This is a common problem: you have a 401k or 403b plan at work, but the plan isn’t very good. All the investment options in the plan have high expenses. The plan itself may also have some hidden fees.
If the plan has a match, you contribute enough to get the full match. That’s a no-brainer, because the match will likely more than compensate for the high costs and hidden fees. But then what? Any additional money you contribute to the plan won’t get any more match. Or perhaps the plan doesn’t have a match to begin with or your employer contributes to the plan regardless whether you contribute or not.
In these cases, should you still contribute to the high cost 401k or 403b plan even when there is no [additional] match? I made a spreadsheet to compare the alternatives.
1. Roth IRA. If you are eligible, contributing to a Roth IRA is a good alternative to a no-match 401k or 403b. Because a Roth IRA is under your own control, you can buy low cost funds in your Roth IRA. The lower your costs, the more investment returns you get to keep.
2. Non-Deductible IRA. If you are not eligible for contributing to a Roth IRA, you are still eligible to contribute to a non-deductible Traditional IRA. The contributions are not tax deductible but the investments grow tax deferred inside the IRA.
You can also convert a non-deductible Traditional IRA to a Roth IRA. This Roth conversion path is beyond the scope for this post. For the purpose of this post, I assume the non-deductible IRA is going to stay as-is and not converted to Roth, although you are likely better off converting it at some point.
3. Taxable Account. Another alternative to a high cost 401k or 403b plan is investing in a regular taxable account.
If you buy tax efficient stock funds, the majority of your returns will come as unrealized capital gains which are not taxed until you sell. When you do sell, long-term capital gains are taxed at a more favorable rate than ordinary income.
4. Contribute to the plan and then rollover. The alternatives are not necessarily better than contributing additional money to the 401k or 403b plan even if the cost is high and there is no match. This is true especially if you are not going to work for this employer for very long.
When you leave your employer, you can rollover the balance in your 401k or 403b plan to your own IRA. Then you will be able to use low cost funds. You just have to hold your nose and pay the high cost until you are liberated from the plan. A key input is how many years you will have to pay the high cost.
Finally, here is the spreadsheet that compares these options:
You will need the estimated tax rates, investment return, extra cost in the plan, how many years you will be in the plan and how many years you have until withdrawal. It then calculates “advantage over 401k” for each alternative. If the result is positive, it means that’s a better option. If it’s negative, it means it’s still better to contribute to the high cost 401k or 403b plan and wait for the rollover.
In many cases you will find that Roth IRA is better than a high cost 401k or 403b but the other two options are not. For example, under this set of assumptions,
|Marginal Tax Rate Now||25%|
|Marginal Tax Rate at Retirement||25%|
|Capital Gains Tax Rate at Retirement||20%|
|Tax Rate on Dividends||25%|
|Front-end Load in 401k or 403b [note 1]||0.00%|
|Dividend Distributions in Taxable Account||2.0%|
|Extra Cost in 401k or 403b||1.5%|
|Number of Years In Plan Until Rollover to IRA||5|
|Number of Years Until Withdrawal||30|
|Advantage Over 401k or 403b|
|Non-Deductible IRA (If Not Eligible for Roth)||-16.9%|
In this example, a Roth IRA is 7% better than a high cost 401k or 403b plan; a non-deductible IRA is 17% worse; and a taxable account is 20% worse. That’s why you often hear about the rule of thumb: 401k for the match, then Roth IRA, then back to 401k.
If you are not eligible for Roth IRA, the spreadsheet also indirectly compares a non-deductible Traditional IRA with a taxable account. In our example if you max out the 401k and you still have money to invest for retirement, you should do the non-deductible IRA before you invest in a taxable account because a non-deductible IRA is not as bad as the taxable account. If you are able to convert that non-deductible IRA to Roth, all the better.
Feel free to plug in numbers applicable to yourself and see how the alternatives play out for you.
Note: Front-end load is often waived for 401k and 403b plans. Please verify with plan administrator.
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