401(k) vs taxable account

[futurehermit]

Hello,

As I attempt to become more self-educated and invest for most tax efficiency, I have come upon the seemingly age-old question of what to do after contributing to the employer match to a 401(k) with high (about 1.5%) fees with seemingly decent historic returns (Manning and Napier target date 2050 fund).

Some threads discuss the merits of the tax breaks of 401(k) vs how much is lost to fees.  I have found the rough number of 2% or if the number of years at current employer less than 30.

My wife and I are in the marginal 25% tax bracket.  When looking into taxable accounts, I see that currently there is no long-term capital gains tax on accounts if in the 15% tax bracket.

So I am trying to figure out the math behind investing in a high fee, moderate return 401(K) after contributing to employer match and the amount saved on current income tax, vs. investing in a low-cost, tax efficient index fund, knowing that we will be in the 15% bracket after retirement (if brackets stay the same, inflation adjusted, over the next 20 years).

I also think that there is an opportunity cost somewhere in there from the standpoint of the money in form of taxes saved with investing in 401(k) can be invested now and suffer the miracles of compound interest (and 401(k) fees) whereas after tax money obviously has already had a hair cut.  But, this money, post gubmint hair cut could potentially grow tax free. 

I have found one thread which discusses this, but without the actual math behind it.  (Unless I am missing something obvious and it really is that great of a difference).

Thank you,
Futurehermit

[apdale]

Have you read anything from the Mad Fientist?  http://www.madfientist.com/archives/

He has a lot of info supporting investing in Pre-tax investments and why they make a lot more sense than investing in Post-tax investment vehicles.  As far as math supporting when to invest in 401(k) vs Post-tax a rule of thumb isn't as useful as running the numbers in your situation.  If you're planning to FIRE you would be able to rollover your 401(k) into a tIRA with low fees so that 1.5% hit would only happen during your working years.  You'll never be able to get back the 25% paid to the government in taxes, if you defer taxes you have the opportunity to pay a MUCH lower rate in the future depending on what other income you expect to have.

Can you use excel and run some numbers to see what you might end up on the two different options?  Or are there some numbers you don't know?

[Roots&Wings]

And Bogleheads guidance to help decide whether to invest in the 401k or a taxable account instead:

http://www.bogleheads.org/wiki/401(k)#Expensive_or_mediocre_choices
Even in a bad 401(k), you should contribute up to the company match. Choose the lowest-cost funds; many bad 401(k)'s have a few lower-cost funds. If you are eligible, additional contributions should usually go into a Roth or Traditional IRA. But unless your 401(k) is very bad and you expect to stay a very long time with the same employer, investing unmatched money in the 401(k) is likely to be better than taxable investing, because you can roll over your 401(k) to a low-cost IRA when you leave.

A reasonable rule of thumb is to consider investing in a taxable account if the product of the extra costs and the number of years you will stay in the plan exceeds 30%. That is, if you pay 1.70% expenses rather than 0.20%, you should still invest in the plan unless you are reasonably certain that you will stay with the employer for more than 20 years. The reason is that a long-term investment, even in a tax-efficient stock fund, is likely to lose 30% or more of its value to taxes on the dividends and capital-gains tax when you sell.[15]

[Jeremy E.]

http://jlcollinsnh.com/2013/06/28/stocks-part-viii-b-should-you-avoid-your-companys-401k/

[futurehermit]

Thank you all for the information.  I found the last link especially helpful.  As a follow-up, do 401(k) fees stay active for the life of your account, including following one's retirement?  I am thinking that once we loose the tax benefit of having lower income once we stop accumulating, the fees will further eat the returns, without the tax benefit.

[NoStacheOhio]

Thank you all for the information.  I found the last link especially helpful.  As a follow-up, do 401(k) fees stay active for the life of your account, including following one's retirement?  I am thinking that once we loose the tax benefit of having lower income once we stop accumulating, the fees will further eat the returns, without the tax benefit.

Yes, the fees are the same as long as you keep the account. You aren't required to keep the account though. You can rollover to a traditional IRA with no penalty or tax upon separation (retirement or not). Some plans even allow rollovers while you're still working.

