Author Topic: At what point do 401k contributions stop making sense  (Read 7963 times)

BallardStubble

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At what point do 401k contributions stop making sense
« on: February 26, 2016, 12:52:58 PM »
Hi everyone!

My 401k account currently averages an expense ratio of 1.05%. Not the greatest, but pretty average from what I've seen. This is my concern though; the lifetime average returns on all sensible investments (index funds) average between 5-6%. My employer doesn't do matching, but rather contributes 3% of my salary, regardless of whether I choose to invest in the program. I have full intentions of taking out a traditional IRA account from Vanguard and maxing it out for both my wife and myself at $11k annually. Would it make sense for me to also max out my 401k at a 1.05% ER and 5-6% average returns if I can invest in a taxable account with higher returns and lower ER?

An answer to that would be nice, but I'm mainly curious to know this. At what combination of ER and lower returns would you consider as reason to go fully taxable (save the $11k that would go into a traditional IRA)? I'm in the 15% tax bracket now and intend to be in the 15% tax bracket when I retire (although shooting for 0% through the Roth conversion ladder :)).

Thanks!

FerrumB5

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Re: At what point do 401k contributions stop making sense
« Reply #1 on: February 26, 2016, 12:56:46 PM »
I'd say - put as much as you can into 401k as every dollar you put in is 15% less at least in AGI. I'm doing both 401k as much as I can (not maxing) + taxable Vanguard (for a reason)

BallardStubble

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Re: At what point do 401k contributions stop making sense
« Reply #2 on: February 26, 2016, 01:13:16 PM »
I'm confused and probably not understanding correctly. If you're advocating maxing a 401k, and just acknowledged you aren't yourself, why are you investing in taxable accounts when you haven't maxed out your 401k contributions yet?

Seppia

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Re: At what point do 401k contributions stop making sense
« Reply #3 on: February 26, 2016, 01:17:34 PM »
Do the math: does the reduced taxation (in the upper tier) compensate for the much higher fees?
My guess would be yes but it's relatively simple numbers

FerrumB5

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Re: At what point do 401k contributions stop making sense
« Reply #4 on: February 26, 2016, 01:17:43 PM »
You understood me correctly. I'm investing in taxable at the time I'm not maxing 401k because I need liquid money in next couple of years. If market goes up or stays - it's a win. If market goes down, I'll bite the bullet. It's that simple.

ShoulderThingThatGoesUp

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Re: At what point do 401k contributions stop making sense
« Reply #5 on: February 26, 2016, 01:28:19 PM »
Can you rebalance to better fees? What's the lowest-fee fund available in your account? Mine has a general US one with a 0.02% ER. You can alter your taxable allocation to fit with the optimal fee structure in your 401k.

BallardStubble

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Re: At what point do 401k contributions stop making sense
« Reply #6 on: February 26, 2016, 01:52:49 PM »
Lowest fee is .79% annually but the average returns don't compensate for the 20 basis point reduction.

BallardStubble

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Re: At what point do 401k contributions stop making sense
« Reply #7 on: February 26, 2016, 01:54:34 PM »
You understood me correctly. I'm investing in taxable at the time I'm not maxing 401k because I need liquid money in next couple of years. If market goes up or stays - it's a win. If market goes down, I'll bite the bullet. It's that simple.
^Got it

MustacheAndaHalf

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Re: At what point do 401k contributions stop making sense
« Reply #8 on: February 26, 2016, 02:12:08 PM »
Lowest fee is .79% annually but the average returns don't compensate for the 20 basis point reduction.
The stock market does not repeat.  In every fund's prospectus is a statement that past returns do not predict future performance.  That statement is mandated by the SEC, but it doesn't stop companies from advertising past returns.

I'm guessing none of your funds are Vanguard, "Fidelity Spartan", or Schwab broad market funds.  All of those have low fees, and track an index.  Most funds will lose to the index.

Not that you're looking for a battle, but you probably have a case against your 401(k) administrator not looking out for your interests.  A list of funds where 0.79% is the lowest is rather bad.

