Everybody loves 401k plans for their tax advantages. But exactly how good are they, really? What if your 401k only offers limited, more expensive options than you can find from a regular brokerage account? I wanted to explore this using some estimated numbers, just to see how it works out. I know my assumptions won’t fit everyone, but people can adjust them to be closer to their own situation.
Assumptions
- Start with a $10,000 pre-tax contribution for each
- Both plans have the same imaginary investments for 30 years
- Annual return on those investments is 8%, broken down into 6% from capital gains, and 2% in qualified dividends. This is to approximate the amount of dividends currently being paid on stocks in general.
- 28% ordinary tax bracket both now and upon withdrawal in retirement
- 15% tax bracket for long-term capital gains and qualified dividends
- Any company matching is ignored, as everyone should contribute up to the match. 🙂
401k Calculations
The calculations for the final value of the 401(k) are relatively simple. You start with $10,000, it grows at 8% annually without any tax consequences for 30 years, and then upon withdrawal it is taxed at ordinary income tax rates. With our assumptions, the math would look like this:
Taxable Account Calculations
For a taxable account, things are a bit more complex as you have to pay taxes on any realized gains as well as dividends received. My assumptions are for the simplified example of a passive index fund that had no turnover and no realized gains, and so the only taxable event each year would be the dividends paid out.
Since we have to pay taxes on the $10,000 pre-tax amount, we actually only start with $7,200. After the first year, it grows 6% ($432) and also gives off 2% ($144) in dividends. On the dividends, we pay taxes of $21.60 (15% of $144), and reinvest what we have left into the account again. So after the first year we would have $7,200 + $432 + ($144 – $21.60) = $7,754.40. We also have to keep track of unrealized gains, which right now amount to $432.
If we repeat this over 30 years, we end up finally with an account value of $66,651, with unrealized gains of $50,324. If we sell now, we would pay long-term capital gains tax of 15% on those now-realized gains. So we are left with:
401k Earns You 23% More Money?
So using these specific assumptions, putting that $10,000 of pre-tax money in a 401(k) would earn you $13,349 more than if you bought the same investment in a taxable account. That’s 22.6% more money!
Changing the returns amount and holding period will alter this number, but the 401k will still win out by a similarly healthy margin assuming the investments within are identical.
A More Expensive 401k Can Wipe Out Any Benefits
But not so fast… often our 401k choices aren’t as good as what we could find in the open market. In addition to possible load charges, one easily measured example is expense ratios, which directly lower returns. Here, it works out that if the investment in the 401k is more expensive by only 0.7%, virtually all the benefit of the 401k is wiped out. Put another way, this would mean a net return of only 7.3% annually.
For example, you can find a passive S&P 500 ETF or mutual fund on the open market with an expense ratio of 0.20% or less (IVV, VFINX, FSMKX). But I’ve seen 401k’s with an S&P 500 index fund with an expense ratio of 0.90%, which would create such a 0.70% gap.
Summary
Nobody should draw any specific conclusions from just one set of simple assumptions. I’ve even ignored the presence of bonds in a portfolio. The numbers above like 0.70% and 23% are just imaginary numbers from a theoretical exercise to satisfy my own curiosity. (However, if my 401k was really bad, I might be concerned.) I guess we end up with the same things we already knew:
- The 401k can be a great way to boost your returns, especially if you are lucky to have good investment options.
- Expenses matter, even a relatively small annual difference can have a big impact over the long term.
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Why on earth would you ignore company match for this comparison? Thats the huge benefit – free money!
I knew someone was going to ask that 😉
Simple – Because going up to the company match is a no-brainer. This is either about those people who don’t have a company match (which neither me or my wife have) or want to contribute over the match.
It was interesting to me. I have a pension, so I don’t get a company match on my 403(b).
One thing you’ve not mentioned is that it’s possible to roll over 401k money into a traditional IRA. You retain the tax status but lose a few thing like loans (which are a bad idea anyway). I plan to use my 401k during the first 5-10 years of building savings then periodically roll money over into a Vanguard IRA. This takes advantage of the employer matching and removes the most costly portion of the fees (late career) when they affect compounding the most.
Don’t forget that on average, people change jobs 7 times during the their entire career in US. I, in fact, think my personal number is likely to be much higher. So it’s not like you are going to be stuck with bad investment options in 401k forever. Plus, bad 401k just provides yet another motive to find a new job, hopefully, with better options in 401k.
