Fees and 401(k) or 457(b) Accounts

Common advice offered to investors is that they should contribute to available tax-deferred plans (like 401ks and 457bs) before investing in after tax accounts. In most cases, this is good advice. It is especially advantageous when company matching contributions are available. If your employer is providing matching funds to your tax deferred accounts, then when you fail to contribute, it is like voluntarily giving up salary. Make sure you get all the matching funds you can get or you are effectively taking a cut in wages.
Even if matching funds are not involved, tax-deferred plans are often better investments than contributions to an after tax account. Consider the following cases:

CASE #1 (After tax contributions):

Contribute $3000 per year to an after tax account for 30 years.

Then withdraw $3000 per year from the account for 30 years.

(net contribution after 60 years =$0)

Assume the account earns 7% per year return with an expense ratio of 0.2% (typical of low-cost index funds)

Assume the pre-retirement tax rate is 28% and the post-retirement tax rate is 18%.

Withdrawals are tax free (since youve already paid tax on the money when you invested).


CASE #2 (Tax deferred account):

As in case 1, contribute $3000 per year to a tax-deferred account for 30 years.

Then, identical to case 1, withdraw the $3000 per year from the account for 30 years.

(net contribution after 60 years =$0)

Assume the account earns at a rate identical to case 1 -- 7% per year return with an identical expense ratio of 0.2% (typical of index funds)

Assume the pre-retirement tax rate is 0% and the post-retirement tax rate is 0% (Consistent with 401(k) and 457(b) regulations).

Withdrawals are taxed at 18%.


CASE #1 describes typical numbers for a taxable index fund account while CASE #2 describes numbers that might apply for a 401(k) or 457(b). Of course every individuals experience and tax situation is different.
At the end of 30 years, the tax-deferred account of CASE #2 would be worth ~$295,000 while the after tax account of CASE #1 would be worth ~$208,000. Tax deferred treatment is worth ~$87,000.
Once the withdrawal phase is started (years 31 to 60), the taxable account has an advantage since withdrawals do not count as income and so are not taxed. Despite this advantage, at the end of year 60, the tax-deferred account is valued at ~$1.8M while the taxable account is valued at only ~$1.2M a $600,000 advantage to tax-deferred accounts.

But what happens if the 401k account is burdened with high fees? Using identical assumptions for the two cases except assuming the CASE #2 tax-deferred account expense ratio is 1% rather than 0.2% results in the complete annihilation of the tax-deferred advantage. With a 1% expense ratio, the tax-deferred account grows only to ~$256,000 in 30 years (an advantage over after tax saving of only $48,000). But even that slight advantage is lost entirely during the withdrawal phase. For higher expense ratios, a tax-deferred account is actually a bad investment when compared to the low-fee, equivalent returning fund in a taxable account.

Fund expense ratios as high as 1%, or even 4% to 5%, are not unusual. With only a 2.1% expense ratio on the tax-deferred mutual fund, all advantage is lost even in the 30 years of the contribution phase. During the withdrawal phase, this tax-deferred account would lose over $500,000 compared to after tax saving of CASE #1. It pays for investors to keep their eye on expenses. If your employer isnt offering matching funds and offers no low-fee mutual funds in their plan, you might be better off investing your money in a taxable account.

Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html
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