High cost 401k, or taxable brokerage?

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rca1824
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High cost 401k, or taxable brokerage?

Post by rca1824 »

I was reading a story from another poster complaining about how his 401k fund had ~3% E/R on all funds, and was debating whether it was worth investing in it at all (there wasn't even a corporate match) after he had maxed out this Roth IRA.

This got me thinking. In this scenario, wouldn't you be better off with a simple taxable brokerage account? Assuming you pay 15% long term capital gains, and your income tax bracket is the same now and in retirement (to keep the analysis simple for now), and assuming the growth on your initial investment dwarfs the initial contribution so we will only focus on the loss on the gains, it seems that the brokerage account is better even for relatively smaller 401k E/Rs in the 1% ballpark.

a 3% fee compounded over 30 years comes out to an effective 60% "tax" at the end.
a 2% fee compounded over 30 years... 46%
a 1% fee... 26%
a 0.5% fee... 14%

So 0.5% is about the break even point between a high-fee 401k and a low-fee taxable brokerage.

And actually, if you add back in the principal, it makes the 401k even worse off since the principal will be subject to the fee but in a brokerage account only the gains are taxed. The brokerage account also seems to have less risk since your tax burden scales with your wealth, whereas the 401k takes a flat fee off no matter whether the fund does well or poor.

Of course there may be some benefit to a 401k since it allows you to defer your income to retirement with a lower bracket, but you can still get some tax deferral with some types of IRAs. There's also the option of rolling over into an IRA if you plan to quit your job soon. There's also the risk that capital gains tax rates will increase relative to ordinary income tax rates in the future (very possible if progressives continue to gain power in Congress), defeating any buy-and-hold taxable strategy, although there should be a chance to sell off your stocks when the tax rate increase is announced but before it becomes implemented, so perhaps that risk is not so great.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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Doc
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Re: High cost 401k, or taxable brokerage?

Post by Doc »

rca1824 wrote:And actually, if you add back in the principal, it makes the 401k even worse off since the principal will be subject to the fee but in a brokerage account only the gains are taxed.
That's not accurate. In either a ROTH or a "deferred tax" 401k there is no tax on the gains of your share. The tax you pay on withdrawal from the 401k is only the future value of the tax you deferred in the first place.

That aside I like your presentation. It illustrates how even good programs from the Guv can become abused.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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Re: High cost 401k, or taxable brokerage?

Post by dickenjb »

You are on the right track. I believe grabiner has a rule of thumb where you multiply the fees by the number of years you expect to remain in the employ of the company. >30, avoid the high fee 401(k).
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rca1824
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Re: High cost 401k, or taxable brokerage?

Post by rca1824 »

dickenjb wrote:You are on the right track. I believe grabiner has a rule of thumb where you multiply the fees by the number of years you expect to remain in the employ of the company. >30, avoid the high fee 401(k).
This is correct and for long periods the rule of thumb will overestimate the true cost.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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rca1824
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Re: High cost 401k, or taxable brokerage?

Post by rca1824 »

Doc wrote:
rca1824 wrote:And actually, if you add back in the principal, it makes the 401k even worse off since the principal will be subject to the fee but in a brokerage account only the gains are taxed.
That's not accurate. In either a ROTH or a "deferred tax" 401k there is no tax on the gains of your share. The tax you pay on withdrawal from the 401k is only the future value of the tax you deferred in the first place.
I think you and I just have a different mental model. I probably skipped a lot of steps that I did in my head but didn't explain very well.
It illustrates how even good programs from the Guv can become abused.
This is precisely true also! The 401k tax exemption is supposed to "help" people save for retirement, but the irony of government intervention is that it often backfires and hurts the very people it intends to help. They need to just eliminate the capital gains tax and eliminate the artificial 401k and IRA categories. Or at the very least, allow people to "opt-out" of 401ks and contribute the full $23k/year to their IRA. There's no reason to force 75% of our tax-advantaged savings to go into a high-cost 401k. But the law will probably never be changed since 401k custodians are probably a powerful lobbying force that would never let go of their special interest stake. The nature of concentrated benefits and dispersed costs allows this injustice to continue unchecked, screwing over everybody for the benefit of fund managers.

