The Real Tax Advantage of 401(k) Plans: A Deep Dive
Last week's analysis demonstrated that tax-sheltered accounts can make investors approximately 35% wealthier over 40 years compared to taxable accounts, even when both earn the same 8% annual return. While tax-sheltered account owners ultimately pay higher taxes (at ordinary income rates rather than capital gains rates), the tax-free growth advantage is substantial enough to overcome this drawback.
## New Questions to Address
However, this analysis didn't tell the complete story. Two key considerations were left unexplored:
1. The impact of 401(k) plan expenses
2. Legacy implications (inherited 401(k) assets don't receive a step-up in cost basis)
## The Model
To analyze the impact of 401(k) fees, let's consider a detailed case study:
### Subject Profile
- Single filer
- Income in the 90th percentile
- Starting salary: $81,818
- Peak salary: $160,000
- Tax brackets:
- Early career: 22%
- Later career: 24%
- Capital gains rate: 15%
- Retirement: Assumes 24% bracket continues
### Contribution Pattern
- Ages 25-34: 7% of income
- Ages 35-64: 10% of income
### Base Case Assumptions
1. Low-cost 401(k) plan:
- Company covers recordkeeping fees
- Investment options: Institutional-price index funds
- Portfolio costs equal to a taxable account
2. No employer match
## Results
Under these baseline conditions, the tax advantage varies by investment strategy:
### Stock Market Index Fund vs. Low-Turnover Balanced Fund
- Balanced Fund:
- 401(k) account final value: $2,205,971
- Taxable account final value: $1,691,177
- Improvement: 30%
This analysis sets the foundation for examining how different fee structures might erode these benefits, and under what conditions a 401(k) might become less advantageous than a taxable account.
## Key Takeaways
1. Even without an employer match, a low-cost 401(k) provides significant tax advantages
2. The benefit varies based on investment strategy
3. This advantage must be weighed against:
- Plan expenses above the baseline
- Legacy planning considerations
- Individual tax circumstances
## Important Considerations
- All figures are in current dollars
- Tax code changes over 40 years could significantly impact outcomes
- Results assume consistent investment behavior and returns
The 401(k) Advantage Without Extra Costs
As expected, these figures are lower than those cited in last week’s article. The gain from a one-time, 40-year investment in the balanced fund was 44% and the stock market index fund 30%, as opposed to today’s findings of 30% and 22%, respectively. (The increase with the balanced fund is larger because it is less tax-efficient than the stock fund, and so it therefore benefits more from tax protection.) That said, the 401(k) structure remains very useful.
Test 1: With 401(k) Fees
As 401(k) plans typically have higher costs than self-directed brokerage accounts—financial advisory fees are another matter, but they lie outside the scope of this article—this exercise overstates the plans’ benefits. A realistic comparison would dock 401(k) plans by 0.50% per year, the median participant price. That, of course, is merely an average. Small plans may charge as much as 1%, while multinationals’ plans can be as low as 0.25%.
The following exhibit plots that range, showing the advantage (or not) for 401(k) plans to assume their annual expenses are 0.25%, 0.50%, 0.75%, and 1% higher than those of a taxable account.
The Cost Effect
That’s less pleasant. Once costs rise above the norm, as represented by the yellow and red bars, the 401(k) benefit for a low-turnover equity investor pretty much disappears. Although the threshold for the balanced-fund investor is higher, at the 1% red bar, many smaller plans charge that much. The good news for such participants is that the 401(k) structure makes saving easy and automatic. The bad news is that while they might believe they are receiving a tax benefit, they really are not, once expenses are considered.
Test 2: With 401(k) Fees and Employer Matches
Fortunately, this analysis is incomplete. I addressed the dark cloud of 401(k) plans but not the silver lining of employer matches. According to the Investment Company Institute, 90% of 401(k) participants receive some level of company contribution. Determining the match size is difficult, but the largest 401(k) provider, Vanguard, reports an average amount of 4.4%.
Less than that is required for 401(k) plans to earn their stripes. The next chart shows the aftertax advantages for 401(k) plans with 1% costs, assuming employer-match programs that range from 1% to 4%, with the original no-match situation shown in red. Even these relatively small matches, each of which is below the national average, restore the 401(k) plan’s advantage.
Company Match With 1% Plan Costs
One slightly worrisome note is that although 90% of overall participants are eligible for a company match, that figure drops to 68% for small companies—which are also the likeliest to offer plans with high expenses.
Conclusion
The claim that the additional expenses of 401(k) plans consume their tax benefits is more theoretical than actual. Although an extra 1% per year indeed changes the math, it also holds that in most cases 401(k) participants receive more money from their employer than they forfeit in plan costs.
Another way of phrasing the issue is that US companies spend about $250 billion per year on their 401(k) plans, while the federal government forgoes a similar amount in tax revenue. Admittedly, some of that $500 billion is spent on plan fees, but most lands in the pockets of 401(k) participants. The industry creates far more successful outcomes than failures.