BallardStubble

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Re: At what point do 401k contributions stop making sense
« Reply #9 on: February 26, 2016, 02:21:05 PM »
Eh, I don't really  have leverage to talk to HR about it. I work at a company that set its minimum salary at $70k for every employee, so I definitely don't want to burn any bridges.

LAGuy

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Re: At what point do 401k contributions stop making sense
« Reply #10 on: February 26, 2016, 02:28:07 PM »
Lowest fee is .79% annually but the average returns don't compensate for the 20 basis point reduction.
The stock market does not repeat.  In every fund's prospectus is a statement that past returns do not predict future performance.  That statement is mandated by the SEC, but it doesn't stop companies from advertising past returns.

I'm guessing none of your funds are Vanguard, "Fidelity Spartan", or Schwab broad market funds.  All of those have low fees, and track an index.  Most funds will lose to the index.

Not that you're looking for a battle, but you probably have a case against your 401(k) administrator not looking out for your interests.  A list of funds where 0.79% is the lowest is rather bad.

He probably works at a smaller company that can't have an in-house retirement department. I'm in the same boat. My 401k plan offers up a bunch of awesome Vanguard funds. Less than 0.1% fee. Of course, the management company, Sharebuilder, takes 0.6% for themselves. OP: don't even waste your time talking to HR, they'll look at you like you're crazy. You can imagine how the conversation goes down at HR, "That young man from Sharebuilder is just so HELPFUL. He comes out and gives demonstrations, distributes materials, educates our employees on their retirement needs, and we don't have to lift a finger! He gave me his card and said if anybody has ANY complaints to just call him, and he'll run right over and handle it! And the best part, he does it all for FREE!!!" Essentially, you'd be going down to HR and asking them to do more work so you can save a few bucks. Good luck with that.

LAGuy

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Re: At what point do 401k contributions stop making sense
« Reply #11 on: February 26, 2016, 02:42:53 PM »
To answer your original question, the TLDR answer is: it probably makes sense to save at least $200,000 in your 401k no matter how bad the fees are. And $400,000 to $500,000 is quite attractive as well.

Why? Well, let's make a few assumptions. In retirement, your primary source of taxable income will be from your 401k/IRA. The idea is to have at least some taxable income every year right up to the year you die. That way you can take advantage of at least the standard deductions and exemptions. Right now, that's about $10,000. A 5% withdrawl rate of $200,000 is $10,000 a year. As such, you'll have traded your original tax rate and turned it into 0%. You're probably in the 15 to 25% bracket right now. Why a higher 5% withdrawl rate? Well, you don't want the 401k to be around past your death. The idea is to get it all out of there (and hopefully spent) by the year of your death. Yeah, that's a neat trick to pull off.

So, the next stop is around $400,000 to $500,000 in your 401k. At this point you're still only in the 10% bracket while trying to pull the money out over your retirement years. That's still a lot better than 15 to 25%.

Finally, are you in a high state income tax state like CA? I am. I make $100,000. After my deductions, I'm still way deep in the 25% bracket. Plus 9.3% CA. So, a 401k basically allows me to trade a nearly 35% tax rate for a 0 to 10% tax rate in retirement (assuming I leave CA at that point). As such, the 401k is really a slam dunk even with the high fees. In fact, for those of us in the 25% bracket the 401k makes sense all the way up to a balance of a million dollars...you'd still only be pulling from the 15% bracket up to that point. 15% is still way better than 35%. Even with the 401k fees eating it up.

Look at it this way. If you plan to retire early, the high 401k fees are only for a short time. As soon as you change jobs or FIRE, you can roll it all out to your own IRA and low fees.

Gone Fishing

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Re: At what point do 401k contributions stop making sense
« Reply #12 on: February 26, 2016, 03:18:14 PM »
Eh, I don't really  have leverage to talk to HR about it. I work at a company that set its minimum salary at $70k for every employee, so I definitely don't want to burn any bridges.

Was your company recently in the news?