The only way people can do anything about it is to negotiate employment as a 1099 contractor instead of a W2 employee, and setup your own SEP IRA. This is what I did.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
LongerPrimer
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Re: High cost 401k, or taxable brokerage?

Post by LongerPrimer »

Our retirement tax code and investment tax code are not aligned. Sometimes 401ks, regardless of fees, are sometimes a trap. Hence we see many retirement investors doing "backdoor" Roths.
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hoppy08520
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Re: High cost 401k, or taxable brokerage?

Post by hoppy08520 »

There's a section in the wiki that discusses this:

http://www.bogleheads.org/wiki/401%28k% ... re_choices

According to the logic in the wiki, for the average participant, you should invest in this plan as long as you expect that you'll stay at the job 10 years or less.

In that wiki section, there's a link to a Finance Buff post that discusses this. The FB post has a link to an elaborate worksheet/spreadsheet into which you can plug in your personal information and it will tell you what the best option might be, given the various assumptions you enter.
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Re: High cost 401k, or taxable brokerage?

Post by Doc »

rca1824 wrote:And actually, if you add back in the principal, it makes the 401k even worse off since the principal will be subject to the fee but in a brokerage account only the gains are taxed.
Please clarify. You have a 401k that charges you 3% of your contribution? That seems very strange.

In a taxable account you initial contribution is after tax. Your gains if any are taxed.

In a 401k you contribute pretax money. When you withdrawal it you have to pay the original tax plus any gains on that original deferred tax. There is no additional tax on the gains of the original portion that belonged to you in the first place. This is the same after tax amount that you contributed to in the taxable case.

If you don't understand this there are many threads on this board that compare the tax consequence of a traditional IRA (tIRA) and a ROTH.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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rca1824
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Re: High cost 401k, or taxable brokerage?

Post by rca1824 »

hoppy08520 wrote:There's a section in the wiki that discusses this:

http://www.bogleheads.org/wiki/401%28k% ... re_choices

According to the logic in the wiki, for the average participant, you should invest in this plan as long as you expect that you'll stay at the job 10 years or less.

In that wiki section, there's a link to a Finance Buff post that discusses this. The FB post has a link to an elaborate worksheet/spreadsheet into which you can plug in your personal information and it will tell you what the best option might be, given the various assumptions you enter.
On rollovers: if your income exceeds the maximum allowed to get the tax deduction for a Traditional IRA, do you have to pay tax on the rollover? Because if you do, this can make rollovers expensive if you have to pay ordinary income tax on both the principal *and* the gains from your 401k investments. But if you can pass it through directly to a Trad 401k regardless of income, then I would agree: the 401k is not so bad.
Doc wrote:
rca1824 wrote:And actually, if you add back in the principal, it makes the 401k even worse off since the principal will be subject to the fee but in a brokerage account only the gains are taxed.
Please clarify. You have a 401k that charges you 3% of your contribution? That seems very strange.

In a taxable account you initial contribution is after tax. Your gains if any are taxed.

In a 401k you contribute pretax money. When you withdrawal it you have to pay the original tax plus any gains on that original deferred tax. There is no additional tax on the gains of the original portion that belonged to you in the first place. This is the same after tax amount that you contributed to in the taxable case.

If you don't understand this there are many threads on this board that compare the tax consequence of a traditional IRA (tIRA) and a ROTH.
No no no, I understand how the taxes work. The point I am trying to communicate is that 401ks often have higher expense ratios than what is seen at Vanguard. These fees can be as high as 1-3%. This is how much the fund manager skims off the top each year. 3% compounded over 30 years is 60% of everything, or essentially a 60% "tax" that is paid to the fund manager. It's a complete scam, and many employees don't have any choice but to bend over and take it because of the tax deferral. But what I am saying is that if your fees are too high, it actually becomes optimal to forego the 401k and just invest in a taxable brokerage, because 15% is less than 60% in that example.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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Re: High cost 401k, or taxable brokerage?

Post by placeholder »

Rollovers are not contributions so the various rules don't apply to them.
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Doc
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Re: High cost 401k, or taxable brokerage?

Post by Doc »

Doc wrote:Please clarify. You have a 401k that charges you 3% of your contribution? That seems very strange.
rca1824 wrote:No no no, I understand how the taxes work. The point I am trying to communicate is that 401ks often have higher expense ratios than what is seen at Vanguard. These fees can be as high as 1-3%.
My question was does your 401k charge you a "load" type fee like some mutual funds. Or only offer funds that have a load which has the same negative result.

