401K vs taxable indexing

[trompowsky87]

Hey All,

At what point does it make sense to invest in taxable accounts rather than keep investing in one's 401k.
To give more detail, let's assume a company match of 3%, and 2% in fees for 401k investments. Do the benefits of tax deferral matter that much? Should I strive to hit the max of $18,500 per year prior to opening a taxable account with vanguard?

I kind of get the impression from reading  the blog that I would be just fine investing completely in a Vanguard Total Stock Market Index fund and not in my 401k.  Let's assume that I don't plan on withdrawing any money for retirement living until age 60 or so.

[johnny847]

I've seen people on the forums link to a spreadsheet that does this kind of comparison, but I don't have it bookmarked. Hopefully someone else will chime in on that.

By your last sentence did you mean you don't plan on withdrawing money from a 401k until 60? Or that you don't plan on retiring until 60. Because if it's the former, you can definitely access your 401k money penalty free before 60: https://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

And another thing you have to consider - how long do you expect to be at your current job? If you're there for a long time, then the compounding nature of fees will at some point take over the tax deferral benefits. However, if we look at one extreme, maybe you only work there for six months whlle you max out the 401k. As soon as you leave you rollover your 401k to an IRA with low cost provider, such as Vanguard. This way you've paid very little in total in fees while still getting that tax benefit. In this scenario it definitely makes sense to use the 401k despite the high expense ratios.

[Eric]

Read this:

http://www.madfientist.com/retire-even-earlier/

Summary:

As you can see, it’s possible to retire over two years earlier, simply by taking advantage of common retirement incentives and tax-advantaged accounts! It’s pretty amazing that he can take years off of an already short working career without earning more, spending less, or taking on any additional risk!

[Cornel_Westside]

Is this 2% in fees actually what you have? Because that's the highest I've ever seen. That's the only real reason you shouldn't max your 401k is fees. As noted above, you can withdraw from your 401k penalty free before 59.5 with a little bit of planning. If you have extra money, your first investment should be a Roth IRA with Vanguard, not a taxable account, as that is also tax advantaged. After that 5500, you can then invest extra in a taxable account.

Check on the actual fee structure and expense ratios for your plan and if it really is that bad, you should talk to an HR person about how much it is costing the company's employees. If no change is possible, remember that you can leave and transfer that money to an IRA and then have access to low expense ratio index funds. You shouldn't necessarily try to leave because of this, but under no circumstances if you do leave should you leave your money in that 401k.

[johnny847]

Read this:

http://www.madfientist.com/retire-even-earlier/

Summary:

As you can see, it’s possible to retire over two years earlier, simply by taking advantage of common retirement incentives and tax-advantaged accounts! It’s pretty amazing that he can take years off of an already short working career without earning more, spending less, or taking on any additional risk!

Eric, I'm not trying to be snarky here. This is a serious question.
Did you read the original post? The OP is specifically asking if a high fee 401k is worth using. One that has 2% in fees. A 2% expense ratio is incredibly expensive. The Mad Fientist post assumes that the 401k fees aren't egregious

Compare these two scenarios:
Scenario 1:
Bob is in 25% marginal tax bracket while working
$18,500 contributed to 401k in year 1. Let's assume Bob earns 80k so the 3% match is an extra $2400. Invested in a US stock index fund, which returns 8% before and 6% after expenses.

After 30 years, the 401k balance is now $120,038. Let's be generous to the 401k scenario assume this is withdrawn over a period of several years at a 10% marginal rate. Then the after tax withdrawals is $108,035.
Even if you want to assume that all of this is withdrawn at 0% through Roth conversions, you'll see that this is still inferior to scenario 2.

Scenario 2:
Bob is in 25% marginal tax bracket while working
To make this comparable with scenario 1, $18500 in pre tax money is $13875 in post tax money. This amount is invested in a US stock index fund which retunrs 8% before and 7.95% after expenses.

After 30 years, the taxable account balance is $137693. This is withdrawn at the 10% marginal income tax bracket, which is the 0% LTCG tax bracket. Hence the after tax withdrawals is $137.693.

