Fees and 401(k) or 457(b) Accounts

Common advice offered to investors is that they should contribute to available tax-deferred plans (like 401ks and 457bs) before investing in after tax accounts. In most cases, this is good advice. It is especially advantageous when company matching contributions are available. If your employer is providing matching funds to your tax deferred accounts, then when you fail to contribute, it is like voluntarily giving up salary. Make sure you get all the matching funds you can get or you are effectively taking a cut in wages.

Even if matching funds are not involved, tax-deferred plans are often better investments than contributions to an after tax account. Consider the following cases:

CASE #1 (After tax contributions):
Contribute $3000 per year to an after tax account for 30 years.
Then withdraw $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns 7% per year return with an expense ratio of 0.2% (typical of low-cost index funds)
Assume the pre-retirement tax rate is 28% and the post-retirement tax rate is 18%.
Withdrawals are tax free (since youve already paid tax on the money when you invested).

CASE #2 (Tax deferred account):
As in case 1, contribute $3000 per year to a tax-deferred account for 30 years.
Then, identical to case 1, withdraw the $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns at a rate identical to case 1 -- 7% per year return with an identical expense ratio of 0.2% (typical of index funds)
Assume the pre-retirement tax rate is 0% and the post-retirement tax rate is 0% (Consistent with 401(k) and 457(b) regulations).
Withdrawals are taxed at 18%.

CASE #1 describes typical numbers for a taxable index fund account while CASE #2 describes numbers that might apply for a 401(k) or 457(b). Of course every individuals experience and tax situation is different.

At the end of 30 years, the tax-deferred account of CASE #2 would be worth ~$295,000 while the after tax account of CASE #1 would be worth ~$208,000. Tax deferred treatment is worth ~$87,000.

Once the withdrawal phase is started (years 31 to 60), the taxable account has an advantage since withdrawals do not count as income and so are not taxed. Despite this advantage, at the end of year 60, the tax-deferred account is valued at ~$1.8M while the taxable account is valued at only ~$1.2M a $600,000 advantage to tax-deferred accounts.

But what happens if the 401k account is burdened with high fees? Using identical assumptions for the two cases except assuming the CASE #2 tax-deferred account expense ratio is 1% rather than 0.2% results in the complete annihilation of the tax-deferred advantage. With a 1% expense ratio, the tax-deferred account grows only to ~$256,000 in 30 years (an advantage over after tax saving of only $48,000). But even that slight advantage is lost entirely during the withdrawal phase. For higher expense ratios, a tax-deferred account is actually a bad investment when compared to the low-fee, equivalent returning fund in a taxable account.

Fund expense ratios as high as 1%, or even 4% to 5%, are not unusual. With only a 2.1% expense ratio on the tax-deferred mutual fund, all advantage is lost even in the 30 years of the contribution phase. During the withdrawal phase, this tax-deferred account would lose over $500,000 compared to after tax saving of CASE #1. It pays for investors to keep their eye on expenses. If your employer isnt offering matching funds and offers no low-fee mutual funds in their plan, you might be better off investing your money in a taxable account.

Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html

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Tax Efficient Withdrawal Strategy in Retirement

You may not currently have a retirement withdrawal strategy, and if you are still in the accumulation phase of your career, you might not need to put too much advanced thought into that strategy. When the time comes to enter the withdrawal phase of your financial life, however, it makes a difference what order you withdraw your funds. The primary issue for most retirees is to keep an eye on taxes. Taxes can potentially be the largest controllable expense a retiree faces. Withdrawing assets tax-efficiently as you manage your retirement is one simple way to save money over the long run.

Basic withdrawal advice is fairly straight forward:

- Educate yourself on your options and legal requirements. You should know, for example, what the minimum age for withdrawal without penalty is. You should also know that if you hold onto your tax-deferred accounts for long enough, the government will require you to take withdrawals. You cannot withdraw money from most tax deferred plans (like 401(k)s, 403(b)s, IRAs, etc) prior to age 59-1/2 without incurring significant penalties. If you are planning early retirement, you need to identify what source of funds you will use prior to that age. There are exceptions for certain kinds of withdrawals, and there is a tax loophole known as 72t withdrawals that get around the penalties – but the laws are very restrictive and specific about how to do this. If you hang onto your tax-deferred account for too long, the law forces you to withdraw a required minimum distribution (RMD) and suffer the tax implications of that withdrawal. RMDs are applicable at age 70–1/2.

- Your goal should be maximum growth. This involves different things depending on your personal situation but in general you want to draw down according to this priority list:

Before Age 70½
1. Taxable assets.
2. Tax-deferred assets (such as those in traditional IRAs and employer-sponsored retirement plans).
3. Assets in tax-free Roth IRAs.

After Age 70½
1. RMDs from qualified retirement accounts.
2. Taxable assets.
3. Tax-deferred assets.
4. Assets in tax-free Roth IRAs.

- Take other tax considerations into account. You might benefit from selling assets that have lost money from your taxable accounts – taking the tax deduction for the loss. Your decisions should not be based on simple minded tax minimization. Instead you should focus first on achieving sustainable growth. It is important to manage risk by rebalancing your portfolio if it becomes too heavily invested in a particular asset or asset class.

Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html

Visit my site: http://www.golio.net/