Have you looked at all the fund choices in your plan to make sure you're in the best one for you?

[Zaga]

Thank you all for the information.  I found the last link especially helpful.  As a follow-up, do 401(k) fees stay active for the life of your account, including following one's retirement?  I am thinking that once we loose the tax benefit of having lower income once we stop accumulating, the fees will further eat the returns, without the tax benefit.

Yes, the fees are the same as long as you keep the account. You aren't required to keep the account though. You can rollover to a traditional IRA with no penalty or tax upon separation (retirement or not). Some plans even allow rollovers while you're still working.

Have you looked at all the fund choices in your plan to make sure you're in the best one for you?

Exactly. 

We had the same situation you are in now.  The best fund in DH's 401-K had an ER of 1.41%, and we were in the 25% tax bracket.

In the end he was only at that job for 2 years, and when he switched jobs we rolled his balance over to his rollover IRA with Fidelity; we bought index funds.  So for the fairly small cost of 2 years of the high ER, we saved 25% in taxes on all of his contributions.  That's still a benefit!

The best part is that his new position has great 401-K funds!

[MDM]

And Bogleheads guidance to help decide whether to invest in the 401k or a taxable account instead:

http://www.bogleheads.org/wiki/401(k)#Expensive_or_mediocre_choices
Even in a bad 401(k), you should contribute up to the company match. Choose the lowest-cost funds; many bad 401(k)'s have a few lower-cost funds. If you are eligible, additional contributions should usually go into a Roth or Traditional IRA. But unless your 401(k) is very bad and you expect to stay a very long time with the same employer, investing unmatched money in the 401(k) is likely to be better than taxable investing, because you can roll over your 401(k) to a low-cost IRA when you leave.

A reasonable rule of thumb is to consider investing in a taxable account if the product of the extra costs and the number of years you will stay in the plan exceeds 30%. That is, if you pay 1.70% expenses rather than 0.20%, you should still invest in the plan unless you are reasonably certain that you will stay with the employer for more than 20 years. The reason is that a long-term investment, even in a tax-efficient stock fund, is likely to lose 30% or more of its value to taxes on the dividends and capital-gains tax when you sell.[15]

Might need to clear the cache on your browser. ;)

That rule of thumb now reads: "A reasonable rule-of-thumb is to consider investing in a taxable account if the product of the extra costs and the number of years you will stay in the plan exceeds one and a half times your combined federal and state tax rates on qualified dividends over your working career. "

See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=172808 and http://forum.mrmoneymustache.com/investor-alley/to-401k-or-not-to-401k-that-is-the-question-43459/.

[Roots&Wings]

And Bogleheads guidance to help decide whether to invest in the 401k or a taxable account instead:

http://www.bogleheads.org/wiki/401(k)#Expensive_or_mediocre_choices
Even in a bad 401(k), you should contribute up to the company match. Choose the lowest-cost funds; many bad 401(k)'s have a few lower-cost funds. If you are eligible, additional contributions should usually go into a Roth or Traditional IRA. But unless your 401(k) is very bad and you expect to stay a very long time with the same employer, investing unmatched money in the 401(k) is likely to be better than taxable investing, because you can roll over your 401(k) to a low-cost IRA when you leave.

A reasonable rule of thumb is to consider investing in a taxable account if the product of the extra costs and the number of years you will stay in the plan exceeds 30%. That is, if you pay 1.70% expenses rather than 0.20%, you should still invest in the plan unless you are reasonably certain that you will stay with the employer for more than 20 years. The reason is that a long-term investment, even in a tax-efficient stock fund, is likely to lose 30% or more of its value to taxes on the dividends and capital-gains tax when you sell.[15]

Might need to clear the cache on your browser. ;)

That rule of thumb now reads: "A reasonable rule-of-thumb is to consider investing in a taxable account if the product of the extra costs and the number of years you will stay in the plan exceeds one and a half times your combined federal and state tax rates on qualified dividends over your working career. "

See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=172808 and http://forum.mrmoneymustache.com/investor-alley/to-401k-or-not-to-401k-that-is-the-question-43459/.

Aah! Thanks for the update :) Though interesting to know the evolving history of such guidance.