With the above assumptions the taxable account is clearly the better choice. However, as I said in my first comment, this implicitly assumes that Bob will remain at his job for 30 years, preventing him from rolling his 401k over to an IRA at Vanguard or similar to reduce the expenses.

ETA: Idk why I chose 18,500 instead of $18k, when the 401k max is $18k. Regardless, it doesn't affect the conclusion

[MDM]

At what point does it make sense to invest in taxable accounts rather than keep investing in one's 401k.

See To 401k or not to 401k? That is the question. for more on this.

[Eric]

Johnny, you need to factor in the 25% tax savings for 30 years on $18k of that $80k income.  You also need to add in more taxes to the taxable account scenario, to account for the fact that his dividends will be taxed for 30 years.

[johnny847]

I think it should be noted that even with egregious 401k fees, getting the match is still worthwhile, even if it means you just withdrawing the money immediately. Unless you've got a marginal tax rate of 70%-80%+, you'll still come out ahead by just paying the 10% early withdrawal penalty

Assume the match is 100% of your contributions, up to 6% in salary:
Contribute $100 to 401k. Get another $100 in match (but it's not subject to payroll taxes). Withdraw all of it. Pay a 10% penalty on the entire withdrawal of $200.
So you've got
$100 of income taxed at your normal income and payroll tax rates
$100 of income taxed at your normal rate
$20 in early withdrawal penalties

Compare that to not using a 401k. You've got
$100 of income taxed at your normal income and payroll tax rate

Unless somehow you've got some weird corner case where you've got a marginal income tax rate of greater than 80%, you come out ahead by getting the match and just withdrawing it right away, despite the penalty.

You can do the same analysis for a 50% match of your contributions up to a salary cap, and you'll get a similar result:
So you've got
$100 of income taxed at your normal income and payroll tax rates
$50 of income taxed at your normal rate
$15 in early withdrawal penalties

Here the breakeven point is a 70% marginal income tax rate.

[johnny847]

Johnny, you need to factor in the 25% tax savings for 30 years on $18k of that $80k income.  You also need to add in more taxes to the taxable account scenario, to account for the fact that his dividends will be taxed for 30 years.

For your first point, I already did that when I compared $18.5k of 401k money to $13875 invested in a taxable account. I didn't compare it to $18.5k invested in the taxable account.

It's true that I forgot about the taxes paid on dividends.
Dividend yield on VTSAX is about 2%. While working, Bob is in the 15% QDI/LTCG bracket. So the reduction in the rate of return is 0.3%.
So I can take $13785 with a 7.65% rate of return, and I get $125,842. The taxable account still comes out ahead

[dandarc]

So only go up to the match if you're tied to the high-fee funds for a long time.  Obvious "early move to low cost fund" is leaving employer and rolling over to an IRA. 

Even if you're staying with the employer for the long term, the high-fee options might not be around the whole time.  You can advocate for better fund options.  Management might get to that conclusion on their own.  Company could be acquired and you get rolled into a better 401K when that happens.  The law might one day require lower-cost funds in all 401Ks (it kinda-sorta does already), compelling management to make a change.

So by not doing the max to the 401K, there is a risk that you're coming out behind down the road, regardless of your time-frame.

[VoteCthulu]

This also doesn't take into account state taxes, which may or may not come into play, as well as complications from social security, etc.

I do agree that 2% fees are highway robbery, of the type that would make me look for a different employer.

[Eric]

Johnny, you need to factor in the 25% tax savings for 30 years on $18k of that $80k income.  You also need to add in more taxes to the taxable account scenario, to account for the fact that his dividends will be taxed for 30 years.

For your first point, I already did that when I compared $18.5k of 401k money to $13875 invested in a taxable account. I didn't compare it to $18.5k invested in the taxable account.

It's true that I forgot about the taxes paid on dividends.
Dividend yield on VTSAX is about 2%. While working, Bob is in the 15% QDI/LTCG bracket. So the reduction in the rate of return is 0.3%.
So I can take $13785 with a 7.65% rate of return, and I get $125,842. The taxable account still comes out ahead

I didn't try to replicate your math at all, but it's clearly way off.  You're compounding for 30 years?  Well $18k x 30 = $540,000 without even factoring in any market gains.  You're hovering at just over $100,000 for both scenarios.

