Now that we’re in the thick of tax season, I figured it might be nice to have a post related to tax savings; specifically what we pay in 401k fees vs the tax saving benefits. I just paid my federal and state taxes and I’m getting ready to pay my property taxes. Part of my decision making strategy when I refinanced, was forgoing escrow so that I could use a credit card to pay my property tax. It lets me make my big property tax payment to get the sign up offer bonus points on a credit card. This year it will be the Hilton Honors Surpass card that will be added to my arsenal of travel hacking weapons. It’ll be my first hotel credit card and I’m looking forward to stacking some points for some free hotel stays, maybe I can utilize it in Mexico or Portugal this year.

Back to the topic of this post. I’ve been doing the usual cursing and head shaking that accompanies thinking about paying taxes. I’m again left wondering what I could have done better to lower what I owe. It’s not that I don’t want to pay any tax at all. I personally like sidewalks, public education, and a safety net for the most unfortunate so I don’t have to install bars on my windows and broken glass atop my fence. But that doesn’t mean I want to fork over more than I have to either.

I think Mr. Godfrey says it best:

“I am proud to be paying taxes in the United States. The only thing is – I could be just as proud for half the money.”

-Arthur Godfrey

What’s the easiest way to reduce how much I’m taxed? Lower the percentage at which the government taxes me. How? By maxing out my 401k to reduce my taxable income…or I could just find a lower paying job–no thanks.

Prior to writing this and doing some research, I really disliked my current 401k. No match and what I considered high fees. It’s through my union and not the company I work for. I guess the union figures that they’re already giving us a pension and annuity, so our 401k doesn’t need to have all the bells and whistles. Anyway, for two years I avoided the union 401k because of the lack of a match and the fees associated with it. It wasn’t until early 2020 that I decided to max it out to see if I could lower my tax bill.

Even then, I didn’t stop to do any math to see what the fees paid to my 401k were vs the tax savings. This year I did. For this post I’m not going to use my income or 401k value, but use what I see as average for a couple our age working full time in San Francisco.

Fees

A TD Ameritrade survey last year found that roughly 27% of people knew what they were paying in 401k fees. I wasn’t among those people, as stated above, I’d glanced once or twice at the fees, but never did the math. It just seemed high. Especially when using Vanguard and seeing their fee for a brokerage account.

Turns out, my 401k fees aren’t high compared to the average 401k fee, they’re actually pretty low. The average 401k annual fee is 1% based on this study. The Department of Labor requires 401k plans to provide an annual fee notice. If you want to see your provider’s plan summary(different than annual notice), click this link from the DOL, where you can search and view it anytime. They are required to report their aggregate administration fees and a bunch of other info to the government.

When it comes to these 401k fees, there’s two parts.

• Direct Fees: Are deducted from our account balances. These will be on the annual notice sent to us and are easiest to find. They will be asset based, transactional, and/or fixed fees. Your statement of activity will usually include these.
• Indirect Fees: These are sneaky fees that 401k providers do not have to include in their notice. These are deducted from fund returns. You have to look at the prospectus and reconcile the fee with the fund’s comparative chart. These can be “loaded” funds. Even funds with no-load can have “12b-1” fees. Target Date funds can have “fund of fund” fees, meaning they charge their fee and the fee of the fund they’re investing in. Another sneaky fee is called a Wrap Fee used more by insurance company based providers.

401k Fees vs Taxable Account Fees

We’ve all read about the drag fees can have on our investments and know it can add up. But let’s compare a 401k’s fees with a taxable account’s fees to see if there’s any savings using one or the other.

The account service fee through my union 401k provider John Hancock is $10 a month and .30% of my account balance annually, which is deducted each month. All this is on top the index fund fee I choose to invest in. If there is a silver lining to this, they offer Vanguard’s VFIAX, which has a fantastically low expense ratio of .04%. The John Hancock fee alone of $10 a month totals $120 a year! Let’s just say for a nice round hypothetical number that my account value is $100,000…which also happens to be the average balance for Americans. The .30% fee would be $300 a year. And VFIAX’s fee would be $40 on the 100k.

So in total, in one year I would be paying $460 to invest my money in my 401k. (.30% value fee+$10 month admin fee+ .04% index fund’s fee=$460 or .459% of 100k)

The total 401k fee is then .46%. Doesn’t sound like much does it? $460 on its own in ten years turns out to be about $7,205 if you factor in potential 7% annual returns. But if you factor in the total drag on your 401k, it turns of to be a loss of $15,360 after ten years of maxing it out at $19,500 a year. And $75,580 after 20 years! I used this calculator for these numbers. Robbery, right?

