Bad 401k, invest anyway?
December 29, 2014 5:24 AM   Subscribe

My employer is beginning to offer a 401k in January. The provider is American. The selection of funds is ... old school: a bunch of managed mutual funds that aim for "growth" with TERs around 0.7-0.9%. I'm totally sold on low cost index tracking funds, so this is disappointing to me, but it's not going to change. I am decades away from retirement. Should I just contribute as normal to the 401k and then hope to roll it over (and change fund allocation) to what will hopefully be a more modern plan at my next employer (in a year or two). Or do I have any other options?

My income is such that I am ineligible for a a Roth IRA and my contributions to a tradtional IRA would not be deductible.
posted by caek to Work & Money (20 answers total) 6 users marked this as a favorite
Is your employer offering to match contributions up to a certain percentage?

The funds might be lousy, but you're passing up on free money if you don't utilize their 401(k).
posted by JoeZydeco at 5:28 AM on December 29, 2014 [6 favorites]

I agree with JoeZydeco, you invest whatever percentage your employer matches. If there's no match, skip the whole thing. Invest in an IRA.
posted by Ruthless Bunny at 5:32 AM on December 29, 2014 [3 favorites]

American Funds suck. Invest anyway.

If you invest outside of a tax-advantaged account, you're paying what, a 30-35% in taxes on that money off the bat? (I assume it's in that ballpark if you're not eligible for a ROTH and you can't deduct a Trad IRA.) Sure, the expense ratio sucks, but you're only planning on paying that for two years max -- so around 2%! 2% beats 35%. The tax-advantaged space is worth it. (ESPECIALLY if they match any of your contributions, as JoeZydeco points out.)

This calculation would be different if you could invest in an IRA of some kind, but in your case, you're not eligible for a ROTH and the trad IRA would not be deductible. Moreover, you can stash a lot more money per year in a 401(k).

For what it's worth, my company has even shittier options -- we have an index fund that has like a 1% expense ratio. CRAZY.
posted by pie ninja at 5:37 AM on December 29, 2014 [2 favorites]

You should absolutely still contribute as normal. It's unfortunate that you'll have to pay such high management fees, but you still get all the tax advantages.
posted by Perplexity at 5:38 AM on December 29, 2014

Response by poster: Thanks for the answers so far! Should have said: there is zero employer match.
posted by caek at 5:43 AM on December 29, 2014 [1 favorite]

Well, can you give some feedback to your employer about including some index fund options in their offerings? They might consider it for next year.

Otherwise, I'd still contribute, especially if you're planning on contributing anything close to the max. As someone said above, saving 35% trumps spending 2%.

However, even if you're not eligible to contribute to a Roth, I think there's no income limit on contributing to a traditional IRA and then converting to a Roth, so you could think about doing that too as a way to get your tax-advantaged money in funds you like better.
posted by The Elusive Architeuthis at 5:52 AM on December 29, 2014 [1 favorite]

You can contribute to a traditional IRA with post-tax money and then convertittoa Roth. Put that in an S&P 500 index fund or whatnot, and max it out. Also contribute to your 401(k).
posted by J. Wilson at 6:06 AM on December 29, 2014

I would invest in this 401k before I invested in taxable funds or a non-deductible IRA.

The expense ratios are on the high end, but not ridiculously so (mine are worse). Based on the fact that they are only beginning to offer a 401k now, I assume you are working for a small employer. One of the ways that fund companies market their 401k plans to small employers is by basically offering plan management for free, but as a consequence the management expenses get passed down to the participants through higher ERs. It stinks, but in the end the tax-deferred growth is worth it, especially if you can roll it over to another plan if/when you change employers. There's an opportunity cost in not investing the tax-deferred money that you are allowed year-to-year. And assuming you are going to select broad equity or bond funds your fund performance shouldn't significantly lag behind the market, even if they aren't index funds. Active fund managers can't claim to reliably beat the market, but there's only so much they can do to really screw up, unless you go into a lot of "tilted" small-cap or sector-specific funds.
posted by AndrewInDC at 6:14 AM on December 29, 2014 [3 favorites]

J. Wilson is referring to what is known as a backdoor Roth. Start with that. You may also be interested in How to campaign for a better 401(k) plan.
posted by Mr.Know-it-some at 6:20 AM on December 29, 2014 [3 favorites]

My income is such that I am ineligible for a a Roth IRA and my contributions to a tradtional IRA would not be deductible.

