The Electric Kool-Aid 401K Retirement Test

Originally published: November 8th, 2015

Can you pass the retirement test? Are you saving enough now to live comfortably then? Do you even know how much you’ll need when you retire, much less how much you need to save now to get there? For most Americans, in spite of how many danged “retirement calculators” proliferate the innerwebs, the answer is “probably not”.

For anyone who has expanded their mind out into the future and realized that maybe they shouldn’t rely on a government sponsored Ponzi scheme to support them after their working years are over, the 401K plan is shoved in their face as THE mechanism to save for retirement.

Go ahead…google it:

401K google search snip

That is from the U.S. Department of Labor. This is coming from the people running the aforementioned Ponzi scheme…which should raise some red flags…but that is a discussion for another day.

Here…have some Kool-Aid. Sign up and contribute ALL YOU CAN….MAN! It’s easy!

It is not just the department of labor sounding this drumbeat. That advice is almost universal. “Max out your 401K”. I’ve heard it from family, friends, bloggers, you name it. Especially when I mention that I want to “retire” early. First reaction is typically something like, “well I hope you’re maxing out your 401K”.

I’m not so sure I buy this “fundamental truth”. In fact I know I don’t buy it. That’s not to say 401K plans are inherently bad. Much like LSD isn’t inherently bad. I just think you really ought to know what you’re getting yourself into.

Since I finally got to a point earlier this year where I had an actual bona fide strategy for investing, I had to grapple with the idea of contributing to a 401K. I hadn’t previously because I just didn’t. I said the reason was that my employer didn’t offer a guaranteed match, but it’s not like I was saving that money in some other vehicle. I just wasn’t serious about saving yet. Now that I wanted to fund my brokerage account, I knew I should at least consider funding the 401K first.

I had to think extra hard about it because of my particular situation. My company offers a 401K plan, but there isn’t a guaranteed match. It is a “profit sharing” match plan, which means the match is completely discretionary. I have no idea if they will match anything or not. It depends on how the company does and how management is feeling. My dilemma was this: If I don’t contribute, and they decide to match some amount, I’ll miss out on that benefit. If I do contribute and they don’t match, would I have been better off doing something else with the money?

In order to answer the dilemma, I conducted a thought experiment: All things being equal, what happens to money contributed to my 401K with no employer match compared to money invested in a ROTH IRA or a taxable brokerage account?

I needed to define some parameters for my thought experiment. They were constructed as follows:

  1. I cannot predict changes to tax laws. For the purposes of the thought experiment current tax law is the same as future tax law.
  2. I want my quality of life in “retirement” to roughly equal my current quality of life. I cannot assume that I will be in a lower income tax bracket when I retire.
  3. I cannot beat the market. The mutual fund managers running the funds available in my 401K cannot beat the market. The only variables that affect the outcome are fees and taxes. Everything grows at the same compound annual growth rate (CAGR).

I had a suspicion that the high fees associated with the fund choices offered in my 401K plan plus the difference between income tax and capital gains tax would offset the benefit of contributing to the plan on a “pre-tax” basis.

For the purposes of illustration I used the base contribution amount as $5,500 which is equal to the maximum allowable ROTH IRA contribution. In other words, what’s the best use of my $5,500? Invest in a taxable brokerage account, a ROTH IRA or contribute to my 401K that offers no guaranteed employer match?

I assumed that “the market” would grow my investment at an 8% CAGR. 2.06% of which is attributable to dividends (that is the 10 year average yield for the S&P 500). Dividends paid in a taxable account are of course taxed at the capital gains tax rate of 15%, which inhibits the growth of the initial investment.

The 401K contribution is “pre-tax” so I can recognize the full $5,500 as “principal”. ROTH contributions and investments in a taxable account have to be adjusted for income tax (I used the upper rate for my tax bracket – 25%).

The ROTH and taxable accounts charge an upfront trade commission. I assumed that I would follow my lot size rule and keep commissions to 0.5%. Upfront trade commission costs also affect the “principal” invested.

Typical Vangaurd index funds have an expense ratio of 0.05%. For the purposes of the thought experiment, I cannot expect to match the diversity of an index fund by only investing $5,500 into individual stocks. So in this scenario, the hypothetical money goes into index funds in order to match the market and the taxable and ROTH investments are assumed to be in funds with a .05% expense ratio. There are index funds available in my 401K, but their expense ratio is about .75%.

Finally I projected the growth out to 20 years. The projected balance after this time is then adjusted for the applicable tax rate. 401K funds are adjusted by the income tax rate of 25%, ROTH funds are not subject to any tax, and the taxable account balance is subject to a 15% capital gains tax on the increased value of the “principal”. Here’s what happens to $5,500 invested in my 401K plan subject to the above parameters:

00_401K growth

And here’s what happens to that same amount invested in a ROTH IRA (note the principal is reduced by 25% to account for income tax paid, and then by 0.5% for commission costs):

00_ROTH growth

The lower expense ratio in the ROTH index fund plus the fact that the balance is not subject to any taxes is a huge advantage for the ROTH. It’s nearly a 13% advantage.

