403b annuity or taxable account?

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Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 9:08 am

Greetings, Bogleheads.

My wife's employer offers only a 403b annuity, and we are trying to figure out if investing in a taxable index mutual fund with Vanguard would be a better option.

403b:
mortality expense fee: 0.85%
expense ratio: 0.04% (VFIAX)
annual account maintenance fee: $25

The alternative would be to invest in VFIAX (or VTSAX - we have a 3-fund portfolio), at 0.04% ER, in a taxable Vanguard account.

(We already max our Roth IRAs, my employer account, and my HSA.)

Federal income tax: 22%
State income tax: 5.75%

Would it be more optimal for her to do the 403b, or just invest in taxable?

Thanks!

aristotelian
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Joined: Wed Jan 11, 2017 8:05 pm

Re: 403b annuity or taxable account?

Post by aristotelian » Thu Sep 05, 2019 9:20 am

She does not have any regular mutual fund options within the 403b?

Based on tax bracket it would generally be preferable to invest pre-tax funds in the 403b but I would need to know more about how the Annuity works if that's the only option.

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 9:28 am

Yes, annuity is the only option with this employer's 403b.

The Vanguard S&P 500 option I mentioned in the original post is through Horace Mann, which had the lowest rates amongst the employer's available partners.

Thanks!

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 9:31 am

There's a 5% surrender fee if she backs out within the first five years. I am reaching out for more details.

Thanks again!

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 10:15 am

Yes, lakpr, the plan is to stay with the employer for 29 years. If it's not too much trouble, could you please provide a URL to your calculator, or share the formula?

Much appreciated!

lakpr
Posts: 2477
Joined: Fri Mar 18, 2011 9:59 am

Re: 403b annuity or taxable account?

Post by lakpr » Thu Sep 05, 2019 10:54 am

It is a private Excel worksheet on my computer, and I am replying to forum posts on my personal iPhone .. can’t attach it. But it is no secret formula. If you have a few basic Excel skills, this is how I proceeded

investment into tax deferred = $10k per year or $833 per month
investment into taxable = $7800 (22% tax taken out of the same initial investment) = $650 per month

7% rate of return assumed in both cases

five columns in each sheet: starting balance, fund expense, return earned, ending balance, after-tax equivalent

The starting balance of a new row = ending balance of previous row

Fund expense = 0.89% * starting balance (tax deferred) or 0.04* starting balance (taxable)

Returns earned = (starting balance - fund expense) * 0.07/12. Since 7% is annualized, monthly return is 1/12th if that

Ending balance = starting balance - fund expense + returns earned

After tax balance formula = 0.88 * ending balance, IF you end up withdrawing the entire amount at a 12% ordinary income tax rate. This is generous, because the 12% bracket ends in 2026, should be 15% more realistically. But there are exemptions, standard deductions etc that I cannot really model into the Excel, so I settled on 12% effective tax rate

Within the taxable account, after tax balance formula = ending balance - (ending balance - $650 * month number) * 0.15. 15% capital gains tax rate being assumed.

Yes I know, I am omitting the dividend tax drag.

Then the after tax balances are compared months on month, and pin point the month at which taxable after tax balance passes after tax balance from tax deferred account.

Hope that helps.

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 11:12 am

Thanks so much. I do appreciate this.

Assuming a 27.75% income tax rate (22% Fed, 5.75% state), with a starting balance in taxable as $7,225, and assuming our SSA + dual pensions keep us in the 22% Federal bracket (probably more like the 25% Federal bracket, plus 5.75% state bracket) in retirement, how would the outcome look, if you don't mind?

Thanks again! I've been digging around with this all morning :shock:

TY!

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 11:38 am

Sorry, the other assumptions I forgot to add:

My state does tax retirement income.

My state taxes capital gains at the income rate (Virginia), so it would be 5.75% for state capital gains, and 5.75% for state income tax.

Thanks!

lakpr
Posts: 2477
Joined: Fri Mar 18, 2011 9:59 am

Re: 403b annuity or taxable account?

Post by lakpr » Thu Sep 05, 2019 1:43 pm

susleni,

This is embarrassing

I think I found a mistake in my Excel sheet. I was applying a 0.89% expense ratio on the starting balance of every month, which I think is wrong. It should have been a 0.89%/12 every month. Or at least, I need to tweak the formula so that the fund expense ratio is applied only once a quarter using some IF statements.

I will edit my previous posts. My apologies for the incorrect information and possibly getting your hopes up.

Please ignore my recommendations above. In your case, with the latest assumptions you put out, there’s no way that the tax deferred option would win over the taxable account. In other words, you start winning from month 1 itself, as long as we are comparing after tax equivalents.

It primarily came down to the tax rates you are escaping now by contributing to a tax deferred account (22% Fed + 5.75% state; but incurring higher tax rates at withdrawal in retirement, with your stated assumptions of 25% Fed + 5.75% state. A higher overall tax rate. Which is a classic case for Roth investment option, if one is available.

If Roth investment option is not available, taxable investment is the next best option, since your capital gain tax rate is 15%, even assume a 1% additional tax rate to compensate for dividend drag. Add 5.75% state tax rate, you still end up with 21.75% tax rate, less than your 27.75% current marginal tax rate.

If a Roth option is available in your plan, I find that even at 0.85% expense ratio differential, you will be better off in the plan than a taxable equivalent, at the end of 30 years. You will have about $860k in Roth 403b vs $625k in taxable. The 20.75% capital gains tax rate kills it in favor of Roth.

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 2:25 pm

Thanks again for your response.

If Roth 403 b is available and is the better option, are your calculations assuming a 22% Federal tax rate through 2025, then 25%, or 22% the entire time?

Thank again! I sincerely appreciate you dragging out this thread!!!

lakpr
Posts: 2477
Joined: Fri Mar 18, 2011 9:59 am

Re: 403b annuity or taxable account?

Post by lakpr » Thu Sep 05, 2019 2:41 pm

Sorry my spreadsheet is not that intelligent to assume 22% tax rate through 2025 and jump to 25% starting 2026. I assumed a marginal income tax rate of 25% + 5.75% throughout.

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FiveK
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Re: 403b annuity or taxable account?

Post by FiveK » Thu Sep 05, 2019 5:32 pm

See Expensive or mediocre choices for an overview, and [Wiki suggestion] Invest in taxable or 401(k)? - Bogleheads.org for details (including links to a couple of spreadsheets that at least agree with each other) on how you might evaluate this choice.

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Thu Sep 05, 2019 5:50 pm

Lakpr: Thanks again for your responses, and time investment throughout the day.

FiveK: I never realized how much was done behind the scenes to keep this site operating as it does. Much appreciated.

krow36
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Location: WA

Re: 403b annuity or taxable account?

Post by krow36 » Sat Sep 07, 2019 4:00 pm

Does your wife work for a public school district? If so it’s possible that there is a low cost state run 457 plan that she could use instead of the 403b. About half the states have such plans available for school district employees.

It’s possible that the district is unaware of this option, and it can sometimes be added if an employee asks for it.

Topic Author
susleni
Posts: 22
Joined: Thu Apr 06, 2017 12:04 pm

Re: 403b annuity or taxable account?

Post by susleni » Sun Sep 08, 2019 9:21 am

Yes, there's a state-administered 457 plan that is excellent; however, her contribution is capped at 4% of base salary, rather than the IRS maximum contribution of $19,000 (under age 50). Not sure why, but that's how Virginia does things for public school employees hired after 1/1/14.

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