Work sponsored retirement plans including 401(k), 403(b), Simple IRA, or Thrift Savings Plans have several key features that make them valuable tools to save for retirement. They provide an easy way to automate investment contributions, free money via employer matches, and potentially lucrative tax benefits.
What’s not to like? In a word: fees. Fees are one of the most important factors that determine your investment outcomes. Many retirement plans are laden with high fees.
How do you determine when 401(k) fees outweigh the benefits of participating in the plan? This requires quantifying and comparing the fees versus the benefits. A cost/benefit analysis allows us to make an educated decision. Let’s dive in…
(Note: I’ll use the terms 401(k) interchangeably with work sponsored retirement plans because it is the most commonly available type. You can substitute whatever plan you have for the purposes of this article.)
How do you calculate 401(k) Fees?
Disclosing 401(k) fees is required. Doing so in a transparent way is not. Determining how much you’re paying to invest in your 401(k) plan often requires detective work.
Fees matter, so it is worth applying the effort to determine what you’re paying. There are several layers of fees that need to be deciphered.
An expense ratio is the fee charged by a mutual fund or ETF to operate the fund. It is expressed as a percentage of the fund’s assets. Expense ratios can range from zero to 2+% at the extremes.
Expense ratios should be easy to find in your list of investment fund options or in the prospectus of any particular fund you’re considering. You can also search the name or ticker symbol of a fund on the internet and find it on Morningstar, Yahoo! Finance, or a number of other popular financial sites.
See the screenshot from Morningstar for Vanguard’s Total Stock Market Index Fund (VTSAX) which has an expense ratio of .04%. For every $10,000 invested in the fund, you would pay $4/year.
As a comparison of an actively managed fund that invests in the same segment of the market, see the screenshot of the Columbia Select Large Cap Equity A shares (NSGAX). It has an expense ratio of .80%, or twenty times the expense of the index fund. For every $10,000 invested in the fund, you would pay $80/year.
If you hold more than one fund, repeat this process for each fund. Then add up the individual fund expenses to determine your total investment cost.
If looking up expense ratios independently, make sure you look at the exact investment options available in your plan. I highlighted the Columbia Select Large Cap Equity fund because it is an example of a fund with different share classes. Expense ratios for this fund range from a low of .41% to a high of 1.55%. A $10,000 investment could have an annual cost of $41 to $155. You may pay nearly four times more for the same mutual fund depending on the share class you invest in.
The next level of 401(k) fees are administrative fees. These fees can be paid by the plan sponsor (employer), passed on to employees, or some combination. You may be charged a flat fee, i.e $25/month or $300/year or a “wrap” fee, i.e. a fee based on a percentage of your assets similar to the expense ratio.
Administrative fees are harder to decipher. They are often buried in plan disclosure documents. In my experience, the harder the fees are to find, the more expensive they will be.
401(k) plans with high fees want to bury them; out of sight, out of mind. Plans with low fees go out of their way to show you how low their fees are.
As an example, I recently tried to find the administrative fees on Kim’s 401(k) plan. To find these fees, I first had to find the 404(a)(5) participant fee disclosure form. This took several minutes of searching the plan’s website.
Inside this 14 page document, were two sentences disclosing fees. There is a .71% record keeping fee and a .44% administrative and management fee. That totals 1.15% of administrative fees charged on all assets in the plan, in addition to expense ratios of the funds.
Many plans give the option of working with an advisor to help you manage your investments. For this service, you may pay an additional layer of fees. You may be charged a flat fee, for example $500/year, or a percentage of your assets under management for this service, for example 1% of assets under management.
All-In 401(k) Fees
To determine your all-in fees, you would need to add up the total investment fees, administrative fees, and advisory fees. As an example, I recently did a fee analysis for Kim’s 401(k) plan.
The only fund she holds in her 401(k) is the John Hancock Total Bond Market Fund. It has an expense ratio of .08%. The plan has a .71% record keeping fee and a .44% administrative and management fee. She didn’t elect advisory services. Her annual expenses are 1.23% of her account balance.
To make the math easy, let’s assume she has a current balance of $100,000. Her all-in investment fees would be $80 for the year. The total administrative cost would be $1,150. She doesn’t pay an advisory fee. The total all-in fees are about $1,230/year.
Escaping High 401(k) Fees
For decades, Vanguard has focused on lowering investment fees. This put pressure on other firms to enter a price war. It is now possible to invest with negligible fees when you choose where you invest your money.
