Choosing Between Pre-tax and After-tax Investing

[ClockWatcher]

Hi Everyone,

I’ve made a few posts already, but didn’t introduce myself here before because I didn’t have any pressing questions to put out to everyone. Now I do: My wife and I have been married for 1 ½ years and are between 8 and 16 years away from retirement depending upon how well our portfolio does and how well we manage our expenses. My wife moved to a higher paying job 2 years ago. The 401(k) plan came with no match and with high fees. My wife and I spoke with management and they initially agreed to implement a low-fee option, but a couple of months later informed us that they were going to revamp the whole program with all new options. This took place at the end of March. We did not expect a match to be added, and none was. My wife’s existing monies were transferred into their lowest cost option, an S&P 500 index fund. What I discovered this weekend, is that while the fees were made very explicit for easy computation, they are even worse than in the prior plan. My wife’s fund comes with a 1.38% annual fee attached!

This morning I put together a spreadsheet comparing pre-tax contributions with a 1.38% fee attached, versus investing in an identical after-tax fund with a .1% fee (I know there are a few funds out there with lower expenses, but I wanted this to be a reasonable match-up). There were some assumptions involved, for example:

(a) Initial investment sum of $40,000
(b) ongoing pre-tax contributions of $17,500,
(c) any monies diverted away from the 401(k) would be taxed at the 28% marginal rate,
(d) 50% of the growth in the taxable fund would be taxed when earned (dividends) while the remainder of the growth would be taxed in a lump sum upon retirement (capital gains), and
(e) monies withdrawn from the 401(k) at retirement would be taxed half in the 15% marginal tax bracket and half in the 25% tax bracket (for an average of 20%).

My spreadsheet became a bit complex, but what I found was that whether at the 8-year mark or the 16-year mark, and regardless of whether I used a growth rate of 5%, 7%, or 9%, the threshold for whether to participate in the 401(k), versus taking a big one-time hit with income taxes and then ongoing smaller dividends and capital gains taxes, was if the 401(k) management fee was greater or less than .87%. To restate, if the annual management fees in the 401(k) are less than .87%, there appears to be benefit to tax deferral. If the annual management fees in the 401(k) are greater than .87%, then it is better to invest in a .1% fee after-tax fund.

Has anyone else calculated this out? What were your results? Is there something you think I might be missing? I welcome your feedback!

 

[growing_older]

I think you are on the right track. When I did a similar exercise, what I also computed was what the annual cost to me of the expensive 401k fees were and used that to help me decide if the company salary was at least that much above what I might make elsewhere. In my analysis, the first few years the 401k, even with higher fees, was still a new positive, but after about 4 years became a strong disincentive to stay at the company.

 

[lemming]

Why in the world does a company do that to themselves? I mean the HCE that runs the company is hit with the same fees, it would be in their best interest to find a better plan.
answer is probably golfing buddy...oops I mean value enhancing network leverage.

 

[urn2bfree]

This is very interesting. I am a spreadsheet ignoramus; it sounds like it was complex anyway. What is the breaking point for those of us in the top tax bracket? Also do I assume correctly that you did reduce the yearly growth in the taxable account by 7.5% (half the growth taxed at 15%) based on the yearly tax on dividends and cap gains in the taxable account in calculating the yields?

 

[sengsational]

You don't talk about what you're doing with your Roth accounts. The general rule is to max out your Roths before a non-matched 401k, regardless of the fees. Only if you had more cash to invest after fully funding both Roth accounts would the decision about the 401k come up.

 

[ClockWatcher]

do I assume correctly that you did reduce the yearly growth in the taxable account by 7.5% (half the growth taxed at 15%) based on the yearly tax on dividends and cap gains in the taxable account in calculating the yields?

Thank you for catching a slip I made! This brings the threshold for breakeven for the fees in my scenario up to 1.25%, not the .87% I calculated earlier.

What is the breaking point for those of us in the top tax bracket?

Using my corrected calculations and throwing in a marginal rate of 39.6% plus the new Medicare tax of .9% for couples earning over $250,000 (for a total of 40.5% and without getting involved with the Alternative Minimum Tax), my spreadsheet gives me a breakeven point of 2.62%, when reducing to the same marginal rates (an average of 20%).

 

[ClockWatcher]

You don't talk about what you're doing with your Roth accounts. The general rule is to max out your Roths before a non-matched 401k, regardless of the fees. Only if you had more cash to invest after fully funding both Roth accounts would the decision about the 401k come up.

My wife and I are both contributing the maximum to our Roth IRAs and to taxable accounts outside of the IRAs and our 401(k)s. I am fortunate to have decent choices in my own 401(k) as well as a small match.

 

[Sarah S]

Another thing you might consider is how long after ER will you need the money. My old 401k has been rolled over and now is an IRA in a lower cost set of funds. I should not need it for some years with luck so it is growing tax free in funds of my choice

 

[ClockWatcher]

Another thing you might consider is how long after ER will you need the money. My old 401k has been rolled over and now is an IRA in a lower cost set of funds. I should not need it for some years with luck so it is growing tax free in funds of my choice

Our plan is to use our pre-tax monies in roughly equal amounts each year, starting from when we retire and ending when we start Social Security, in an effort to minimize taxes. We expect to have ample Roth monies with which to supplement our Social Security income. In this circumstance, the key variable is how long my wife will remain at her job. Because she enjoys her work, and views her boss and co-workers as friends, she may wind up owning these funds for the rest of her career. The longer she owns these funds however, the more damage these fees will have upon our efforts to reach financial independence, even if she continues to choose to work. It is for this reason that I am considering our alternatives now.

 

[seabourne]

I expect that you've already looked, but is there a self-managed option with an annual flat fee?

 

[ClockWatcher]

I expect that you've already looked, but is there a self-managed option with an annual flat fee?

My wife was able to assist me in speaking with the 401(k) plan manager on Tuesday. What he told me was that the reason that the fees had become so much larger with the new plan was because they were now disclosing all of them, as a result of some new law. Previously they had been hidden and only showing up as lower returns which weren’t apparent to me with the rising stock market. The plan manager offered to roll a portion of my wife’s contributions into an IRA, but she is already contributing the maximum to her IRA. There was no other fee structure that was available to her, like a self-managed option.

Part of what he explained to me was that as the total plan assets (AKA the funds from all employees at her company) go above certain thresholds, that the fees would gradually be reduced. What my wife and I decided to do was to cut her contribution from the full $17,500 per year to half that, and contribute the resulting post-tax funds to a low-cost Vanguard fund, in an effort to hedge our bets with regard to getting the better return. When or if the fees are reduced (possibly next year the plan manager said), she will increase her contributions again - should the numbers indicate it is the better investing option.