[Editor’s Note: Thanks to reader feedback, this article has been amended to account for matching contributions or the possibility of lower fees in the future because of a job switch or an employer’s policy change. – WSP]

Everyone knows the benefits of investing in a 401(k). You get that upfront tax deduction and tax-deferred growth on your investments. However, unlike in regular taxable accounts, you don’t get much flexibility in your investment options. Some employees, unfortunately, get stuck with a bad 401(k) with high fees. In this case, could it actually be better to not invest in the bad 401(k) and save the money in a taxable account?

Pros of Investing in a Bad 401(k) with High Fees

You get an upfront tax deduction

In a traditional 401(k), your retirement account contributions are not taxed. For physicians and other high-income professionals, that could potentially be a 35% tax break or more.

Your money grows tax-deferred

You can change your 401(k) investments as much as you please without any tax consequences. In a taxable account, every time you sell or change your investments, there are potential tax consequences. You have to choose your taxable account investments carefully, because it can be expensive to change them. You do not have to worry about this in a 401(k).

Cons of Investing in a Bad 401(k) with High Fees

You may withdraw your capital gains from the 401(k) at a higher tax rate than the long-term capital gains rate in a taxable account

For most people, the long-term capital gains rate in retirement is currently 15%. For people in the 10% or 15% income tax brackets, the long-term capital gains rate is actually 0%, leading some people to take the strategy of tax-gain harvesting.

In a 401(k), your withdrawals are taxed at your ordinary income tax bracket, regardless of whether the money is your initial contribution or investment gains. In many cases, your 401(k) withdrawals are taxed at a higher rate than the long-term capital gains rate you would have paid in a taxable account.

Your investment returns are significantly lower because of its higher fees

With bad 401(k)s, your investment returns are significantly eroded, and that can severely hurt your 401(k) value at retirement.

You cannot withdraw the money early without paying a penalty

There is less flexibility with your money in a 401(k). In general, if you make a non-qualified withdrawal before the age of 59 1/2, you have to pay a 10% penalty tax. With a taxable account, you can withdraw the money at any time without an additional tax penalty.

At What Point Do The High Costs Of A Bad 401(k) Outweigh Its Benefits?

Assumptions

Consider a 30-year old employee who contributes the maximum $18,000 to her 401(k):

  • Tax bracket at contribution – 35%
  • Tax bracket at retirement – 15%
  • Long-term capital gains tax rate – 15%
  • Investment returns – 5% real (after-inflation) returns
  • Time horizon – 35 years (retire at age 65)
  • Trading frequency: never – in a taxable account, she would invest in a low-cost index fund and never sell until retirement
  • Withdrawal strategy: for simplicity, she will withdraw her money at age 65 and pay either ordinary income taxes in a 401(k) or long-term capital gains in a taxable account

Results

In our base case scenario (no job switches), the 401(k) is less valuable than the taxable account if fees exceed 1.2%.

When you have a good 401(k) where the fees are equal to that of a taxable account, the 401(k) is vastly superior. However, as the 401(k) fees rise, the benefits of a 401(k) decline, and when the fees of 401(k) hit 1.2%, the 401(k) and taxable accounts have equal values at retirement. If the 401(k) fees rise above 1%, then the value of the 401(k) becomes less than the value of a taxable account.

Sensitivity Analyses

This chart is based on several assumptions, including your age, tax brackets, and investment returns. If you switch jobs, you can rollover your 401(k) to your new job, whose 401(k) may have lower fees. Your current 401(k) may also lower their fees during your career. The results may vary depending on your specific situation.

Age

For example, as you get older, the effect of higher 401(k) fees go down, because you are investing (and paying the higher fees) for fewer years. Using all of the other base case assumptions, I’ve graphed the break-even fee difference between the 401(k) and taxable account for different ages.

As you get older, it becomes worth it to invest in 401(k)s, even those with very high fees.

Switching Jobs

If you are in a high 401(k) plan with your current employer, you should immediately rollover your 401(k) to your new employer’s 401(k) if you switch jobs.