Unfortunately, 401(k) plans limit your ability to choose. If you have a 401(k) plan with high fees, you are stuck with the plan’s fees until you part with your employer. At that point, you have the option to roll over your 401(k) to an IRA with lower investment fees.
SIMPLE IRAs are an exception to this rule. You can roll over money in a SIMPLE IRA to a traditional IRA with lower fees periodically without parting service. See the IRS website for full details.
Know Your 401(k) Fees
We monitor our investment fees in an Excel spreadsheet. As of year end 2020, I noticed that Kim’s 401(k) fees accounted for 50.8% of our investment expenses, while the fees on the remainder of our portfolio accounted for the other 49.2%. This is remarkable considering her 401(k) balance represents only 6.6% of our total portfolio value. The remainder of our funds account for the other 93.4% of our balance.
There is nothing we can do about fees on investments already in the fund until she parts service with her employer and can move the money to an IRA with a different brokerage. This prompted my question of whether the fees for ongoing contributions outweigh the benefits gained by continuing to contribute to her 401(k) plan.
Quantifying Future 401(k) Fees
To determine the cost of future contributions, we need to know several variables.
- All-in fees on the contribution
- Contribution amount.
- Anticipated growth rate of investments
- Anticipated number of years until parting service
Kim’s 401(k) fees are much greater than our other investments. The investments in the 401(k) are tax-deferred and we will eventually owe taxes on this money and any growth. For these reasons we elected to hold a portion of our bond allocation here. With interest rates being so low and her 401(k) fees so high, we are anticipating her annual growth rate to be about 0% after fees.
We don’t know how long she will continue to work. We plan everything a year at a time, so we anticipate a minimum of at least one more year and a maximum of 10 more years. This provides reasonable “best case” and “worst case” scenarios for the amount of time fees will compound .
So for every $1,000 invested, in the “best case” scenario, she would pay $12.30 in fees. In the “worst case” scenario it would cost her $123 for every $1,000 invested.
This is an estimate. For our purposes, it is good enough to inform our decision.
If you anticipate a higher rate of growth or longer tenure with your company, your asset based 401(k) fees will compound non-linearly along with your investment balance. It may be worth your time to calculate this growth in fees more accurately.
Quantifying 401(k) Benefits
Next, you need to determine the benefits of utilizing the 401(k) plan so you can determine whether it makes sense to contribute. There are two major financial benefits you need to consider.
- The impact of the employer match.
- Tax benefits of contributing to your plan.
Determine the Employer Match
Many 401(k) plans offer an employer match. This is additional money that an employer contributes to your retirement account to match your contribution.
Some plans will match 100% up to a particular contribution limit. For example, a plan may call for an employer to match 100% of every dollar contributed up to 5% of an employee’s salary. If you make $50,000 and contribute $2,500, your employer will invest an additional $2,500 for you. This is an immediate 100% risk-free return on your money.
Other plans’ match at different levels depending on how much you contribute. A common scenario is that the employer would match 100% of the first 3% of your salary and 50% of the next 2%. In the same scenario as above, you would receive a $1,500 employer match on your first $1,500 contributed, then an additional $500 match for the next $1,000 contributed. This would be an immediate 80% risk-free return on your money.
Guesstimate the Tax Benefits
The contribution limit for 401(k) plans in 2021 is $19,500. For those age 50 and over, you can also make a $6,500 “catch-up contribution,” bringing the contribution limit to $26,000. This leaves a lot of room for contributions beyond the employer match.
There may be tax benefits for contributing to a 401(k) that outweigh high fees. These tax benefits are less clear. We can know with certainty the tax impacts on the front end when contributing to the accounts. Determining the benefits on the back end when taking money from the account requires zooming out to look at your overall situation and making some assumptions.
Tax Rate Now
To calculate the current year federal income tax implications of your decision to participate in your 401(k), determine what your marginal tax rate will be on your highest earned dollars. Then multiply how much you would contribute to a tax deferred account by the marginal rate. If you don’t understand this concept, it is explained in detail here.
In our case, our last taxable dollars should fall in the middle of the 12% marginal tax bracket this year. So for every thousand dollars invested, it would save $120 in federal income taxes in the current year.
Tax Rate Later
Contributing to a 401(k) does not eliminate your tax burden. The taxes are being deferred and will be owed later. To determine how much, if any, tax benefit you’ll receive by utilizing your 401(k) account you need to estimate how much you’ll pay in the future.
If you have the option of contributing to a Roth 401(k), you could perform a similar analysis but calculate the impact tax-free growth and withdrawals would provide compared to the fees you would pay for participating in the retirement plan.