There are three things in play - high 401k e/r's, 401k "load" fees of some type and taxes on the gains of your share of your 401k balance.

The tax question seems to be a non issue. Apparently I misinterpreted your statement:
rca1824 wrote:... it makes the 401k even worse off since the principal will be subject to the fee but in a brokerage account only the gains are taxed.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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rca1824
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Re: High cost 401k, or taxable brokerage?

Post by rca1824 »

The advantage of a 401k over a taxable brokerage is that you only pay tax once: either upon contribution or upon withdrawal. If your marginal tax rate is the same in both periods, it actually doesn't matter when it's taxed, but the point is that it's only taxed once.

In a taxable brokerage, you are taxed twice: once on income, and again on the gains. This double taxation makes taxable brokerage accounts seem less favorable if one has 401k space left, which can avoid the double taxation.

But if you have high 401k fees, either from the fund e/r or the 401k load fees (it doesn't matter where--only the total), then the 401k fees can exceed the tax on the capital gains in the taxable brokerage scenario. And, since the capital gains rate is only 15%, it's actually quite easy for many 401ks to become worse than a taxable brokerage. Using the rule of thumb, even a typical 1% fee becomes dominated after 15 years. A 2% fee is dominated after 7.5 years, and so on.

I hope that makes sense. I may have once again skipped logical steps that I did automatically in my head.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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Re: High cost 401k, or taxable brokerage?

Post by grabiner »

rca1824 wrote:But if you have high 401k fees, either from the fund e/r or the 401k load fees (it doesn't matter where--only the total), then the 401k fees can exceed the tax on the capital gains in the taxable brokerage scenario. And, since the capital gains rate is only 15%, it's actually quite easy for many 401ks to become worse than a taxable brokerage. Using the rule of thumb, even a typical 1% fee becomes dominated after 15 years. A 2% fee is dominated after 7.5 years, and so on.
The tax cost of a brokerage account is more than 15%, because you pay tax on dividends every year, and this compounds over time. The best case is a 2% yield, all qualified dividends, which costs you 9% in 30 years, and you'll probably lose about 11% more to capital gains if you sell then (not a full 15% because the reinvested dividends increase your basis). In addition, if you invest in a 401(k), you can roll the 401(k) to an IRA when you leave your employer, getting rid of the high fees and keeping the advantage of tax deferral.

This is the basis for my 30% rule of thumb; multiply the number of years you will be with the employer by the extra fee, and if this exceeds 30%, consider taxable investing in preference to unmatched 401(k) contributions. (30 years at 1% expenses represents a 26% loss.)
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Re: High cost 401k, or taxable brokerage?

Post by Doc »

grabiner wrote: The tax cost of a brokerage account is more than 15%, because you pay tax on dividends every year, and this compounds over time. The best case is a 2% yield, all qualified dividends, which costs you 9% in 30 years, and you'll probably lose about 11% more to capital gains if you sell then (not a full 15% because the reinvested dividends increase your basis). In addition, if you invest in a 401(k), you can roll the 401(k) to an IRA when you leave your employer, getting rid of the high fees and keeping the advantage of tax deferral.

This is the basis for my 30% rule of thumb; multiply the number of years you will be with the employer by the extra fee, and if this exceeds 30%, consider taxable investing in preference to unmatched 401(k) contributions. (30 years at 1% expenses represents a 26% loss.)
There are two different approaches to discounting the value of taxable accounts for the effect of taxes. The approach David is describing say that the future value is going to be lower because of both current and future taxes on the earnings. So you discount the current total value by maybe 20%. I prefer discounting the current value only by the amount of accrued taxes on the unrealized losses but then I reduce the annual earnings on that amount when calculating the future value. Both approaches get you to a similar result.

(Like David I use a lower LTCG but because of the tax deferment. The rate is about the same. I don't like the idea of the reinvesting of dividends assumption. It is probably wrong because dividends are often used for rebalancing and it complicate the calculation and can lead to mistakes if you are nor very careful with your spreadsheet. Besides you get the same exact result without the assumption by using the present value rather than the future value formulation in you calculation. Either gives exactly the same result since they are same except for multiplying both sides by (1+i)^N)
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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