[MDM]

I didn't try to replicate your math at all, but it's clearly way off.  You're compounding for 30 years?  Well $18k x 30 = $540,000 without even factoring in any market gains.  You're hovering at just over $100,000 for both scenarios.

Might want to brush up on the difference between "compounding" vs. "annual contributions". ;)

[johnny847]

I didn't try to replicate your math at all, but it's clearly way off.  You're compounding for 30 years?  Well $18k x 30 = $540,000 without even factoring in any market gains.  You're hovering at just over $100,000 for both scenarios.

Might want to brush up on the difference between "compounding" vs. "annual contributions". ;)

Exactly this.

Eric, I purposely did not create an example where Bob contributes yearly. I constructed one where Bob contributes ONE time, and then lets it ride for 30 years.

Why? Because for the 401k to not make sense, the fees must be a) sufficiently high and b) compounded for long enough. I was only trying to show that it can make sense to avoid the 401k, not that it always should be avoided. It's certainly true that if Bob knows it's likely he's going to switch jobs or retire in the next few years, he should use the 401k despite the high fees.

[Eric]

Okay, I see.  I hope no one works for 30 years to see that happen.

[moof]

Hey All,

At what point does it make sense to invest in taxable accounts rather than keep investing in one's 401k.
To give more detail, let's assume a company match of 3%, and 2% in fees for 401k investments. Do the benefits of tax deferral matter that much? Should I strive to hit the max of $18,500 per year prior to opening a taxable account with vanguard?

2% fees would indicate a HORRIBLE plan.  You'd want to find a way to roll over the balance ASAP.  Fees for me are 0.08% for my 401k plan for reference.  That said...

Assuming a 7% ROR, ignoring inflation, and the 3% match (I'll assume a 100k salary, since I have no idea what you make), 18k in pre-tax money (2017 is $18k max, not $18.5k) you can stomach investing, and a 34% tax rate like I deal with in Oregon I get:

18k into 401k:
Year 10 235k total
Year 20 610k total
Year 30 1.22M total

6k into 401k (to get your match for example), remainder taxed at 34% and put into a taxable:
Year 10 192k total
Year 20 527k total
Year 30 1.13M total

So worse despite the super high 2% fees, but not by much, and you'd have probably lower taxes and much less hassles withdrawing your money due to over half sitting in a taxable account

How about just 0.25% fees and put it all into your 401k, you know, if you don't work for some schlock outfit:
Year 10 256k total
Year 20 738k total
Year 30 1.66M total

So even with very high fees you are better off in a 401k, though with withdrawals being easier and maybe lower taxed with the large taxable chunk it might break even.

With reasonable fees you'll have almost 50% more gross money going the 401k route than the taxable route with my stated assumptions.

My case is about $6k in matching, and thanks to a spousal IRA I can put $23.5k into pre-tax accounts.  I also have lower fees.  I can stomach about $60k a year in pre-tax money to save (working to do better...):
Year 10 673k total
Year 20 1.95M total
Year 30 4.42M total

Saving MORE money is the #1 thing you can do while accumulating.
Avoiding taxes is the #2 thing you can do while accumulating.
Avoiding high fees is most important in the long term.  A few years of high fees will not derail you, but parking money with a high fee brokerage for the long term is potentially fatal for you withdrawal rate.

[johnny847]

Hey All,

At what point does it make sense to invest in taxable accounts rather than keep investing in one's 401k.
To give more detail, let's assume a company match of 3%, and 2% in fees for 401k investments. Do the benefits of tax deferral matter that much? Should I strive to hit the max of $18,500 per year prior to opening a taxable account with vanguard?

2% fees would indicate a HORRIBLE plan.  You'd want to find a way to roll over the balance ASAP.  Fees for me are 0.08% for my 401k plan for reference.  That said...