If I were to just plunk this $100k into a taxable account I would only pay Vanguard $20 a year for their account fee. and $40 for VFIAX. So $60 bucks a year…or .06% of the value. Not bad. In 10 years the loss on return, if $19,500 were contributed each year, would be $2,077, and $10,370 after 20 years.

Makes early retirement look even better so we don’t have to pay those damn 401k fees for decades. Sooner we can roll it over to an IRA the better!

So isn’t the choice obvious? Why in the world would I continue to max out my 401K?

Tax Efficiency?

I’ll run through some numbers to see how a 401k benefits a person when it comes time for Uncle Sam to conduct April pocket checks. First here are the brackets.

For shits and gigs lets use a hypothetical couple who’s in the middle at the 24% bracket at Married Filing Jointly.

I pretty much have to relearn how this works each year, so if you’re like me, this is how it works. If you’re in the MFJ 24% bracket, you would pay 10% on your first $19,750. Then 12% after and up to $80,250 and 22% on anything after $80,250 to $171,050. And so on…

For a nice round number lets say the household gross income is $200,000. This means this person would be paying:

• 24% tax on $28,950. Which is $6,948.
• 22% tax on $90,800. Which is $19,976.
• 12% tax on $60,500. Which is $7,250.
• 10% tax on $19,750. Which is $1,975.
• Grand total the IRS would want: $36,149!!

So after taxes, a family making $200k is really making $164k (not including 6.2% social security and 1.4% medicare deductions…so it’s even less!).

How much tax savings does maxing out a 401k at $19,500 really get you? By contributing the max allowable, the taxable income on $200k gross reduces to $180,500.

This means only $9,450 will be taxed at 24%. Which would be $2,268 owed instead of $6,948 in the 24% bracket. Or in total $33,881.

Tax savings of $4,680. That’s 2.34% of a $200k income back from the clutches of the government.

Let’s not forget California’s share of our hypothetical income.

In this case, with no 401k contributions a person making $200k would owe $12,857 to the Golden State. If we do the same as we did with federal and reduce income to $180,500 by maxing out a 401k, they would owe $11,043. A savings of $1,814.

Tack that onto the federal savings of $4,680 and the grand total saved in a year, just by maxing out the lovely 401k is: $6,494…or 3.24% of a 200k gross income.

Okay, now the 401k fee of .46% looks to be worth its $460 yearly price tag. And even with the “average” 401k 1% fee ($1,000 a year in this hypothetical case using $100k as the value), the tax savings benefits outweigh the 401k fee drag. To really make the benefit worth it, investing this saved money would be the preferred option. This would offset the fee drag in your 401k and compound to benefit you big time.

I mean, we all knew there was a savings to be had by maxing out a 401k even without crunching numbers. How did we know that? Because everyone says it? Because it just feels right? If everyone says it, it must be true right?

I’m more than certain there’s not a one shoe fits all approach to 401k fees vs overall tax savings. We all have different employer programs and salaries and states to deal with. So take my exercise above with a grain of salt. If fees were higher, or income lower, or the 401k value lower/higher, any number of varying scenarios, you might be do better to not max out the 401k based on fees vs tax savings. Fees are inherently a moving target.

Most of the time it’s a no brainer to save. No matter the vehicle. If you’re saving and investing, you’re probably doing something right. Especially so if you’ve been reading PF material for some time. But I think it’s important to know what kind of fees you’re paying versus the tax benefits and run the numbers yourself.

Just because everyone is doing it, doesn’t make it right.

Here’s a couple more tax quotes I was debating on using in lieu of Arthur Godfrey’s up above. Might as well dump them off here…

“The best measure of a man’s honesty isn’t his income tax return. It’s the zero adjust on his bathroom scale.”

Arthur C. Clarke

“Few of us ever test our powers of deduction, except when filling out an income tax form.”

Laurence J. Peter

“Is this Paradise?’
‘I can guarantee you that it isn’t,’ Jubal assured him. ‘My taxes are due this week.”

― Robert A. Heinlein, Stranger in a Strange Land

Love this book by the way. Classic sci-fi.

“We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.”

― Winston S. Churchill

“You don’t pay taxes-they take taxes.”

― Chris Rock

What about you? Do you or did you max out your 401k? If you only contribute(d) up to the match, what’s your reasoning? Any easy tricks for saving on paying taxes–other than moving out of California?