Are Your 401k Fees Worth The Tax Savings?
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?’
― Robert A. Heinlein, Stranger in a Strange Land
‘I can guarantee you that it isn’t,’ Jubal assured him. ‘My taxes are due this week.”
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?
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First, I’m glad your daughter is okay. Great and detailed analysis here, Noel. You did a yeoman’s job of breaking it all down, including the dreaded California “Sunshine Tax!” 😎. I’m so grateful I moved out of CA. Last year was my 1st full year in WA and my effective tax rate went from 50% to 4%! Okay, much of that has to do with retiring and having more tax efficient income, but I don’t miss the CA taxes and over regulation at all.
Thanks Mr. Fate. She’s doing great now and more importantly, has a newfound respect for stairs.
Smart move getting out of California…and to a state with no income tax! Well played. Taxes never bothered me much till I started making more money haha. I’m doing everything I can to lower my tax bill. I need to do some reading to make tax efficiency a strength of mine. But yes, I think once I hit my FI number, moving out of the state will be the first thing we do. I hear its hard to lose the residency, we’ll find out. I very much liked the yeoman’s reference. That’s what I should have been in the Navy and maybe I would have done my 20 and would be retiring this year. Thanks for stopping by.
This is a great assessment, and the fees in my 401k are ridiculous haha. I’m in the same boat with those California taxes. I love living here but don’t anticipate retiring here, for taxes and cost of living alone. But hey, never know!
Thanks IF. I know California doesn’t play around with taxes. There’s ways to retire cheaply in CA, but that prob means leaving the Bay Area, and becoming a master of the tax code.
Good to see this broken down and the details divulged, Noel! Fun to see how the math really does work out in favor of 401(k)s for those of us still in savings mode.
I almost didn’t max my 401(k) at the end of last year. Same with Jenni. The math was starting to look pretty hazy for it to be worthwhile.
I think this will be the year where it won’t make sense.
Why? Because we won’t be paying much in taxes when we’re not earning very much! 🙂 Semiretirement is going strong and we’re getting closer to a truer form of early retirement. Exciting.
But the match…well, always take that free money—when it’s offered!
PS: Hilton Card—
We’ve each had a Surpass for a handful of years. I think it’s a great system, but Hilton has been devaluing their points consistently for years. It’s taking its toll. But, the free annual night is pretty fantastic. Since we each have one, we combine and do a few nights at a Waldorf Astoria. 2019 was in Park City, right on the slopes. Loved it.
For Mexico, Hilton has a great program. Last time we were there, tons of 5k/night options were available. Stayed in some great places super cheap around Mérida. Their “Hilton Experiences” program puts on auctions you can use points for, too, which is pretty neat. We won a Mexican Independence Day celebration downtown Mexico City with it along with entertainment, food, drinks, etc. for multiple nights. And it was under 100k points if I recall. Very cool. I assume COVID is blocking any good auctions at the moment though.
Man, the Hilton Experiences Program sounds pretty good! We’re really excited start putting some of these points to use now that there is a light at the end of the tunnel. That must have been an amazing time down in Mexico city. That place is really underrated, and so close to us in the US. LOL I can feel the points burning a hole in my pocket now.
I have to admit it was fun working it out finally, after months of just “feeling” like it was right. I know the 401k thing is an over played PF hand, but what a relief working through it. What’s finally starting to sink in is that knowledge of the tax code is crucial for those pursuing FIRE prior to the draw down phase. For me its a weak point that I need to work on now, before I start literally paying the price for my ignorance. I think one of these years I’ll have to manually do my own taxes, just once, to get a better feel for it. I re-balanced the portfolio in April of last year and that REALLY saved my butt this year on taxes because of the loss. I agree with you about the match, such low hanging fruit. Pity I don’t get one, but as someone getting a pension I have no room to cry about that.
Interesting assessment. I never quantified the benefit, except to say to myself, “I need to save money for retirement, might as well save some money on taxes at the same time.” I think about our top marginal tax rate, and how much benefit there is to avoid being taxed on those last few dollars.
Part of our reason for moving from CT to VA was to reduce the tax burden. Actually state income taxes are not much different, but we will probably save $6000 or so in property taxes and insurance, when we finally buy a home down here.
