401k (high expense ratio) vs. Non-Tax deferred account (low expense ratio)

[Mike54]

Hi,

I'm wondering which is better:

1) 401k Index fund offers a 0.5% price ratio.
2) A similar index fund outside the 401k offers a 0.05% price ratio.

Let's say the tax bracket is 25% and the goal is to invest 30+ years.

Is there a clear answer which option is better?
What are some factors that could make one option better than the other? Approximately, how much would these factors have to change?

IRA and 401k matching employer contribution is already maxed out.

Thank you

 

[growing_older]

Unless you have a very unusual career, any one employer's 401k plan is temporary. On changing jobs, any funds in a 401k can be rolled over to an IRA of your choice, capturing those better expense ratios. In the meantime, while still enrolled in the 401k, the tax advantage and any match usually more than make up for the poor expense ratios.

On balance, that 0.5% is not bad for a 401k. I'd snap it up if I were you.

 

[pb4uski]

It all depends on your current marginal tax rate and your tax rate when you withdraw from the 401k. The conventional wisdom is that if you are working now and are, for example, in the 25% bracket that for every $100 of 401k savings you are also saving $25 in tax and if you are in a lower tax bracket when you withdraw from the 401k, say 15%, you'll pay $15 for each $100 withdrawn and will have in effect saved $10 in tax as a result of saving through the 401k compared to a taxable account.

 

[kaneohe]

some results to start you thinking: the format didn't come out like the preview but
hopefully you can make sense of it. The table is 2x2 with 8% results in the first column and 12% results in the second.

Gross Return
8% 12%

Time

30yr 0.979 0.965


16yr 0.955 0.933


The numbers in the table are the ratio of the aftertax results of the taxable account to the 401K. The gross return is the annual return before the expense ratio. The assumptions are 25% ordinary income tax rate for both contribution and withdrawal for the 401K and 15% LTCG tax rate for the taxable fund with all LTCG at the end of the time period shown. Note that the ratio in the range shown is < 1.0 which means that the 401K is larger (aftertax) than the taxable account which means the tax deferral of the 401K dominates the higher net annual return of the taxable account.
The table suggests that the 401K is relatively more favorable at higher rates/shorter times and the taxable account is relatively more favorable at lower rates/longer times.

The obvious variables are the tax rates at contribution and withdrawal times, the gross return of the fund and the time period. As mentioned by
pb4uski, if the tax rate at withdrawal is lower, the 401K return is even more favorable.

 

[Finance Dave]

Hi,

I'm wondering which is better:

1) 401k Index fund offers a 0.5% price ratio.
2) A similar index fund outside the 401k offers a 0.05% price ratio.

Let's say the tax bracket is 25% and the goal is to invest 30+ years.

Is there a clear answer which option is better?
What are some factors that could make one option better than the other? Approximately, how much would these factors have to change?

IRA and 401k matching employer contribution is already maxed out.

Thank you

I think you're mixing two variables.
1) Whether the 401k is better than a fund outside the 401k, regardless of the fees, depends on your assumption about tax rates and your income both before and after you retire. If your income is exactly the same, and tax rates are exactly the same, then there is no difference.

2) As for the fees, lower is better assuming all other things equal...but is it true that all else is equal? What about service? Financial stability of the company? Website better on one vs. the other?

In general, I think it's best to have money in both types of accounts, tax-deferred and otherwise. So I'd recommend 401k up to the match point, then the rest in a Roth or other account outside the 401k...absent of knowing any more about your situation.

 

[pb4uski]

.....In general, I think it's best to have money in both types of accounts, tax-deferred and otherwise. So I'd recommend 401k up to the match point, then the rest in a Roth or other account outside the 401k...absent of knowing any more about your situation.

I would agree if accumulation and withdrawal marginal tax rates are similar, but for most people accumulation phase marginal tax rates will be higher than withdrawal phase tax rates - which would favor the tax-deferred investment (401k).

 

[Finance Dave]

I would agree if accumulation and withdrawal marginal tax rates are similar, but for most people accumulation phase marginal tax rates will be higher than withdrawal phase tax rates - which would favor the tax-deferred investment (401k).

You're focusing more on the income side, which I would agree with. I was pointing out the debt situation in our country, and the potential for average tax rates to be increased to pay off that debt.

In my case, I'm betting my taxes will be higher in retirement, even at a lower income level...but only time will tell. That's why having some money in both buckets makes sense to me....gives me the flexibility to manage the withdrawals by bucket.

 

[thefinancebuff]

Unless you have a very unusual career, any one employer's 401k plan is temporary. On changing jobs, any funds in a 401k can be rolled over to an IRA of your choice, capturing those better expense ratios. In the meantime, while still enrolled in the 401k, the tax advantage and any match usually more than make up for the poor expense ratios.

On balance, that 0.5% is not bad for a 401k. I'd snap it up if I were you.

Exactly. The rule of thumb breakeven is the difference in expenses times the number of years equals to 30. If the expense in the 401k is higher by 2% and you are working for that employer for no more than 15 years, then you are better off investing in the 401k as opposed to in a taxable account. Here the OP's expense difference is only 0.5%.

 

[FinanceDude]

What is the match on the 401K??

 

[Animorph]

I think you're mixing two variables.
1) Whether the 401k is better than a fund outside the 401k, regardless of the fees, depends on your assumption about tax rates and your income both before and after you retire. If your income is exactly the same, and tax rates are exactly the same, then there is no difference.

Wait, no difference between a taxable account and a 401k account if marginal rates in and out are the same? Sounds like a mash-up with Roth versus traditional. Those are almost equivalent with equal tax rates in and out, though you can stash more value in the Roth. So all things equal favors the Roth.

