[Wiki suggestion] Invest in taxable or 401(k)?

[FiveK]

[Moved into a stand-alone thread from: Suggestions for the Wiki, see below. --admin LadyGeek]

In http://www.bogleheads.org/wiki/401%28k% ... re_choices it says "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%."

At the bottom of viewtopic.php?t=117854 is this comment: "The 30% number in the wiki is slightly oversimplified, and was a better estimate when the tax break on qualified dividends was still temporary, but the basic conclusion hasn't changed." Prior to that is a rather long list of assumptions.

Given the changes in tax laws and all the assumptions that may or may not apply, should the "rule of thumb" language in the wiki be deleted? Instead, refer the the reader directly to the cited reference, http://www.bogleheads.org/wiki/401%28k%29#cite_note-21, and/or a similar tool noted at http://forum.mrmoneymustache.com/invest ... #msg773810?

[LadyGeek]

Hi,

Sorry for the delay. I took a stab at updating the wiki: 401(k)

I also PM'd another wiki editor who might be able to help further, especially about the changes in tax laws and assumptions.

[LadyGeek]

In http://www.bogleheads.org/wiki/401%28k% ... re_choices it says "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%."...

Hi,

Sorry for the delay. I took a stab at updating the wiki: 401(k)

I also PM'd another wiki editor who might be able to help further, especially about the changes in tax laws and assumptions.

I revised the wiki again (based on an editor's suggestion) to remove the reference to Re: New Job - 401k Kinda [Stinks] and just cite Alternatives to a High Cost 401k Or 403b Plan which contains a spreadsheet that can be used for your situation.

[FiveK]

In http://www.bogleheads.org/wiki/401%28k% ... re_choices it says "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%."...

Hi,

Sorry for the delay. I took a stab at updating the wiki: 401(k)

I also PM'd another wiki editor who might be able to help further, especially about the changes in tax laws and assumptions.

I revised the wiki again (based on an editor's suggestion) to remove the reference to Re: New Job - 401k Kinda [Stinks] and just cite Alternatives to a High Cost 401k Or 403b Plan which contains a spreadsheet that can be used for your situation.

Perhaps removing the "30% rule of thumb" language altogether is best. There are many "for examples" when it doesn't apply under current tax law. For example,
- For anyone in the 15% marginal bracket, any extra 401k fee makes that worse than taxable due to the 0% tax on LTCG and Qualified Dividends.
- In the financebuff example, the calculations are more sensitive to "Number of Years Until Withdrawal" than "number of years you will stay in the plan"
- If withdrawal coincides with leaving the plan, there is essentially no (i.e., <0.5%) difference between 401k vs. taxable for 1-9 years, after which taxable become increasingly better.
- If withdrawal comes in 30 years, then 401k is better through 20 years in the plan. This coincides well with the 30% rule of thumb.
- Staying with the financebuff example, but using 15% (i.e., current tax law) for LTCG and QD tax rates, taxable become better after 14 years in the plan.

This may be a matter of taste, but the Excel spreadsheet in the MMM link seems "more accessible" than the Zoho sheet in thefinancebuff link. In other words, I can manipulate the Excel document and see the graphical results.

Or maybe I'm missing something important altogether...?

[LadyGeek]

FiveK is suggesting to modify the wiki's 401(k) article on Expensive or mediocre choices

I've made some changes, but there is some disagreement. Here's the original version: Revision as of 20:23, 19 June 2015

I split this discussion into a new thread so we can get a consensus on the proposed update.

Should FiveK's suggestion to remove the "30% rule of thumb" be incorporated?

[grabiner]

I would like to have a rule of thumb, possibly with a few caveats, because it's useful to provide initial guidance, particularly when new posters ask, "Should I contribute to a bad 401(k)?" However, you are correct that 30% is not the right threshold.

My suggested correction: the product of the extra expense ratio and the number of years you will be stuck with the plan is 1.5 times your combined federal and state tax rate on qualified dividends and long-term capital gains (averaged over your career if you expect your income to change).

For example, if you pay 15% federal tax on qualified dividends (the rate in the 25%-35% tax brackets) and 5% state taxes, the rule of thumb gives 30%. If you expect to stay with your employer for 20 years, you should consider taxable investing only if the extra expenses in the 401(k) are 1.5%. If you pay no state tax, the 30% becomes 22.5%, and the 1.5% becomes 1.13%.