In medicine, you never know when (if ever) you will switch jobs, but the possibility of changing jobs in the future may effect your decision to invest in a bad 401(k) today.

Also, even if you are in a bad 401(k) today, that doesn’t mean that it will be a bad 401(k) forever. Your HR department (with or without the prodding of its employees) may make changes to their 401(k) over time to significantly lower the company’s 401(k) fee structure. In this case, it might be worth it to invest in a bad 401(k) today with the hope that it gets better over time.

Let’s examine the impact of investing in a 401(k) at age 30 with the base case assumptions above, except that you are able to switch jobs or lobby your current employer to lower their 401(k) fees down to the fees of a taxable account. Depending on your age when that happens, it could be beneficial to invest in a bad 401(k) today:

If you are able to switch jobs or negotiate lower fees with your current employer, it’s almost certainly worth it to invest in a bad 401(k) today.

Matching Contribution

It almost always makes sense to contribute to the 401(k) when your employer will match your contribution:

You should almost always contribute to your 401(k) if your employer will match your contribution.

Conclusion

For most physicians and other high-income professionals, you should invest in a 401(k) even if it has high management fees. A possible exception might be if you are young, do not get an employer match, and anticipate never switching jobs. Even in this rare scenario, if you can lobby your HR department to lower fees, it makes sense to invest in a bad 401(k) today.

What do you think? Are you stuck with a bad 401(k)? Have you considered not investing in your 401(k) because of high fees? At what point is a bad 401(k) not worth it?

14 COMMENTS

  1. I think it depends. In today’s day and age people job hop so much they might be able to transfer their 401k out before the break point. I.e. The assumption of hold to retirement is probably not realistic. A match coupled with fees would cover the difference for at least the typical Americans job changing time of two years. It might be interesting to run the numbers and determine that point.

    • Excellent points — the article assumes you are a lifer (which many physicians are). It also assumes that the fees will not go down over time or you don’t negotiate down the fees. I will do additional analyses and addend the article.

  2. Would you invest in a high fee 401K to the company match (5% or so) then divert additional investments to an IRA or taxable account? Or would you still suggest heading for the taxable account (assuming the 401K fees are >1% over the taxable)? Thanks!

  3. Fulltimefinance hit on what I was thinking – even if you have higher fees, you need to consider what the employer match is. If they match a decent amount, even 3%, that will likely outpace any fees you would encounter over time as your money compounds.

  4. Conclusion, hope that your company allows investment in a Fidelity or Vanguard 401K. Low fees! The danger comes when people do not pay attention to exactly what they are getting into. Nice post WSP!

  5. It isn’t just the bad fees it is typically bad funds with high fees. The mutual funds in mine have an average fee of around 1.2% but they are also return about 1% less than an ETF like VTI. So double whammy. I have been in process of getting our fees lowered for a few months now. They seem to be at least working on it. Right now I’m only putting about 6 grand in and putting the rest in taxable accounts.

  6. This was exactly what I was looking for. My fed are 1.7%. I recently started out in my career (though I’m not that young, 39) and do plan to work in this group for a long time, if not forever. I’m thinking I need to talk to our office manager more about this plan before I sign up (just become eligible) and meditate in this post more. Thanks!

  7. The expense ratios for the funds in my wife’s 401(k) are around 1.5%. We tried to lobby her HR department to change the 401(k) provider to one with lower fees, but they refused. We then debated whether to put the 18,000 into her 401(k) or into a taxable account. Like your analysis suggests, since she has a 4% match and she is unlikely to be with her current employer for the entire duration of her career, we elected to max out her 401(k) despite the high fees. This will also provide us with additional tax diversification in retirement. Hopefully if she moves to a new employer we will have a lower fee 401(k) option. Thank you for discussing these issues for those of us who are stuck in poor 401(k)s!

    • You’re welcome, Live Free, MD. It’s good to see that you came up with the same conclusions as me. I expect that your wife’s HR department will eventually cut their 401(k) fees. Hopefully, its sooner rather than later.

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