Why do you subtract taxes from the taxable account but don’t tax your 401k? Correct me if I am wrong, but you do not have to pay unrealized gains taxes until you withdraw, so by taking those taxes into account (reducing from 66k to 59k) you imply that you take the money out.
In that case, you need to compare that to the amount you would have if you take those 72k from 401k and withdraw it. Assuming you don’t pay any penalties, you will still have a good chunk taken out in taxes.
Seems like you are comparing apples to oranges here, but then what do I know 🙂
This is an interesting post, but as with most things, there are a ton of complications that are difficult to account for. The company match is a good one, but so is state tax, which can easily take away another 4-6% from your taxable investment. This would make the spread between your taxable investment and the 401k investment larger.
Still, I think the point you are making is to look out for the fees – they are killer! 🙂
Great comparision Jonathan. But if your 401K has great funds which offer more than the Index, and higher expense ratios would that not work in your favor? Many PF blogs refer to Index funds outperforming 80% of actively managed funds. But one should also check if the returns from your Actively managed 401K funds is significantly higher than the Index funds for a 15 year period. Thoughts??
As DJ alludes to, most people don’t hold their jobs at a single company until they retire, so a person doesn’t have to be stuck with terrible 401(k) choices forever.
My company’s 401(k) plan is beyond awful (no match, no index funds, high ERs), but I contribute anyway to reserve the tax-deferred space to rollover to an IRA when I leave.
DJ – That’s a good point. I always find it hard to imagine leaving when I’ve just begun working 🙂
Dima – Taxes are taken out at the end of the 401k example. Otherwise, you’d end up with $100,627. Take 28% out, and you end up with the number shown.
Patrick – Yes, that is another factor.
John – The problem is that (1) would you have picked those funds with great 15-year returns…. 15 years ago? and (2) studies have down that such high historical returns do not predict future 15-year returns. A someone has said, performance comes and goes, but expenses are forever 😉
Personally, I still don’t see why 401ks can’t be like IRAs and simply set up anywhere. If we can do direct deposit for paychecks, why not do something like direct deposit for 401ks?
401ks will never be simple and easy to understand because it isn’t in the best interest (i.e. as profitable) for the investment company. Therefore, the laws will never be changed.
After all, the single premise for a 401k was to allow the ‘sponsor’ to quietly eliminate their ongoing and future costs and responsibilities for their employees.
All of the marketing is b.s. and designed to hide the actual structure from the employees, while overstating the possible ‘benefits’ until most of them are too confused to continue to listen.
So, the companies get to brag about a benefit that doesn’t cost as much as they claim compared to a real pension system, the investment companies can take as much profit as possible while blaming it on the laws they themselves wrote, and the employees are financially abandoned while being told their company is looking out for them.
It’s a great system for executives and politicians to talk a good game while personally benefiting off the average victim.
Interesting, thanks!
Interesting post and a good reminder to look hard at those fees! It amazes me how that information is really not discussed when you set up your 401k plan. So many people don’t know very much about it and just plonk their money in what looks good without paying attention to the fees through ignorance (like I did initially.) It really pays to educate yourself about the intricacies of personal finance (pun intended.)
Aye, I agree it is important to look at 401(k) fees — I’ve heard a few authors say to ‘max the match’, then go Roth IRA, and then any remaining retirement money back into 401(k)), but this seems to over-simplify things like taxes and how one would construct an actual retirement portfolio….
* Need to calculate asset growth during retirement as well — retirement accounts aren’t liquidated on the first day of retirement, but needs to last 30 years or more.
* This assumption ends up with a high-risk portfolio (100% stock on the day that you retire), which isn’t usually recommended. Add bonds or customized asset allocation, and reballance / re-allocation / dividend costs grow.
* “My assumptions are for the simplified example of a passive index fund that had no turnover and no realized gains”
Even index funds have turnover and gains (even if a lot less than actively managed funds.)
* And that 28% effective tax rate in retirement — that is one high assumed retirement income, given that for a couple in 2007, first ~$15,600 is at 10%, then 15% up to ~$64,000. (The federal 28% bracket _starts_ at ~$128,000 in 2007. And subtract the standard deduction of ~$10,700)
So, in Florida, can make close to $80,000 (in 2007) and pay only 15% in income tax. Even in CA or MA wouldn’t get up to 28% at $80,000/yr.
An important, but rarely mentioned benefit of a 401(k) account is that it is considered a “protected asset” under law, meaning that creditors cannot go after the assets within it should you get sued or declare bankruptcy. With the litigious nature of society these days, combined with the incredibly expensive costs of modern medical care, one should not overlook this important benefit.
