had something on his mind.

He then shared with me what was bothering him by asking "Was I sold a fallacy by contributing so much to my 401k?"

When I asked Ted what he meant, he explained that he never paid so much in taxes throughout his working career.

Even though he had a high paying job, taxes always felt like a reasonable amount.

But now that he has to take his Required Minimum Distributions (RMDs), his tax bills are larger than they have ever been.

Perhaps this issue sounds familiar to at least some of you…

In today's newsletter, I want to dive into this deeper which will hopefully help you better understand your own situation.

So are pre-tax retirement accounts really worth it?

To answer this question, let me walk you through two hypothetical examples that will illustrate the point.

Pre-tax Patrick

To start our deep dive, let's look at "Pre-tax Patrick."

Assume Patrick started maxing out his 401k when he was 30 years old (which is quite an accomplishment on its own)!

In 2026, this is $24,500 of pre-tax income.

In my examples here, I'm going to try to keep things straightforward and say that the market returns an average of 8%.

I'm also not going to adjust for inflation to keep things simple (I know it makes a big difference but not for this comparison).

And to keep things equal in our case study, I’ll say that his employer does not contribute anything to the plan.

So, fast forward to the future. After a long and fulfilling career, Patrick is ready to retire at age 74.

His retirement account, funded entirely with pre-tax funds, is around $8.75M.

Not bad, right?

The following year, when he's 75, he'll need to start taking his RMD, which will be around $350,000 or 4% of the account value and fully taxable.

Now, this doesn't look all that appealing, which is exactly what created the issue with my client, Ted.

But is this really a "bad" outcome?

After-tax Katie

Now let's look at "After-tax Katie."

Katie is also 30 years old and she invests the same amount into her brokerage account that Patrick did, but adjusted for 35% in taxes.

To make it clear, you have to pay taxes on your income before you invest in a brokerage account.

This is, in fact, one of the primary benefits of retirement accounts.

So in 2026 Katie contributes $15,925 into her brokerage account from her after-tax take home pay.

Fast forward to the future. Katie is also ready to retire at age 74.

Under the same market return assumptions but accounting for "tax drag" along the way, Katie's account balance is "only" around $4.1M.

What happened?

Why is Patrick's balance so much higher than Katie's?

There is a concept called "tax drag" and as you hopefully see here, the impacts are quite significant, specifically in the long run.

We have to understand that every year, Katie most likely needed to rebalance her account which generated capital gains and capital gains taxes she has to pay.

There are no such issues with retirement accounts.

There are also taxable dividends and you have to pay taxes on those too.

In my example, I used a 10% portfolio turnover on the average annual balance, and had Katie paying a 15% federal capital gains tax and 8% in Maryland.

So, the bottom line is, Katie paid taxes on the contribution to her brokerage account and then every year when she rebalanced her allocation and received dividends.

It all adds up in the long run…

But what about RMDs?

I know you're thinking about large RMDs, right?

After all, Patrick has to distribute around $350,000/year when he's 75 and Katie doesn't have to distribute anything if she doesn't want to.

But the reality is that Patrick has accumulated so much more than Katie, more than double, that paying more taxes in retirement is still a much better deal in the long run.

Also note that most of the funds inside of Patrick's 401k continue to grow tax-deferred even after he begins his annual RMDs.

Now, here is the part I have to skip in this newsletter.

If you are smart about your tax planning and do things like Roth conversions, you can significantly reduce the tax impacts.

You just need to be proactive about it and know what options are available to you.

What does this mean for you?

If your situation is similar to Ted's and most of your portfolio is in pre-tax retirement accounts (TSP, IRA, 401k or 403b), I hope this newsletter made you feel more positive about the approach you took to save for retirement.

But I want to be clear. Everyone's circumstances are unique and the approach you take would be different from someone in a seemingly similar situation.

In my professional experience, it is quite rare to find a situation where all or the vast majority of investments are in pre-tax accounts, but it is possible.

There are usually at least some funds in brokerage or taxable accounts which can greatly help with planning.

And there are real benefits to post-tax retirement accounts like Roth IRA and Roth 401k too, especially if you expect to be in a similar or higher tax bracket in retirement.

The point is, please be proactive when you think about your retirement and specifically the tax component of it.

Having significant assets is a great accomplishment. So please congratulate yourself for years of hard work and good financial decisions!

But don't stop there. Make sure you have a clear plan to minimize your taxes along the way!