Assuming a 7% ROR, ignoring inflation, and the 3% match (I'll assume a 100k salary, since I have no idea what you make), 18k in pre-tax money (2017 is $18k max, not $18.5k) you can stomach investing, and a 34% tax rate like I deal with in Oregon I get:

18k into 401k:
Year 10 235k total
Year 20 610k total
Year 30 1.22M total

6k into 401k (to get your match for example), remainder taxed at 34% and put into a taxable:
Year 10 192k total
Year 20 527k total
Year 30 1.13M total

So worse despite the super high 2% fees, but not by much, and you'd have probably lower taxes and much less hassles withdrawing your money due to over half sitting in a taxable account

How about just 0.25% fees and put it all into your 401k, you know, if you don't work for some schlock outfit:
Year 10 256k total
Year 20 738k total
Year 30 1.66M total

So even with very high fees you are better off in a 401k, though with withdrawals being easier and maybe lower taxed with the large taxable chunk it might break even.

With reasonable fees you'll have almost 50% more gross money going the 401k route than the taxable route with my stated assumptions.

My case is about $6k in matching, and thanks to a spousal IRA I can put $23.5k into pre-tax accounts.  I also have lower fees.  I can stomach about $60k a year in pre-tax money to save (working to do better...):
Year 10 673k total
Year 20 1.95M total
Year 30 4.42M total

Saving MORE money is the #1 thing you can do while accumulating.
Avoiding taxes is the #2 thing you can do while accumulating.
Avoiding high fees is most important in the long term.  A few years of high fees will not derail you, but parking money with a high fee brokerage for the long term is potentially fatal for you withdrawal rate.

Moof you can't just compare ending account values. The two scenarios are taxed at different rates. The 401k withdrawals are taxed at normal income tax rates, but the taxable portfolio "withdrawals" are going to be taxed at long term capital gains rates.

Furthermore, for the taxable account, you have to take into account the basis, since you're only paying taxes on the gains, not the entire balance.

[MDM]

For those starting from scratch, to avoid reinventing the wheel, see reply #2 in To 401k or not to 401k? That is the question. for a couple of spreadsheets.

Of course, if you find a mistake in either of those, that would be worthwhile.

[Radagast]

Another consideration is if investing in the 401k would drop you into a lower tax bracket. For example, if you were in 25% but putting money in the 401k dropped you to 15% it would be worth it regardless I suspect (I'm on a math holiday).

[johnny847]

Another consideration is if investing in the 401k would drop you into a lower tax bracket. For example, if you were in 25% but putting money in the 401k dropped you to 15% it would be worth it regardless I suspect (I'm on a math holiday).

No, that would actually be an argument against maxing out the traditional 401k. Think about it. A 401k can make sense despite the high fees because of 1) a match if applicable and 2) the tax benefits.
If contributing $10k drops you from the 25% to the 15%, and then you decide to contribute another $8k, your tax benefit for the last $8k is now 15%, not 25%*. Meanwhile, your 401k fees are still assessed on all of your contributions.

Technically it's the difference between 15% and the tax rate upon withdrawal, but that's not really the point here.

[Radagast]

Another consideration is if investing in the 401k would drop you into a lower tax bracket. For example, if you were in 25% but putting money in the 401k dropped you to 15% it would be worth it regardless I suspect (I'm on a math holiday).

No, that would actually be an argument against maxing out the traditional 401k. Think about it. A 401k can make sense despite the high fees because of 1) a match if applicable and 2) the tax benefits.
If contributing $10k drops you from the 25% to the 15%, and then you decide to contribute another $8k, your tax benefit for the last $8k is now 15%, not 25%*. Meanwhile, your 401k fees are still assessed on all of your contributions.

Technically it's the difference between 15% and the tax rate upon withdrawal, but that's not really the point here.

Definitely investing the first $10k to get down to 15% tax rate is best. After that it depends on the other assumptions. But lets use an example of investing $16k in taxable at 25% plus $2k in the 401k, compared to investing 18k in the 401k with a 15% marginal rate which you don't take advantage of. It isn't clear to me that taxable is better.

(I'm on a math holiday).