Jonathan: “Personally, I still don?t see why 401ks can?t be like IRAs and simply set up anywhere. If we can do direct deposit for paychecks, why not do something like direct deposit for 401ks?”
The plan has a long history tied to defined benefit plans which necessarily have been tied to employers. There is a huge industry that’s profiting from this structure and will not let it go easily even though it’s obvious that an IRA structure is far more appropriate.
Although the subject is being debated and hearing committees convene regularly, the underlying assumption that the employer/plan sponsor needs better disclosure is incorrect. Plan sponsors understand, they just prefer to transfer the costs to participants. It’s the elephant in the room nobody wants to talk about.
Dig up details about your employer’s exact arrangement with the plan administrator and you’ll be in for unpleasant surprises. Conflicts of interest abound. To those who think that the next employer will offer a better plan, good luck. There is however a positive correlation between company size and quality of plan. Still the vast majority of all plans suffer from the same issues and it’s very difficult to know ahead of accepting a position all the pitfalls of the offered plan.
If you want a good cause to pick up and make noise about, this is the issue no one will discuss.
tolak – I agree, but I think much of that evolved because the burden of administrating these plans were place on the businesses. So the small businesses went for the crappy (but cheap for the business) plans that made their money off of the employees.
Like you said most big companies are with Vanguard or Fidelity, and offers relatively good choices because they offer economies of scale.
I think if the cost of administration and all those legal issues of fiduciary responsibility could be legislated away and moved onto individual brokerages like IRAs, that would be great. IRAs have their own paperwork costs, but we let the open market compete for the money. I suppose Fidelity will have some lobbyists against such a plan, though.
Jonathan,
Let me ask you another spcific question: my company does not offer the match on my 401(k), whatever Amt. in there would be from my pocket. In that case, which direction should I go? Keep max out my 401(k) or just go maxing out my Roth IRA? Then the rest of my $ (most from savings) to be invested in stocks, bonds?
tolak: I agree with you. As an example, my wife was in a startup and lobbied hard for some type of retirement plan (SEP, 401k, anything!). After a year the CEO, without input from anyone else, presented a 401k plan run by an acquaintance. The plan was chock full of no name funds with a 5% front load! The CEO was furious when my wife disclosed that fact and explained its meaning to the other employees. The CEO was the only one who signed onto the plan.
I think that this hypothetical makes one massive assumption which is by no means assured: that tax rates will not go up before you retire. In actual fact, given current trends, I believe that it is unlikely that the same 15% rate will apply — and it is entirely possible that parts of 401(k) might be altered significantly as well. The leading Democratic candidates have already proposed raising capital gains and income tax rates, and one must accept that a 401k puts you at risk of a change in the tax code. Your points are not unreasonable, but one must at least consider the very significant political risk of keeping your money tied up with a 401k.
Another factor to consider is the constant devaluation of the US dollar. This might not be a big issue for some, but for those hoping to retire abroad, it is critical. The past ten years have seen the dollar fall by approximately 40% against major world currencies, making retirement abroad unfeasible for some, in just a short period of time. In a 401k, it is very difficult to hedge this risk. If one operates outside of a 401k, one can invest directly in foreign hard assets which are not permissible within a 401k (real estate). With hindsight, one can now say that a hypothetical retiree hoping to purchase a home and retire in France/England/Italy/Brazil etc., would have been significantly better off cashing out of their 401k and investing directly in real estate. There is therefore significant currency risk within a 401k as well, that might not make it the best choice for everyone.
LeAnn – Personally, I would max out my Roth IRA first. All of the gains there are tax free. After that, I would see what your expenses are in your 401k options. If they are the +.7% or so that Jonathan pointed out, I’d favor the after-tax funds. Vanguard is the no-brainer for that area, but other exist if you look closely. You could also diversify your options and do half of your planned contributions to 401k and half to brokerage/mutual fund account to diversify among tax options…..
Jonathon – Nice job. It is amazing how that .7% eats away so much. I wonder if you would want to do a tweak where you don’t take out the taxes on the $10k until the SECOND year since money you get in 01/07 is not really paid for in taxes until 04/08…. That would add more $$ to the after-tax case…. Also keep in mind ETFs are out of the picture since they do no auto reinvest without additional transaction fees.
Everyone’s case and funds are different so this is where a GOOD financial planner would figure that out for you, but so many of them stick to “conventional” wisdom (“max 401k”) rather than go the extra mile….
