Worse Than Nothing

August 13, 2007

The 401(k) market certainly is a racket, Jim.  And it's a racket that puts Tony Soprano to shame.

I was recently looking for information on the average "all-in" expense ratio for 401(k) plans. That information is hard to find, of course, but I did stumble on one survey of "leading 401(k) providers" that put the average fund and fee expenses at 1.67% (Sharebuilder.com). With over $2.7 trillion invested in 401(k) plans nationwide, we're talking ... oodles of money.

It got me to thinking: Are these fees so large that they actually obviate the tax advantages of 401(k) plans?

Let's take a simple example. Suppose you've just entered the workforce and get a $10,000 bonus at year-end. You plan to retire in 30 years, and you've decided this money should help fund that retirement.  Which is the better choice?

  • a) Take the money and invest it in the company's 401(k) platform, which charges the average fee of 1.67%; or,
  • b) Pay taxes on the income and invest it in a brokerage account outside of the 401(k) structure.

Assuming the market returns 8% over the next 30 years, that 401(k) investment will net out to $63,058. If you're in the 25% tax bracket when you retire, you'll end up with $47,693.24 after taxes. Not bad.

But the brokerage account does much better.  Taking the worst-case scenario, let's assume that you're in the (highest) 35% tax bracket, meaning that $10,000 bonus is reduced to a $6,500 investment. You invest that $6,500 in the Vanguard Total Stock Market ETF (AMEX: VTI), which charges 7 basis points (0.07%). At the end of 30 years, your account is worth $64,147.15. After you pay capital gains, you're left with $54,525.08 ...or nearly $7,000 MORE than in the "tax-advantaged" 401(k) platform.

You get similar results even if you have the market return 10% per year.

[My example assumes that the 401(k) platform returns will match VTI over the long-term. I'd submit that most 401(k) investors actually underperform the broader markets.]

The way the current 401(k) market is structured, fund providers are arrogating all of the supposed tax savings and then some.

Some deal...

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