Sounds like we’re similar. I was doing the same thing for years, not maxing it out, but just sort of ignoring the 401k fees in the hopes that I was doing the right thing. Absolutely true about that top bracket. The savings might seem small, but over just a couple of years the numbers grow immensely.
Ah, there you go. Nice move. I sometimes fantasize about moving out of state to a slower, cheaper place. But I’m not sure I could find a similar paying job out of state, especially while contributing to my local union pension. Maybe Seattle? But you know, I’ve never done the “math” on that either. Maybe the math still works out, or is better, with a lower salary combined with a lower cost of living and tax savings? Good on you for making the right moves to beat the system. Inspirational to say the least. Good luck on the home buying front. Thanks for the comment!
my wife used to have a 401k with principal financial that was pure larceny! some of the fees were close to 2% for index type funds. tiny companies like hers get the short end for not knowing how to set it up differently. best thing that happened was the plan closing, rolling to an ira, and buying stocks that took off in that ira.
we’ve never maxed our 401’s in our house but always maxed both roths since 2006. i always felt like we have to pay the taxes at some point and always felt like we would have a lot of money in retirement so tax free withdrawals for us were pure gold. plus, if you are going to retire early it’s harder to get at that tax deferred scratch.
You’re right. The smaller the company, typically the worse the 401k. That really sucks its that way. I would love if we could have a national 401k system that could follow us around, no matter the employer to even things out and give the small businesses a chance. I agree, such freedom in an IRA.
I’ve had both Roth and traditional 401k’s. I’m sure glad I had the Roth 401k a few years back because it helped me roll into a Roth IRA despite my income. Yeah, that’s true. It’s way harder to get to when it’s locked away tax deferred. I know I’ll have to be very strategic when it comes time to doing a Roth conversion ladder ie. dropping my income way down, having 5-6 years of expenses in taxable accounts and for me it will also be 30% bonds to live the first 5 years on.
Good point about paying the taxes at some time or another. I’m worried taxes will be going up in the future to pay off all this stimulus. For me, this means really learning and becoming a master on tax code. I just listened to this fantastic podcast on the Stacking Benjamins podcast, and the retirement expert they interviewed was emphasizing that the game is won in the last quarter or minutes of the game not the first half. Nobody cares about the first half score. Meaning what we do and know about taxes during withdrawal is the most critical thing we can do with our money, more important than investing. Thanks for the comment!
I’ve been lucky and had good 401K matches and low fees. I’ve been maxing out mine and my wife’s for a few years now. Although, she’s going to leave her job in a few months, but my plan is to continue maxing out mine. I have that planned in my budget so it’s pretty much automatic and I don’t see the money. A lot of my net worth is tied up in pre-tax 401Ks. I plan on doing some Roth IRA conversion ladders at some point to bridge the gap to 59 1/2 and have been focusing more on after tax accounts now.
Just curious – is your union small? Those seem like some high 401K fees. I think I’m just used to seeing the lower rates at big corps, so that surprised me.
And my big beef with taxes is not paying them, but them being wasted. Half the time the bureaucracies waste the money and that kills me. If I could control where my taxes went, I’d be more obliged to pay more… haha. We can always dream right?
Cool you’ve been able to max out for so long. I was late to the train because of my union and their pension, and just being a careless twenty something for too long. The conversion ladder is the way to go. I sure hope congress doesn’t somehow close that loophole in the future…I’m with you on the taxable accounts. We both max out the Roth IRA too.
You know I thought my fees were on the higher for years! I researched online for the post and from what I read, saw that average is 1%. But they sure feel high! I’m not sure how big the carpenters union it is compared to other unions. I know northern california has 30k members. They go through John Hancock which serves the entire union in the US..and I hate John Hancock personally. So un-user friendly.
Agree on taxes feeling like they’re wasted most of the time…and they add up quick. I pay higher than average property taxes in my area, but I can see where some of that money goes. The city does such good landscaping job around my neighborhood. I love it and think it keeps the property values high here. Those damn bond measures sure do add up though, don’t they? Now that I manually pay my property taxes I see all the line items I usually ignored lol