Oh, the point that 401k funds can be converted to a Roth IRA should not be over looked. Even if the 401k/brokerage was a wash, if you convert your 401k to a Roth later, you now are getting tax free income for the rest of your life (vs taxes on where ever you put the brokerage gains you get AFTER the assumptions above….). You can not gratuitously convert your brokerage account to Roth…
John…
I like your thoughts. One of the things I still am able to comprehend is why so many people are so zealous about index funds. The reason I say this is because of an old adage, “If it sounds too good to be true, it probably is.” I cannot understand that if these funds are so great, then why do we even have people investing in actively-managed funds anymore? It doesn’t make any sense to me at all.
As far as the 80% that you mentioned. I was thinking that most people agreed that the INDEXES themselves beat actively managed funds 80% of the time. To me, that says that the index beat index funds 100% of the time, right?
DISCLOSURE,
I am not a fan of funds, period. While I do hold a few, I buy more stocks than anything else. My non-retirement portfolio is approximately 75% stock, 20% funds and 5% bonds. The majority of my retirement portfolio is in my 401k which is all funds though… 🙁
Great analysis! How about a look at “my wealth after with a mocha a day or without with the difference going in my 401k”?
I have a question about the subtracting the 28% upon withdrawal in retirement. My understanding of being in the 28% tax bracket is that 28% is the rate of your “last dollars.”
Are you assuming that non 401K income is used up until the 28% bracket and then the 401K withdrawals are used after? If you were using your 401K withdrawals for most of your retirement income, wouldn’t the amount of tax you paid on your 401K withdrawals be much lower?
Whenever I see 401K examples it is always done the way you did it so I am sure I am missing something.
Unnamed said:
“I like your thoughts. One of the things I still am able to comprehend is why so many people are so zealous about index funds. The reason I say this is because of an old adage, ?If it sounds too good to be true, it probably is.? I cannot understand that if these funds are so great, then why do we even have people investing in actively-managed funds anymore? It doesn?t make any sense to me at all.”
Index funds win for the investor, non-index funds win for the fund company / broker.
History has shown that over time, the vast majority of actively managed funds trail the index, even before investment fees, taxes, and other costs are included. So, if you go with the index, you get the market gains with the lowest expenses (if pick the right index fund.)
For a detailed explanation, read “The Four Pillars of Investing” by William Bernstein or “Common Sense on Mutual Funds” by John Bogle (can probably get from your local library — I did.)
I think one example is that over 30 years, in an active fund, you have a much better chance of significantly trailing the index than you do of beating it — you need the fund manager of a specific fund to be consistently better than everyone else in the market, as the “market” is really the collective wisdom of everyone in the market.
Not to be a 401(k) apologist, but there are cases where expenses can be LESS in a 401(k) than outside. For example, some 401(k)s invest in lower fee fund classes by pooling investor money (for example, Vanguard Admiral shares, which normally require $100,000 for each investor.)
Not a huge difference, but another indicator that one needs to look at the specifics of ones plan and treat your entire portfolio as one portfolio (per goal), not your IRA as separate for your 401(k). Not that I do this yet, but I’d do better if I had all my retirement Vanguard 500 Index fund allocation in my 401(k), and Value funds in my IRA — I don’t have the $100,000 for Admiral funds in my IRA, but do have better value index funds in my IRA than my 401(k).
Nice analysis. One thing to add: The 401k outperformance increases as the tax rate on investments increases. The Bush tax cuts have dropped these rates well below historical averages and if we see a reversion to historical rates the 401k will outperform the standard account by about 40% instead of 23%.
It’s not certain that rates on investment income will rise faster than rates on earned income, but I suspect that as time goes on we are probably going to see more of the tax base come from investments rather than incomes which will pressure congress to generate funds via investment taxes.
Thad, thx a lot for your advice of “going extra mile”. I have thought the same thing.
However, I also consulted with my financial planner and friends whom work in this field, all they advised me maxing out on 401(k) FIRST.
Therefore, I really confused which direction I should go.
LeAnn, depends on how good your 401k investment options are and what your current tax bracket is. Assuming relatively par investment options, I’d put the tax bracket threshold at 25% and up. 25% and up, 401k first. Less than 25%, Roth IRA first.
Excellent post. Yes, fees matter. But, there is much more to conclude from this analysis than simply a difference in fees. The primary reasons for the different outcomes are tax rates and initial value. There is a huge difference in tax rates for the two investment vehicles: 401k withdrawls are taxed at income tax rates that are significantly higher than capital gains rates for taxable accounts.