Have you done the math?  This is what I get with a very basic example:

$18,000 yr contribution, 15 year investment time frame, 10% return with a low fee provider, 9% return with a high fee provider.

Ending balance at 10%  $572k
Ending balance at 9%    $528k

Difference                     $44k

Total Contributions             $270,000

Tax savings at 15% vs 0%  $40,500

Based on this I would estimated the break even point to be around a MMM style working career of 13-14 years or so.  Less than that and a 1% additional management fee would be worth the tax savings, more than that and the fees could possibly erode away the tax savings.  This could all be complicated by changing jobs mid-career which would allow for rolling balances into a low fee IRA or low fee 401(k) offered by the new employer, an employer that allows for in-service distributions, climbing into the 25% tax bracket or above, your company adding low-cost investment options later on, or a rollback of preferred tax rates for qualified dividends and long term capital gains. If it were me, I'd probably pay the management fee for two reasons:  the odds of shifting the funds into a lower expense fund are probably pretty good for the average employee, 401(k) money can more easily be worked into a ROTH later on,  and 401(k)s offer greater protection from lawsuits and bankruptcy vs taxable accounts.   

Gone Fishing

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Re: At what point do 401k contributions stop making sense
« Reply #13 on: February 26, 2016, 03:20:54 PM »

Finally, are you in a high state income tax state like CA? I am. I make $100,000. After my deductions, I'm still way deep in the 25% bracket. Plus 9.3% CA. So, a 401k basically allows me to trade a nearly 35% tax rate for a 0 to 10% tax rate in retirement (assuming I leave CA at that point).


Good point!  I didn't even consider state taxes.

BallardStubble

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Re: At what point do 401k contributions stop making sense
« Reply #14 on: February 26, 2016, 05:06:45 PM »
I understand and appreciate the information about the taxes vs ER. But I'm curious about the break even point on that if I'm only averaging 5% returns vs 8% returns through taxable. That would have a pretty substantial effect on compounding interest, right?

Full_Beard

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Re: At what point do 401k contributions stop making sense
« Reply #15 on: February 26, 2016, 07:37:09 PM »
Would it make sense for me to also max out my 401k at a 1.05% ER and 5-6% average returns if I can invest in a taxable account with higher returns and lower ER?
If the employer 401K offers index funds, what taxable account can offer you higher returns? Wouldn't you just be in more index funds (potentially with a lower expense ratio)?

LAGuy

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Re: At what point do 401k contributions stop making sense
« Reply #16 on: February 26, 2016, 08:37:53 PM »
I understand and appreciate the information about the taxes vs ER. But I'm curious about the break even point on that if I'm only averaging 5% returns vs 8% returns through taxable. That would have a pretty substantial effect on compounding interest, right?

All funds have been in the crapper for the past few years. No funds are looking real hot at this point and nobody is getting 8% much less 5% annual returns. Surely they at least offer an S&P index or even a target date fund isn't horrible. If you want a serious answer to what's better: 8% taxable, or 5% pre-tax, just go take another look at So Close's analysis. Basically, you're break even at 15 years at merely a 1% difference. So yeah, 8% taxable is WAY better than 5% pre-tax. But I think you're fooling yourself that you're going to get that much of a better return outside of even marginal 401k choices.

BallardStubble

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Re: At what point do 401k contributions stop making sense
« Reply #17 on: February 26, 2016, 10:18:19 PM »
Maybe, but these aren't 5, 10 or 15 year return averages. These are return averages since inception of the fund in the 70s and 80s and index funds seem to have much higher returns in that same time frame.  The index fund holdings for these funds are also weirdly allocated as well. Top 10 companies in term of asset allocation is way different then those listed in the Vanguard Total Stock Market Index. Of course, I understand there will always be variance in different index fund builds, but to be that different seems strange to me.

CanuckExpat

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Re: At what point do 401k contributions stop making sense
« Reply #18 on: February 26, 2016, 10:27:01 PM »
Do you plan to work at this company for the rest of your life, or have some other reason to keep the funds in their 401k for a long time??