I think many people are ignoring this aspect of your question. I am in a similar position and I say, hell yes you should contribute. Max it out if you can afford it. If I understand the law correctly (and I may not...), it is about your only option for pre-tax investing. You can roll various things over into a Roth, but you still have to pay the capital gains on the way in, and if you get audited the IRS may give you stink-eye depending on how big the rollover was and how soon after contributing to the traditional IRA, etc. Consult an accountant or lawyer before you go too far down this path.

And really, how big of a bite is this? You acknowledge there are some funds in the 0.6% range; realistically you're going to be paying 0.1-0.2% for anything other than a strict S&P 500 index tracker anyway. It is not worth missing out on pre-tax investment in order to "save" 0.4-0.5% of your assets. And then yes, roll it over into a traditional IRA at Vanguard or something two seconds after you quit this job.

I also like Mr. Know-it-some's advice to campaign for a better 401(k). I am considering something similar at my company. You will be making a case that benefits nearly all the employees at your company and has downsides only for American Funds and your 401(k) manager.
posted by Joey Buttafoucault at 8:52 AM on December 29, 2014

I agree with Joey Buttafoucault.

A back-door IRA isn't a bad idea, bu, there's no reason to be paying taxes on that money, putting you in such a high bracket.

Expense ratios aren't the end all and be all. If the funds' returns are beating them and doing well over all in their sectors, they are still a decent investment.
posted by small_ruminant at 10:09 AM on December 29, 2014

If you plan to be at a new employer with a better plan in all of a year or two, I would not sweat the expense ratio that much.

That said, if you think the new employer's plan might be just as bad, or if there is a chance you'll stick around...

Some of the posts above overstate the benefit of investing with pre-tax money. Let's say you put $1,000 of pre-tax money into a fund, leave it there n years, then retire, earning an average return of y. You owe fraction t of the money to the IRS when you withdraw it. At retirement, you'd get $1,000*(1+y)^n*(1-t).

Now let's say you want to invest in the same fund using post-tax money. The next $1,000 in salary you earn nets you $1,000*(1-t). You invest this much for n years, earning an average return of y, meaning you end up with $1,000*(1-t)*(1+y)^n. This is the same amount as if you had invested the money pre-tax.

This is ignoring 1-the role of capital gains and dividends taxes (you would pay these only if investing with post-tax money), 2-the possibility that you'll be in a different tax bracket at retirement, 3- the possibility that the return might be higher investing with post-tax money, and 4- the greater liquidity of post-tax accounts. 1 is an argument for investing using pre-tax money, 3 and 4 are arguments for using post-tax money, and 2 could go either way depending on your own expectations of your future tax rate.

tldr: sure, pre-tax plans have advantages, but there are reasonable circumstances under which you can feel good about investing with post-tax money. It is possible you are describing such a circumstance.
posted by deadweightloss at 11:22 AM on December 29, 2014

Those variables are too big to ignore. 1) Capital gains/dividends are a real thing. This year seems to be a case in point. 2) People who make too much to invest in a Roth are VERY likely to be in a lower bracket when they retire. 3) That is a total wild card and the stats I've read say that money that most people invest themselves gets lower return. You might be the exception, and the OP might be the exception- lots and lots of people are- but it's statistically not the usual outcome. Statistically people who manage their own money get out at the wrong time, and, worse, get back in at the wrong time. (If they pay any attention at all.) 4) I also don't agree that retirement accounts being less liquid is a variable for lower returns. If anything, knowing human behavior, it's a variable for higher ones.
posted by small_ruminant at 1:17 PM on December 29, 2014

1) Capital gains/dividends are a real thing

Yeah, but you don't pay capital gains taxes until you cash out the asset, and a 15% tax on lifetime cap gains is not enough to offset a 1% lower annual rate of return due to expense ratios. Dividend taxes are paid annually, but, for index funds, will not be much. Avoiding these taxes are the reason to use pre-tax money, and this point had not been made prior. Since these taxes are finite, which is better depends on OP's specific situation.