I made my own spreadsheet to check the numbers.

https://docs.google.com/spreadsheets/d/ ... sp=sharing

Assuming 20 years in the plan and 30 years to withdrawal, and a 2% QDI yield with 6% unrealized gain, the break-even extra expense is 0.34% at a 5% tax rate, 1.04% at a 15% tax rate, 1.41% at a 20% tax rate. The rule of thumb above gives 0.38%, 1.13%, 1.50%.

Assuming 30 years in the plan and 40 years to withdrawal, the break-even extra expense is 0.27% at a 5% tax rate, 0.82% at a 15% tax rate, 1.11% at a 20% tax rate. The rule of thumb gives 0.25%, 0.75%, 1%.

In both examples, changing the retirement federal tax bracket from 25% to 15% makes relatively little difference. The tax rate on 401(k)/IRA withdrawals decreases from 25% to 15%, but the tax rate on taxable account withdrawal in retirement decreases from about 11% (15% but only on the capital gain and dividends received after retirement) to zero.

The reason the rule of thumb makes sense is that most posters who have this question are in about the situation discussed here: they are with an employer which offers a bad plan, expect to stay with this employer until they retire, then withdraw their investments spread out over retirement, so that they have about 10 years after retirement to benefit from further tax-deferred growth. Investors who change employers before retirement are almost always better off contributing to a bad 401(k), so it doesn't matter as much that the rule of thumb is off.

[FiveK]

I would like to have a rule of thumb, possibly with a few caveats, because it's useful to provide initial guidance, particularly when new posters ask, "Should I contribute to a bad 401(k)?"

Good in theory.

My suggested correction: the product of the extra expense ratio and the number of years you will be stuck with the plan is 1.5 times your combined federal and state tax rate on qualified dividends and long-term capital gains (averaged over your career if you expect your income to change).
For example, if you pay 15% federal tax on qualified dividends (the rate in the 25%-35% tax brackets) and 5% state taxes, the rule of thumb gives 30%. If you expect to stay with your employer for 20 years, you should consider taxable investing only if the extra expenses in the 401(k) are 1.5%. If you pay no state tax, the 30% becomes 22.5%, and the 1.5% becomes 1.13%.

Even better in practice! Very well done!

I made my own spreadsheet to check the numbers.
https://docs.google.com/spreadsheets/d/ ... sp=sharing

Always interesting to see how different people develop tools differently - and again even better when they get the same answer (at least this one and the MMM spreadsheet do).

Assuming 20 years in the plan and 30 years to withdrawal, and a 2% QDI yield with 6% unrealized gain, the break-even extra expense is 0.34% at a 5% tax rate, 1.04% at a 15% tax rate, 1.41% at a 20% tax rate. The rule of thumb above gives 0.38%, 1.13%, 1.50%.

Assuming 30 years in the plan and 40 years to withdrawal, the break-even extra expense is 0.27% at a 5% tax rate, 0.82% at a 15% tax rate, 1.11% at a 20% tax rate. The rule of thumb gives 0.25%, 0.75%, 1%.

And this new rule of thumb also works perfectly in the extreme case of a 0% LTCG/QD rate: the break-even extra expense is 0%.

In both examples, changing the retirement federal tax bracket from 25% to 15% makes relatively little difference. The tax rate on 401(k)/IRA withdrawals decreases from 25% to 15%, but the tax rate on taxable account withdrawal in retirement decreases from about 11% (15% but only on the capital gain and dividends received after retirement) to zero.

The reason the rule of thumb makes sense is that most posters who have this question are in about the situation discussed here: they are with an employer which offers a bad plan, expect to stay with this employer until they retire, then withdraw their investments spread out over retirement, so that they have about 10 years after retirement to benefit from further tax-deferred growth. Investors who change employers before retirement are almost always better off contributing to a bad 401(k), so it doesn't matter as much that the rule of thumb is off.

Excellent background information on the rule of thumb derivation - probably worth including in the wiki to alert anyone who falls far outside these assumptions.

Great work David Grabiner.

[grabiner]

I updated the wiki article with the new rule of thumb, and I will also use it when giving advice on the forum, as this is a common question requiring advice.

FiveK, thank you very much for your help. I try to get things right, but I don't always think of all the details, and I believe that when I created the 30% rule of thumb, I didn't even think of investors in the 15% tax bracket (who, at the time, paid 5% tax on capital gains.)