Roth 401(k) Double Jeopardy

I’m not talking about the game show.

And I’m not referencing the delightful thriller staring Ashley Judd.

Today, I’m talking about a very odd quirk that should make you think long and hard about how you fund your Roth 401(k) if the annual expense is anywhere north of .5%.

And I’m going to do this with as little number-crunching as possible. I’ve already written about retirement account expenses in my whimsically titled Are you 401(k)o’ed? I disclosed in that article that the average annual expense within the average 401(k) for plans with 1000 or more participants is 1.08%. The difference between the retirement account and a regular brokerage account is the tax status. In a 401(k) you hope to deposit money at say, 25-28% (this covers couples with a taxable $72,500 to $223,050 in 2013) and then withdraw it in retirement at a lower 10-15%.

There’s no complicated math – after 10 years, that extra 1% fee will wipe out all the benefit of a 25% to 15% tax difference.

double-jeopardy

Now, here’s where the Roth 401(k) Double Jeopardy comes in – In normal times, the market will double over a ten year period. This would be a return of 7.2% per year compounded. So, you’ve deposited $10,000 to your Roth 401(k), ten years go by, see the market grow 8%/yr and with that average fee of 1.08% you have $19,525 in the account. You then check to see that if the fee were 1% less, you’d have $21,430 or $1,905 more money. Drumroll, please. It just cost you $1905 to make that $9525 grow tax free, an effective 20% cost over the 10 years.  Looking at it a different way, if $10,000 grew to $21,430 and you sold the stock or fund, you’d have a 15% capital gain to pay. You’d net $19,715.

I use the term Double Jeopardy because the effect of the fee over the 10 year period is doubled. While the standard 401(k) is deferring tax on the full deposit, the Roth flavor is eliminating tax solely on the growth. So over that 10 year period, your cost of $1905 to save you the tax on the $9525 growth was an effective 20% expense. If this doesn’t make sense, please read up to this point one more time.

The logical next step is to look at this effect for just one year, the very first year. In one year, the 1.08% retirement account will cost you $100 in fees. In the pretax 401(k) you’ve deferred tax on an account worth $10,692 so if you retire and withdraw the funds in a lower bracket, the result is favorable. In the Roth 401(k) however, you just spent $100 to avoid tax on the $692 growth. This is a 14% hit. The impact is exactly the opposite of the traditional account where the fee for a very short period of time makes sense for someone soon to retire or change jobs.

I hope this article prompts you to look at your retirement account expenses a bit more closely. If the 401(k) gets matched deposits, especially dollar for dollar, deposit to the matching limit, even if the ongoing fees are high. It takes a long time along with some very high fees to negate the benefit of that match.

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