Max out your 401k (after maxing out IRA first), hold your nose and absorb the high fees for now. When you leave the employer you can roll it into a low fee IRA of your choosing, or into a new employers better 401k plan. You only have to pay those high fees for as long as you are employed with your company.. if you give up on tax advantaged space, you have lost it forever.

BallardStubble

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Re: At what point do 401k contributions stop making sense
« Reply #19 on: February 26, 2016, 10:55:18 PM »
I plan to work there until retirement (hoping that will be in 2025).

arebelspy

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Re: At what point do 401k contributions stop making sense
« Reply #20 on: February 27, 2016, 04:33:43 AM »
"At what point do 401k contributions stop making sense"

At the point at which you are no longer allowed to legally contribute more.
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maizefolk

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Re: At what point do 401k contributions stop making sense
« Reply #21 on: February 27, 2016, 05:33:18 PM »
Feel free to ignore all the assumptions and math and skip to the bolded sentence at the end, which is my answer to the question posed in your title.

I plan to work there until retirement (hoping that will be in 2025).

So you have nine years of suboptimal funds with ridiculous expense ratios. Then you can move your money into an IRA with normal index funds.

Eh, I don't really  have leverage to talk to HR about it. I work at a company that set its minimum salary at $70k for every employee, so I definitely don't want to burn any bridges.

So let's put you in the 25% income tax bracket and assume you live in a state with no state income tax (say Washington).

Furthermore, lets assume the stock market returns 9.1% before adjusting for inflation (S&P 500's long term CAGR), which is 7.1% appreciation (taxed at 15% but only once at sale) and 2% dividends (taxed at 15% as they are paid). Your question is how big a difference in hit in investment return in your 401k you can tolerate before it makes more sense to just save the equivalent amount of money in a taxable account.

Let's say you can afford put $10,000 a year into your 401k, which is the equivalent of having $7,500 a year to invest post-tax. If the 401k performed the exact same as an index fund you picked yourself, after 9 years you'd have $130,757 in the 401k account or $96,843 in the taxable account (after adjusting for taxes on dividends every year). After adjusting for unrealized capital gains tax for the taxable account and assuming you end up taking money out of the 401k at an average tax rate of 10% (some at 0%, some at 10%, some at 15%) those numbers work out to: $117,681 and $92,441 (advantage 401k by 27.3%) In order to get the final returns (using all of the numbers listed above) to come out equal (meaning there is no advantage to investing in the 401k instead of saving in a taxable account), I had to reduce the annual rate of return inside the 401k to 3.27% (so an expense ratio of 5.83% assuming you had access to equivalent index funds which you don't).

So if, after fees, you're expecting your 401k savings to earn less than 3.27%, just save in a taxable account ahead. At anything higher than that, you're still better off contributing to your company 401k and then rolling it over to an IRA with low expense ratios and proper index funds the very minute you retire. Obviously varying any of the assumptions would change the result but hopefully this illustrates just how badly a company can take advantage of its captive audience and still not make saving in a 401k worse than the alternative.

MDM

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Re: At what point do 401k contributions stop making sense
« Reply #22 on: February 27, 2016, 05:45:23 PM »
See the '401k vs Taxable' tab in the case study spreadsheet.

Does that help you answer your question?  If so, great.  If not, what different analysis would help?

ETA: See also http://forum.mrmoneymustache.com/investor-alley/to-401k-or-not-to-401k-that-is-the-question-43459/
« Last Edit: February 27, 2016, 05:50:27 PM by MDM »

MustacheAndaHalf

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Re: At what point do 401k contributions stop making sense
« Reply #23 on: February 27, 2016, 08:53:47 PM »
Lowest fee is .79% annually but the average returns don't compensate for the 20 basis point reduction.
The stock market does not repeat.  In every fund's prospectus is a statement that past returns do not predict future performance.  That statement is mandated by the SEC, but it doesn't stop companies from advertising past returns.