How important is that? Awhile back, I considered increasing my 401k contribution to the max to take advantage of tax deferred growth. I wanted to reduce my tax bill. Sounds great, right. wrong. Here’s an example: Any 401k contributions over $15000 are non deductible or you can simply elect to contribute non-deductible money into a 401k. So lets use the $10000 example. After tax, (its non-deductible remember) we have $7200 to invest in a 401k.
(7200*1.08^30) = 72451
Since tax has already been paid on the intial 7200 only the gains are taxed. That rate is 28%. Even if you roll into an IRA the tax rate is still 28%.
(72451-7200)*(1-0.28) = 46980
Yikes! Take a look at the numbers again. The 46980 is 20% less than the taxable account final value (59102). What was the biggest factor? The final tax rates: 15% for taxable gains versus 28% for income.
There’s more to learn. The 46980 is 35% less than the 401k deductible account final value (72451). By paying Uncle Sam first, the inital seed money was reduced from 10000 to 7200. When you give up a dollar to taxes or spending, you not only give up the value of that dollar but all future earnings of that dollar, as well. Powerful stuff.
LeAnn – Just ask your financial planner why and to show you the numbers. They may know/assume something that we are not. What I am going on from your post is that there is NO match in your 401k (which means you get tax deferral bene on $ put in as your only bene) and you QUALIFY to contribute to a ROTH (no tax bene now, but all withdrawals are tax free). They may be assuming a lower tax bracket in retirement that may sway things.
A Roth would be like Jonathan’s brokerage case, but no tax at the end (and no tax on dividends). This puts the numbers north of $66k. If it is a wash (or near a wash) then maybe put half in each. Specifically know what funds you’d be in for the 401k and Roth and compare performance and fees. Also, ALWAYS know how the planner is making his pay because he may steer you into what pays him the most. Ask them explicitly.
I believe it is wise to diversify among tax vehicles as well as investment options. A little in a 401k and Roth is wise. They have been making tweaks along the way with all of these accounts. This is all art as well as science and intution. Pick a plan and monitor along the way!
Thanks for this article, I was just pondering something similar with an HSA account. There are bank accounts with ~5%apy but about the only investment option without ridiculous fees is saturna.com . . . which has ridiculous expense ratios (~1.3%).
So then you have to balance how much you need for medical expenses (tax free withdrawal) versus how much to add just for retirement purposes and if it’s any better than just using a taxable account with low expense ratio funds.
LeAnn, just consider your limits for 401k versus IRA. both have different benefits (limits and taxes) and it isn’t an all or nothing situation. If you have the funds, then contribute to both.
I believe they are telling you to max your 401k first, because it comes out of your pay. You won’t be able to make a lump sum in order to catch up in the end. moreover, you have until tax time the new year in order to contribute to your Roth. Since 401k also has a higher limit, your dollar-cost averaging will help spread out your exposure in your 401k.
as far as 401k versus brokerage. i think you need to add the tax amount first rather than reducing $10k to equal $7200. This will change the numbers. You are contributing $10k either way before or after taxes. It cost more rather than being worth less from the start in order to invest $10k in regular brokerage. For the 401k you reduce the tax burden of your income, because $10k is cut off from your taxable pay.
Why do you say everyone should contribute up to the company match? At my previous company the company matched 10% of my contribution. If I contributed $10 the company would contribute $1. It seems to me if the fees are high enough there’s an intersection point where I’m still better off investing into a brokerage account than I would be taking the 10% match if I can reduce the fees from 1% each year to 0.05% each year.
I still couldn’t intuitively understand why 401(k)s accrue faster than taxable accounts, given the higher marginal tax rate applied to them, so I wanted to find a general formula that would calculate the after-tax balance in a taxable account. I had to dust off my algebra skills, and also had to look up the formula for geometric series for the capital gains accumulation part. It’s probably not simplified to the most compact form, but here is the correct formula:
T=P*(1-I)*((1+r-d*D)^t-(r-d)*C*((1-(1+r-d*D)^(t+1))÷(d*D-r))),
where T is the total balance in the taxable account after all taxes and after the given period of time, P is the principal (here, $10000), I is the Income tax rate (.28), r is the overall rate of return (.08), d is the dividend rate of return (.02), D is the dividend tax rate (.15), C is the capital gains tax rate (.15), and t is the time elapsed in years (30).
i still don’t intuitively understand why 401(k)s accrue faster, but there it is in black and white.
For some reason the minuses in the formula turned into question marks.
I think I fixed the minuses.
Overall, the regular haircut on taxable accounts prevents the “snowball effect” on compounding returns. Even a big final haircut is better than many small haircuts along the way.