What about the taxable brokerage account?

00_taxable growth

Since any dividends paid are taxed at 15%, the actual CAGR is only 7.64% for the taxable investment compared to 7.95% for the ROTH. That “actual growth” still beats the growth rate in the 401K because of the lower expense ratio, but because of the lower initial investment principal and the fact that cumulative capital gains are still subject to tax, the end result is the lowest amount of money actually available in this scenario.

But it’s not really that much lower than the 401K. It’s only a difference of $722 dollars or 4.4%. And that is assuming I invest in the lowest expense fund available in my plan. There are only three equity funds with an expense ratio less than 1%. What happens if we change the expense ratio of the 401K fund to 1%…which is a pretty standard rate for most funds?

00_401K growth 1percent

Any advantage is completely wiped out by the lower actual CAGR. It’s worth noting that the expense ratio is calculated based on assets under management (AUM) which is calculated after the year’s growth is added to the principal. For a 0.05% expense ratio, that amount is negligible and is essentially a rounding error when calculating the true CAGR. But for higher expense ratios…it matters…a lot.

My conclusion? The 401K is not a total scam. If I carefully select the funds with the lowest expense ratio, the tax deferred benefit is a slight improvement over buying index funds in a taxable account. But it’s only slightly better. If I invest in individual stocks, I only have to beat the market by an annual 0.22% (4.4% over 20 years) in order to do as well as unmatched 401K contributions. Add to the fact that I have complete, unfettered access to the balance of my taxable account at any time over that period, and the 401K seems less and less appealing.

Unlike the internet, I try not to make broad sweeping statements about the value of things. Given the parameters of this particular thought experiment and my particular situation, the 401K is not the end-all be-all retirement savings vehicle. It’s an option…an okay one. I will vehemently oppose anyone who says you should absolutely max out your 401K no matter what, but I also won’t say categorically that no one should contribute to their plan.

For example: my wife’s 401K situation is completely different.

  1. Her employer offers a match. It’s a goofy match, but it’s a match. Contribute a minimum percentage of your income, and they’ll match a fixed dollar amount. It’s weird, because the higher your salary, the lower the effective match as a percentage of the contributed amount. Whatever, at least she gets a match.
  2. Her plan offers a number of funds with much lower expense ratios, including the Vanguard 500 Index Admiral Fund which has an expense ratio of 0.05%
  3. Her plan does charge a 1.2% commission on new deposits which affects the end result, but not as significantly as high annual fees.

So with that option available, what do the numbers look like? First of all, the match helps. For the purposes of illustration, I’ve kept the hypothetical investment amount the same at $5,500. Rather than publish my wife’s salary on the internet, I’ll just say that at her salary, the effective match from the fixed amount is 13.33%. This means a hypothetical $5,500 contributed is the equivalent of a starting principal of $6,158.35 (13.33% match less a 1.20% commission on new deposits).

00_401K growth good 401K plan

Well that blows the ROTH out of the water.

What about funds contributed beyond the minimum needed to earn the match?

00_401K growth good 401K plan_no match

Not so much. The ROTH edges out my wife’s 401K without a match, although barely. Again though, the ROTH has better flexibility since you can take principal back out at any time.

But it crushes the taxable account option. This is because we can invest so much more initially (1.20% commission versus a 25% tax hit), plus the growth isn’t impaired by capital gains taxes on the dividends, and at the end, the 10% delta in income versus capital gains taxes isn’t enough to make up the difference in growth potential.

So after all this, what are we doing? Our investment funding priorities are as follows:

  1. Fund my wife’s 401K with the minimum contribution to be eligible for the match.
  2. Max out our respective ROTH IRA contributions.
  3. Max out my wife’s 401K plan
  4. Invest remaining savings into a taxable account except…
  5. To the extent that we can use contributions to my 401K (selecting the “low” cost index fund options) to keep our upper tax bracket below 28% and/or to maintain an adjusted gross income (AGI) such that we can continue to be eligible to contribute to ROTH IRAs at all

Obviously our investment priorities are extremely specific to our situation. Just like everyone’s investment priorities should be tailored to their own situation.

I have an issue with the blanket statement: “If your employer offers a retirement plan, sign up and contribute all you can.”

Granted it’s better than: “Don’t worry about retirement. Future generations will pay to support you through government sponsored entitlement schemes.”

But there’s waaaaaay more to it. You have to be ready to go down the rabbit hole…a little bit anyway. Can you pass the retirement test? I hope so. But don’t drink the Kool-Aid without doing a little bit of research first. It’s pretty good Kool-Aid, but it’s still a hell of a trip. Be prepared.

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