I'm guessing none of your funds are Vanguard, "Fidelity Spartan", or Schwab broad market funds.  All of those have low fees, and track an index.  Most funds will lose to the index.

Not that you're looking for a battle, but you probably have a case against your 401(k) administrator not looking out for your interests.  A list of funds where 0.79% is the lowest is rather bad.

He probably works at a smaller company that can't have an in-house retirement department. I'm in the same boat. My 401k plan offers up a bunch of awesome Vanguard funds. Less than 0.1% fee. Of course, the management company, Sharebuilder, takes 0.6% for themselves. OP: don't even waste your time talking to HR, they'll look at you like you're crazy. You can imagine how the conversation goes down at HR, "That young man from Sharebuilder is just so HELPFUL. He comes out and gives demonstrations, distributes materials, educates our employees on their retirement needs, and we don't have to lift a finger! He gave me his card and said if anybody has ANY complaints to just call him, and he'll run right over and handle it! And the best part, he does it all for FREE!!!" Essentially, you'd be going down to HR and asking them to do more work so you can save a few bucks. Good luck with that.

It's not about discussing it with HR, it's about the Supreme Court decision on fiduciary duty.  If the company fails to improve expense ratios over time, that breach of fiduciary duty is ongoing, and resets the statute of limitations.
http://www.scotusblog.com/case-files/cases/tibble-v-edison-international/

meyling

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Re: At what point do 401k contributions stop making sense
« Reply #24 on: February 27, 2016, 09:09:35 PM »
Hey, I recently read an article about a company where minimum salary is 70k! I too am curious if your company has been in the news.

I agree with everyone else that says to just max it out.

msilenus

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Re: At what point do 401k contributions stop making sense
« Reply #25 on: February 29, 2016, 11:09:59 AM »
Some quick notes:
1) Whether your burn bridges or not by talking to whomever runs the plan about expense ratios depends entirely on how you approach it.  No one hates friendly, well-reasoned, constructive feedback.  If you're worried about alienating someone then that's probably valid, but think through how you're going to approach a conversation to make sure you come off okay instead of just closing the door on the possibility.  It should help to remember that improvements to the plan make the company more competitive and help everyone.  In corporate jargon: this is a "leveraged" and "impactful" thing to look at "constructively influencing.
2) If you get in good with whoever is doing this, that opens the door to other improvements like AT 401(k)->Roth options.
3) Let's say fees stay at 1% forever.  The second you leave the company they drop down to whatever your favorite index fund is offering because you roll it over into an IRA.  So your expected tenure with current employer is an important parameter.  An earlier posted captured this earlier by asking about account balance.
4) You're gonna have to do the math.  If you don't know how to work a spreadsheet yet, this is a great time to learn.  You'll build a little simulation of fees and tax benefits as the account grows.  You'll also need to know your marginal tax rate of course.

whodidntante

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Re: At what point do 401k contributions stop making sense
« Reply #26 on: March 05, 2016, 01:00:50 PM »
Hi everyone!

My 401k account currently averages an expense ratio of 1.05%. Not the greatest, but pretty average from what I've seen. This is my concern though; the lifetime average returns on all sensible investments (index funds) average between 5-6%. My employer doesn't do matching, but rather contributes 3% of my salary, regardless of whether I choose to invest in the program. I have full intentions of taking out a traditional IRA account from Vanguard and maxing it out for both my wife and myself at $11k annually. Would it make sense for me to also max out my 401k at a 1.05% ER and 5-6% average returns if I can invest in a taxable account with higher returns and lower ER?

An answer to that would be nice, but I'm mainly curious to know this. At what combination of ER and lower returns would you consider as reason to go fully taxable (save the $11k that would go into a traditional IRA)? I'm in the 15% tax bracket now and intend to be in the 15% tax bracket when I retire (although shooting for 0% through the Roth conversion ladder :)).

Thanks!

I doubt the 1% ER you are paying will be a decision maker.  The potential tax savings will eclipse that.  Run the numbers to convince yourself of that.