Is a Subpar 401(k) Worth Investing In?

In recent years, 401(k) plans have come in for some heat. A 2013 PBS Frontline documentary painted a grim picture of Americans' retirement preparedness and took 401(k) plans to task for being too costly and failing to offer simple but effective index funds. Helaine Olen's book Pound Foolish: Exposing the Dark Side of the Personal Finance Industry is similarly critical.

No doubt about it, many 401(k) plans--especially those offered by smaller employers--are not serving savers well. Their administrative costs are often too high, employer matching contributions can be lackluster, and investment lineups can be full of costly also-rans.

Given all the bad press--and the reality that some 401(k) plans are weak--it would be hard to blame would-be 401(k) participants to pass on the vehicle altogether. But should they?

As discussed in this article, investors should definitely invest enough in a 401(k)--even a lousy one--to earn matching contributions. If the 401(k) plan is poor (and here's a checklist for making that assessment) and they have additional retirement assets they have to invest, they should opt for an IRA in lieu of steering more money to the poor 401(k) plan.

But what if they have additional retirement assets to invest? Once the IRA is fully funded, would those dollars be better off in a weak 401(k) or in a brokerage account held outside of a tax-sheltered account?

The answer here, as with so many financial questions, depends on a couple of key factors, especially the following:

• The investor's tax bracket at the time of the contributions: The ability to make pretax contributions--as is the case with 401(k)s--will be more valuable to the investor who's in a high tax bracket at the time of that contribution than it will be to the person who's in a lower tax bracket.
• The tax bracket at the time of withdrawals: Withdrawals from taxable accounts receive more favorable (and flexible) tax treatment than withdrawals from traditional 401(k)s. Investors pulling from their taxable accounts will owe capital gains taxes, whereas money coming out of a traditional 401(k) is taxed at the investor's ordinary income tax rate, which is higher. Moreover, because the 401(k) money has never been taxed, investors owe taxes on the entire withdrawal, not just the appreciation; taxable-account investors, by contrast, will only owe tax on their gains. Finally, 401(k) assets are subject to required minimum distributions at age 70 1/2. For investors who expect to be in a high tax bracket upon retirement, having assets in a taxable account--and enjoying more favorable taxation on the distributions--will tend to be particularly beneficial.
• 401(k) quality: Just how bad is the plan? Does it have high administrative costs and subpar and/or expensive investment options? Or is it simply that the lineup includes some lackluster funds that are past their prime, while also including some reasonably priced options?
• The quality and tax efficiency of the investments in the taxable accounts: Investing in a taxable account will rarely be the better option unless you're able to invest in securities that make few ongoing distributions of income, capital gains, or both.

The Trade-Offs in Action Because these factors all work together, it's difficult to make one-size-fits-all assessments about the virtues of investing in a 401(k) versus investing inside of a taxable account. Here are a couple of simplified examples that help illustrate the interplay between all of these variables--and specifically the trade-off between tax costs and investment expenses.

Example 1: Anne plans to invest $10,000 per year in a balanced portfolio within her lousy 401(k). While her account earns 5% per year on a pre-expense basis, that number shrivels to a 3.5% return once all the fees are taken out. She makes pretax (traditional) contributions to the 401(k) account for 30 years, at which time she begins pulling the money out and paying taxes on the withdrawals at her 25% income tax rate. Anne would have about $534,000 on a pretax basis at the time of retirement, but the taxes on her withdrawals would take that amount down to about $400,000.

Example 2: Jerry, meanwhile, skips the costly 401(k) and goes straight to a taxable account. He doesn't receive the tax break on his initial contributions, so he can only contribute aftertax money into the account; whereas Anne can send the whole $10,000 into her 401(k) each year, Jerry--in the 25% tax bracket at the time of his contribution--can only afford to contribute $7,500 to his taxable account. He, too, invests in a balanced portfolio and earns 5% on a pretax, pre-expense basis. But he sticks with low-cost, tax-efficient equity index funds and municipal-bond funds, so he's paying just 0.5% per year in taxes and just 0.25% in fees. He'd accumulate about $457,000 over 30 years. When Jerry withdraws the money in retirement, he won't pay taxes on the $225,000 he put in--his basis, which he has already paid taxes on--but he will owe capital gains taxes of 15% on his appreciation of $232,000 (assuming he's in the 25% income tax bracket). Thus, Jerry's aftertax, take-home total would be about $422,000. Jerry did better than Anne.

Example 3: James' 401(k) includes a 0.5% layer of administrative fees, but he opts for the ultracheap index funds within his plan, bringing his total costs on a balanced portfolio to 0.6%. He invests $10,000 into the plan for 30 years, earning a 5% pre-expense return that drops to 4.4% once the plan's expenses and the fund costs are factored in. He amasses about $626,000 in the plan, which drops to about $470,000 once he pays taxes at a 25% rate on the withdrawals. By taking advantage of the tax benefits of the 401(k) while also finding a way to lower his overall costs, James comes out ahead of both Anne and Jerry.

Example 4: Monica bypasses her company's poor 401(k) and instead invests $7,500 per year in a taxable account. She chooses low-cost funds--with average expense ratios of 0.50%--but they're tax-inefficient, so she pays an additional 1% per year on their taxable capital gains and income distributions. While her balanced portfolio returns 5% on a pre-expense, pretax basis, she earns just 3.5% once taxes and expenses are taken into account. She has about $400,000 at the end of the 30 years--$225,000 of her own contributions, which she can withdraw tax-free--and another $175,000 in appreciation. Once the 15% capital gains tax on the appreciation is factored in, she ends up with about $374,000. By not taking advantage of the ability to make pretax contributions to the 401(k) and failing to invest in tax-efficient investments inside of her taxable account, she fares the worst of any of our hypothetical investors.

Takeaways The preceding examples illustrate that investors would do well to weigh their own personal tax situations--both current and future--as well as the quality of their 401(k)s when determining which account types to fund. Obviously, the preceding examples are highly simplified: Rarely does an individual's tax bracket stay the same over a 30-year period; tax rates on a secular basis are also apt to change. (Capital gains tax rates, in particular, are quite low by historical standards.) That underscores the virtues of tax diversification--splitting assets across accounts with varying tax treatment, whether tax-deferred, taxable, or Roth--when saving for retirement.