2) People who make too much to invest in a Roth are VERY likely to be in a lower bracket when they retire.

Not if tax rates go up, nor if their savings rate is unusually high, their pension unusually generous, or their returns unusually large. Again, this is certainly something OP should take into account, but there is no "rule of thumb" here.

4) I also don't agree that retirement accounts being less liquid is a variable for lower returns.

No, but the liquidity has value, and so investors are willing to trade lower return for more liquidity. The extent of this tradeoff depends on the individual; for some it may indeed be virtually 0. There are estate planning implications as well. If the OP expects to be in a 401k with a generous loan option, then this mitigates the benefit of the post-tax investments' liquidity.
posted by deadweightloss at 2:20 PM on December 29, 2014

Mutual funds generate capital gains nearly every year, along with their dividends.

These are in addition to whatever capital gains you get from buying or selling shares in a taxable account.
posted by small_ruminant at 3:03 PM on December 29, 2014

Mutual funds generate capital gains nearly every year, along with their dividends.

Unrealized capital gains are not taxed. If you buy and hold a mutual fund, you will pay cap gains taxes once, when you cash it out.
posted by deadweightloss at 3:50 PM on December 29, 2014

Mod note: This needs to not turn into an extended argument in the middle of someone's ask thread.
posted by cortex (staff) at 4:11 PM on December 29, 2014

Unrealized capital gains are not taxed. If you buy and hold a mutual fund, you will pay cap gains taxes once, when you cash it out.

You might want to investigate capital gains distributions, which are a real and ongoing thing, year in and year out, for people who hold mutual funds. Anyway, seeing cortex's admonishment, to tie this to the OP's question: I would agree that paying 1% annually in perpetuity (or, let's stick with the facts: 0.6% annually) could seriously erode the advantage of tax deferral, but you're never going to avoid fees entirely so the question is the marginal fee over what he or she would be paying in the alternative. And I also don't think the OP will be paying this fee rate forever; there has already been some consideration, and advice, about shifting this to an external IRA eventually. But it may be that, as a practical matter, the only way to get it into a tax-advantaged account is to put it in the 401(k) now.
posted by Joey Buttafoucault at 4:16 PM on December 29, 2014 [1 favorite]

A very few employers will allow you to do an "in-service rollover" where they'll let you roll some or all of your 401k over to an IRA while you're still an active employee. Then you could contribute to the most stable fund and roll it over once a year or something. It's a long shot but it's worth asking about.
posted by VTX at 7:23 PM on December 29, 2014

Whatever contributions you make to your 401(k) remain tax deferred for 50 years or more. Your job at your current employer may last only a few years or less. When you change employers you can withdraw your 401(k) money and roll it into a self-directed IRA to invest as you see fit in low-fee index funds for the rest of your life.

But you can't do that if you don't contribute now. You get only one chance each year to make 401(k) contributions. You don't get a do-over if you pass up the opportunity.

Your 401k choices while not spectacular are not that bad. American is one of the better of the managed fund companies. Their AMCAP and Income Fund of America both have multi-decade track records that closely match what you would get with a S&P 500 Index fund.

The fees of 0.7% or 0.9% aren't terribly bad. If you you will be at your current job less than a couple of decades, you should be contributing to your 401(k) and then take the opportunity to transfer the funds into a IRA when you change jobs. Even a couple of decades of higher fees is better than the taxes you would pay on a taxable investment if you don't contribute.
posted by JackFlash at 12:23 AM on December 30, 2014 [2 favorites]

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