Anyhow, this is the sort of thing people have filed lawsuits over and won, so you have a good chance of persuading the company to find a lower fee option.

[johnny847]

Another consideration is if investing in the 401k would drop you into a lower tax bracket. For example, if you were in 25% but putting money in the 401k dropped you to 15% it would be worth it regardless I suspect (I'm on a math holiday).

No, that would actually be an argument against maxing out the traditional 401k. Think about it. A 401k can make sense despite the high fees because of 1) a match if applicable and 2) the tax benefits.
If contributing $10k drops you from the 25% to the 15%, and then you decide to contribute another $8k, your tax benefit for the last $8k is now 15%, not 25%*. Meanwhile, your 401k fees are still assessed on all of your contributions.

Technically it's the difference between 15% and the tax rate upon withdrawal, but that's not really the point here.

Definitely investing the first $10k to get down to 15% tax rate is best. After that it depends on the other assumptions. But lets use an example of investing $16k in taxable at 25% plus $2k in the 401k, compared to investing 18k in the 401k with a 15% marginal rate which you don't take advantage of. It isn't clear to me that taxable is better.

(I'm on a math holiday).

Anyhow, this is the sort of thing people have filed lawsuits over and won, so you have a good chance of persuading the company to find a lower fee option.

I don't know if you're trying to disagree with me or not. I said dropping tax brackets would be an argument against maxing out the traditional 401k. So I agree that the first $10k is better than the last $8k.

I don't understand why you're trying to compare $16k in taxable at 25% plus $2k in the 401k vs $18k in the 401k at 15%.
1) $16k in the taxable costs you $21.3k in pre tax dollars at a 25% marginal rate. Or did you mean $16k in pre tax dollars into a taxable, which would actually mean $12k into the taxable?
2) Why the heck are you comparing these at two different tax rates?? If you're trying to compare taxable vs 401k, and someone is avoiding taxes at 15% by contributing $18k into a 401k, then they're not going to be paying taxes at 25% on the dollars they contribute to a taxable. They're going to be paying taxes at 15%.

[moof]

 
Moof you can't just compare ending account values. The two scenarios are taxed at different rates. The 401k withdrawals are taxed at normal income tax rates, but the taxable portfolio "withdrawals" are going to be taxed at long term capital gains rates.

Furthermore, for the taxable account, you have to take into account the basis, since you're only paying taxes on the gains, not the entire balance.

Taxes will not be 30% for a frugal retirement.  I expect for my withdrawal plans to be well under 10% tax rate on the back end.  I acknowledged that a taxable stache is more flexible for sure.

The OP asked a very general question, and I answered using a rough approximation of my situation to fill in the blanks.  401k wins unless you come up with contrived circumstances.

[MoonLiteNite]

1% can make a world of difference.
Even with crazy high fees i would suggest you do that, unless the stress and though of an IRA ladder or other early withdraw strats really stress you out

[johnny847]

 
Moof you can't just compare ending account values. The two scenarios are taxed at different rates. The 401k withdrawals are taxed at normal income tax rates, but the taxable portfolio "withdrawals" are going to be taxed at long term capital gains rates.

Furthermore, for the taxable account, you have to take into account the basis, since you're only paying taxes on the gains, not the entire balance.

Taxes will not be 30% for a frugal retirement.  I expect for my withdrawal plans to be well under 10% tax rate on the back end.  I acknowledged that a taxable stache is more flexible for sure.

The OP asked a very general question, and I answered using a rough approximation of my situation to fill in the blanks.  401k wins unless you come up with contrived circumstances.

Moof, I agree with you that taxes will not be 30% for a frugal retirement. But you can't just leave that out entirely. Flexible, at least not to me, doesn't mean "lower taxes". You have to at least acknowledge that the taxes will be different.

Furthermore, you're assuming that the OP is actually Mustachian. We don't know that. Considering this is the OP's only post, we have no post history to go on.

I already showed an example where the 401k loses. For a non mustachian, it's not as contrived as you'd think for a person to work at a company for long enough that the high fees kill the 401k tax advantage.