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% |
| Investment Return | 8.0% |
| 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 |
we get
| Advantage Over 401k or 403b | |
| Roth IRA | +7.2% |
| Non-Deductible IRA (If Not Eligible for Roth) | -16.9% |
| Taxable | -19.9% |
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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Ulysses says
Thanks! Would you be so kind as to allow us to copy this zoho sheet to our zoho accounts and/or export it? I would like to be able to open it locally and work on it instead of going through the browser. Thanks!
arvind says
If my company has a layered 401K plan (100% match for 1st 1500, 50% for next 1500, 33% for next 7500, 10% for remaining until max), do you know how it will affect your above spread-sheet?
Harry Sit says
@arvind – Even a 10% match fully compensates for the higher cost. You don’t need a spreadsheet. 401k wins hands down. Maximize 401k contributions before you even look at anything else. The spreadsheet only compares when there is no [additional] match.
arvind says
Thanks for the info. But with Fidelity 401K my investment options are limited to a few funds (only one index fund). I am wondering will it be better to take the money out and invest on my own.
Do you know how good the Fidelity Retirement 2015, 2025, 2035 etc. funds are?
Harry Sit says
After thinking about it a little more, I think if you treat the match as a one-time bonus, you can use the same spreadsheet because there is no additional match after year 1. Even when there is no match, a high cost 401k plan often still beats taxable investing as long as you don’t stay with the same employer for many years and you rollover to your own IRA as soon as you leave. I would rate the Fidelity Freedom funds as above average for 401k plans. They can be better, but they are far from being terrible.
Arvind says
Could you please recommend some good places to rollover my previous 401K to a IRA? I’ve heard Fidelity and vanguard are the best.
Harry Sit says
Vanguard is the best. See previous post Best Mutual Fund Company.
arvind says
Thanks for the info.
arvind says
I just saw that Fidelity has lower expenses 0.1% compared to Vanguard (0.25%) for their US stock market Index fund. If I am planning to just put all my money into an index fund, isn’t Fidelity better?
Vig Oren says
Hi tfb, how a Roth 401(k) or Roth 403 (b) would fit in above calculations? Also, by any chance, do you know if USAA Brokerage has an option of “no transaction fees” (NTF), whereby I could buy Vanguards funds at low costs there?
Harry Sit says
@Vig – Roth 401(k) or Roth 403(b) are covered in these posts: The Case Against Roth 401(k) and Roth 401(k) for People Who Contribute the Max.
Don S says
Excellent info and spreadsheet . . . i guess this is a good template for placing any alternative to the 401k side by side .. .
David says
tfb, you have the Roth and traditional IRAs confused. The Roth contribution is non-deductible while the earnings are tax free. Vice versa for the Traditional.
Harry Sit says
David – I’m pretty sure I didn’t have the Roth and traditional IRAs confused. What made you think that’s the case? When you are not eligible for contributing to a Roth IRA and you are covered by a 401(k) plan, your contributions to a traditional IRA are not deductible.
David says
My mistake. I as scanning the article and didn’t realize you were coming from the standpoint of a 401k participant. Carry on.
John says
Does anyone know why you can’t contribute to both a 401k and an IRA? I would like to contribute 5% to my employer’s high cost retirement plan to get the 5% match and then put the balance (up to the allowable limit) in an IRA and deduct it at tax time. Why is this not allowed?
Harry Sit says
John – You CAN contribute to both a 401k and an IRA. If your filing status and income meet the qualification, you ARE allowed to take a deduction. See IRS Publication 590.
DQ says
Have you given any thought to what are called Brokerage 401k’s, also known as self directed brokerage 401k’s? This is where an employer has allowed the employee to move their money to a brokerage firm (schwab, fidelity) and all funds available on those platforms are available. I mention this because you can then finally make a best of class 401k where the funds you acquire are no- load funds, with low fund expenses, and your money is operating in the realm of the best funds like Amana Growth Trust, Fairholme, Pimco Managers Bond Fund, Vanguard funds etc…. Let’s face it, most funds in typical in the box 401k plans are on the whole mediocre at best.