As far as taxable versus 401k/IRA, with tax rates equal in and out, all of the otherwise taxable growth within the 401k/IRA is untaxed. That's the benefit. Clearly that is true for a Roth versus a taxable account. And the math works the same for the traditional 401k as well.

So if the portfolio just sits in the 401k with the extra 0.45% ER and gains nothing for 10 years (no additional contributions), you've saved nothing in taxes and paid about 4.4% in extra fees. Should have been in a taxable account.

If the portfolio gains a little over 7% per year in both accounts for 10 years, you've doubled your value in the 401k. But lets say you make 0.45% less due to the extra ER. Instead of doubling you get 1.918x (subtracting 0.45% from the yearly gains). With a tax rate of 15% you end up with 1.918 * 0.85 = 1.63x your original contribution. Your taxable account starts with 0.85 of taxed income, doubles it to 1.7 in 10 years, and then pays capital gains taxes on the 0.85 gains. Say that's 15% still, you have to pay 0.85 * 0.15 = 0.1275 capital gains tax. You net 1.7 - 0.1275 = 1.5725, compared with 1.63 using the 401k. Should have been in the 401k in this scenario.

Somewhere in between 0% growth and 7% growth (and various possible tax rates) is the happy medium where the taxable and 401k with extra ER come out equal.

 

[Finance Dave]

Wait, no difference between a taxable account and a 401k account if marginal rates in and out are the same? Sounds like a mash-up with Roth versus traditional. Those are almost equivalent with equal tax rates in and out, though you can stash more value in the Roth. So all things equal favors the Roth.

Ah, you are right....getting my accounts mixed up lol.

 

[Mike54]

Thank you for all the answers!

On changing jobs, any funds in a 401k can be rolled over to an IRA of your choice

Is that true even if the new employer offers its own 401k plan? That is, can the old 401k be rolled over into an IRA (and maintaining all it's tax advantages). Is it possible to start a brand new 401k with the new company even though the old 401k was rolled over into a IRA?

The table suggests that the 401K is relatively more favorable at higher rates/shorter times and the taxable account is relatively more favorable at lower rates/longer times.

Exactly. The rule of thumb breakeven is the difference in expenses times the number of years equals to 30. If the expense in the 401k is higher by 2% and you are working for that employer for no more than 15 years, then you are better off investing in the 401k as opposed to in a taxable account.

Somewhere in between 0% growth and 7% growth (and various possible tax rates) is the happy medium where the taxable and 401k with extra ER come out equal.

All three answers are spot on.
With the suggestions provided in this thread I did my own calculations comparing Roth 401k vs. Private Investing.

Maxing out the Roth 401k first seems to be the way to go, especially if it is possible to roll it into a Roth IRA when changing employers.

On a side node: Does anyone know if a change in legislature is in the talks that would allow people to decide on their own how to divide funds in IRA and 401k as long as it doesn't exceed the total maximum contribution limit? It never made any sense to me that it is not possible to opt out of the 401k and put that money into an IRA.

 

[LOL!]

Thank you for all the answers!


Is that true even if the new employer offers its own 401k plan? That is, can the old 401k be rolled over into an IRA (and maintaining all it's tax advantages). Is it possible to start a brand new 401k with the new company even though the old 401k was rolled over into a IRA?

Yes, this is true.

All three answers are spot on.
With the suggestions provided in this thread I did my own calculations comparing Roth 401k vs. Private Investing.

Maxing out the Roth 401k first seems to be the way to go, especially if it is possible to roll it into a Roth IRA when changing employers.

On a side node: Does anyone know if a change in legislature is in the talks that would allow people to decide on their own how to divide funds in IRA and 401k as long as it doesn't exceed the total maximum contribution limit? It never made any sense to me that it is not possible to opt out of the 401k and put that money into an IRA.

It would be very unusual for a Roth 401(k) to make sense over a traditional 401(k). See also: Traditional versus Roth - Bogleheads

My spouse was in a very expensive traditional 401(k) with expense ratio of about 2% annually. She was able to take out a 401(k) loan and save money by investing outside of the 401(k) while keeping the 401(k) intact. Then she was able to rollover the 401(k) to a low-fee IRA when she changed employers. So I think a 0.5% 401(k) expense ratio is heavenly.

 

[growing_older]

Does anyone know if a change in legislature is in the talks that would allow people to decide on their own how to divide funds in IRA and 401k as long as it doesn't exceed the total maximum contribution limit?

I am aware of no such proposal and it seems unlikely that that would be proposed. There have been a few proposals to scrap the whole 401k/IRA/403b/... and replace them all with a unified account, but that seems to have very few proponents. Much more likely are proposed rule changes to limit 401k fund options and/or encourage annuitization. As far as I know, none are far enough along or showing enough support to realistically want to adapt plans in case they do get passed.

 

[Bruce]

When considering marginal rates, don't forget about state taxes also, here in Rhode Island the marginal tax rate on most income is 3.75% or 4.75%. If you retire to a low or no tax state, you never have to pay the state tax man (or woman )!

 

[Mike54]

It would be very unusual for a Roth 401(k) to make sense over a traditional 401(k). See also: Traditional versus Roth - Bogleheads

I can't thank you enough for this link. I guess I should be contributing to a 401k till I hit the 15% marginal tax rate and then put whatever is left to a 401k Roth / Roth IRA.

When considering marginal rates, don't forget about state taxes also, here in Rhode Island the marginal tax rate on most income is 3.75% or 4.75%. If you retire to a low or no tax state, you never have to pay the state tax man (or woman )!

I was considering a Roth, because I currently live in an income tax free state and might retire in a state that charges income tax. I'm also expecting taxes to go up.