No-Match Roth 401(k) or Taxable Brokerage?

Submitted by Amar Patel on Wed, 2014-11-26 01:48

My wife and I max-out each of our Roth 401(k)s, our Roth IRAs, and still have some funds left after bills to put into a taxable account. She gets a match from her employer into her 401(k) (pre-tax of course). I do not.

But I used to get a match. When the match ended, I figured “oh well, it was nice while it lasted”. But recently, after seeing the fees and lack of performance in my employer’s plan, I started wondering if my Roth 401(k) contributions are better off in my taxable account, or maybe funneled into the pre-tax 401(k), or left as-is.

Saving $17500 on my MAGI doesn’t bring me and my wife down to a lower tax bracket today. I don’t know the future of tax rates, but I don’t think my marginal tax rate will be smaller in the future than it is now. And though the fees and performance suck now, I may be able to convince the employer to offer better options (at least they seemed willing to talk) and/or I could change jobs, allowing me an immediate rollover to a Roth IRA with better options.

But… what about the taxable account? I know most would probably balk, but does it make any sense, especially if in the near-term I cannot get the employer to add better options or I don’t change jobs for years? I’m potentially losing performance to fees (over 1% per fund). And seeing that it is after-tax money already, in that sense it is the same as the taxable account right? So the analysis of what is better is on the back-end I figured.

And in that way, I was trying to compare what 30 years of contributions and growth looked like in a Roth 401(k) with 1% fees and no back-end taxes versus the same 30 years of contributions and growth in a taxable account with much smaller fees (under 0.20%) but taxed. But then my brain box exploded.

Does anyone have any suggestions if I’m even go about such an analysis the right way? Does a no-match Roth 401(k) continue to make sense? Should I switch to a pre-tax 401(k)? Take the funds homes to a taxable account?

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Permalink Submitted by Amar Patel on Thu, 2014-11-27 04:02

I wonder if this was the right forum for this post? If not, can someone direct me to other resources on the Net?Thanks!

Permalink Submitted by Bruce Steiner on Fri, 2014-11-28 03:03

The best way to look at the 401(k) is that it’s part yours (1 minus the tax rate) and part the government’s (the tax rate).

Assume a constant 30% tax rate. You put $17,500 into your 401(k). It’s $12,250 yours and $5,250 the government’s (the tax you would have paid if you hadn’t made the contribution.

Over some period of time, your $17,500 401(k) grows to $175,000. You or your beneficiaries take out the $175,000, pay $52,500 tax, and have $122,500 left. Your $12,250 share grew to $122,500 tax free.

If you didn’t make the contribution, you would have had $12,250 in your taxable account. However, it would have grown to something less than $122,500, since you would have been taxable each year on the income and gains.

The complexity here is that your 401(k) is hit by a 1% a year expense. You’ll have to compare the investment return on your taxable account net of income tax to the investment return less 1% a year in the 401(k). However, you may be able to move the 401(k) assets over to an IRA at some point, either upon death or retirement, at a specified age, or if you change jobs. Or at some point the employer may offer less costly choices. You’ll have to consider when you think you’ll be able to move the money or the employer might offer less costly choices.

If at some point you can convert to a Roth at a bracket less than, equal to, or not too much higher than the tax rate that would otherwise apply to the distributions, that may add substantial value to the 401(k) benefits. If you don’t think your tax rate will be lower after you retire, you might consider contributing to a Roth 401(k), if your plan offers that option.

Bruce Steiner, attorney, NYC, also admitted in NJ and FL

Permalink Submitted by Amar Patel on Fri, 2014-11-28 20:32

Thanks for the response, Bruce. And on Thanksgiving no less!
I’m not sure I followed your math there but I did some of my own math. Assuming I did it right (this is a big assumption, because finance is not my day job… but I’m willing to show my work if desired!), I saw that:

Bypassing any 401(k) contribution provided the largest retirement nest egg by instead getting money into a Roth IRA (via backdoor methods if needed) up to the max and getting the rest into low-cost S&P 500 index ETFs held until retirement in a taxable account
The pre-tax 401(k) + Roth IRA + taxable account came in at second place
The after-tax 401(k) + Roth IRA + taxable account came in third place

I checked scenarios where Roth IRA contributions were not made (presumably sending the balance into a taxable account to grow like the rest). These scenarios were losers… and validates (at least to me) the power of a Roth IRA!

I did not check any scenarios where a pre-tax 401(k) was an option for me, because my wife is matched on her 401(k) contributions up to a limit and we’re not walking away from free money

I did not check any scenerios where my pre-tax 401(k) contributions were later rolled/converted into a Roth IRA at some point (death, retirement, change of jobs)… too many variables make me a dull boy after Thanksgiving.

However, all the math I did do makes *MANY* assumptions, like

The S&P 500 will grow annually at 5% in a smooth manner for 30 more years
The 401(k), whether pre-tax or Roth, has a 2% “drag” versus low-cost index ETFs (from expenses, turnover costs, general underperformance, etc.)
The “drag” of S&P 500 index ETFs is only 0.17% (like Vanguard’s mutual funds or ETFs in that category)
My marginal tax rate (28%) stays the same into the future
The capital gains rate in the future (when the index ETFs are sold) is 35%

But, even after playing with the variables like my net income and tax rates (marginal and capital gains) in the future, the difference between first place and third place wasn’t *huge*… it was within like $10000 for that $17500 that could be contributed in the coming year

While nice to have, that $10000 in retirement would mean giving up on my ability to pad a Roth 401(k) in hopes of being able to roll that over to the champ (a Roth IRA) at some near-term point (change of jobs, death)

I also seem to be making an assumption that my employer will *not* improve the plan to reduce the drag (by adding lower-cost options, reducing their kick-back on higher-cost options, etc.). Improvement is a possibility… though I won’t hold my breath too long hoping my employer will do better for his employees.

In the end, staying the course (maxing the Roth 401(k), maxing the Roth IRA, and being efficient in my taxable account) seems to be the best route *if* I can