Why Your Future Taxes Could Be Lower
Future income taxes owed could be less than you would pay at your current marginal tax rate. Circumstances that could cause your money to be taxed at a lower rate in the future include having:
- Less taxable income when taking the money to provide living expenses in retirement,
- Less taxable income when converting the money to a Roth IRA,
- The same taxable income in the future, but tax rates generally being lower due to a change in tax policy.
Why Your Future Taxes Could Be Higher
Taxes owed could also be greater in the future than you would pay at your current marginal tax rate. Circumstances that could cause your money to be taxed at a higher rate in the future include having:
- Income from Social security, a pension, and/or paid work in retirement that push these dollars into a higher future marginal tax rate in retirement.
- High required minimum distributions. Oversaving in tax-deferred accounts can force you to take large distributions in years when they will be taxed in higher marginal tax brackets in retirement.
- The same taxable income in the future, but tax rates generally being higher due to a change in tax policy.
- Future income taxes you anticipated paying married filing jointly compressed into narrower marginal tax brackets as a single filer after the early death of a spouse.
Our Cost-Benefit Analysis
In our situation, for every $1,000 Kim invests in her 401(k) she will pay about $12.30 in fees in a “best case” scenario of staying in the plan for only one more year and $123 in fees over ten years in a “worst case” scenario.
Her plan has a policy such that her employer will match 100% of the first 3% of her contribution, plus 50% of the next 2%. The plan has no vesting period for employer matching contributions.
For every $1,000 she contributes up to 5% of her salary, she will get an immediate risk free $800 return. Even if she stayed in the plan and paid high fees for ten or more years, this benefit alone would easily eclipse the high 401(k) fees.
Quantifying the fees and comparing them to the impact of the employer match gave us clarity that she should contribute enough to her 401(k) to receive the full employer matching contribution. In 401(k) plans with all but the most egregiously expensive fees and long vesting periods, it is a no brainer to contribute at least to the amount of receiving the full employer match if at all possible. The benefits of the employer match clearly outweigh high 401(k) fees.
After receiving the match, we could put more money in the 401(k) for potential tax savings. Being in the 12% marginal tax bracket means she would defer $120 in federal income taxes for every $1,000 contributed to her 401(k).
Our best guess based on our situation is that these dollars will be taxed at a rate of 5% in the future. So she would pay $50 federal income tax on every $1,000 in the future.
Assuming our assumptions are reasonably accurate, every $1,000 contributed to the 401(k) account would save $70 in taxes. But the potential $70 tax savings would come at a cost of $12-$123 in 401(k) fees.
With no clear answer, we zoomed out and looked at the bigger picture.
Some additional factors you should consider in this secondary analysis include:
- Tax Cliffs. Are there benefits that can be achieved by lowering taxable income in the current year? Examples include obtaining a larger ACA premium tax credit or getting income low enough to be in the 0% long term capital gains tax bracket. If not, can you position yourself for future tax flexibility based on current year decisions?
- The absolute size of tax deferred accounts. Larger accounts means you’ll pay more taxes in the future.
- Number of anticipated years with low or no income prior to RMDs and Social Security. The more years you have to spread out retirement withdrawals or Roth IRA conversions in the lowest tax brackets, the less taxes you’re likely to owe on tax-deferred money.
- Tax rate diversification. If all or most of your money is already in tax-deferred accounts, it may be beneficial to save in Roth or taxable accounts. If you emphasized Roth or taxable accounts earlier, it may make sense to defer some income taxes now.
- Capital gains taxes. High earners who bypass retirement accounts to invest in taxable accounts will be subject to annual capital gains taxes on these investments. Lower earners may pay 0% on long-term capital gains, so this will have a smaller impact.
Our analysis didn’t provide the definitive answer we were seeking as to whether high 401(k) fees outweigh the benefits of contributing to retirement plans. However, they did give us an objective basis to make an informed decision and take action.
Kim will definitely continue contributing to her 401(k) up the level of the employer match for as long as possible. After that, we will emphasize diversifying our portfolio by adding to our Health Savings Account (HSA) and Roth accounts which make up only 2% and 11% of our portfolio respectively, compared to 49% already in tax-deferred accounts.
We will only make additional contributions to the 401(k) if it makes sense to lower our taxable income for other tax benefits in a given year.
Have you done a similar analysis? Do you know what your 401(k) fees are? Do you fully understand the benefits of contributing to work sponsored retirement plans?
How are you using your retirement accounts? Are you able to share any lessons from the other side of retirement about ways you would have used these accounts differently with the benefit of hindsight?
Let’s discuss it in the comments.
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at email@example.com.]
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