High-fee 403b vs. After-tax investment account

[superstah]

My spouse and I currently max out my 401k and each of our Roth IRA's, but only contribute a few thousand a year into spouse's 403b. Spouse also has a pension (teacher) that will fully replace his income upon retirement, but we do not count it at all in our numbers since it is so far into the future and pensions are so uncertain.

We have a lot more disposable income that we can put towards investment but are unsure what the best investment vehicle would be. We can max out spouse's 403b (there is no employer match), but when we looked at the various providers offered by the employer (school district), they charge administrative fees that are percentages (0.35% - 0.90% depending on the provider) each year based on the balance of the account. This is in addition to all of the individual fund fees.

When I did the math, it didn't seem to provide much of a benefit since, as the account grows, so do the fees. It seems that just investing the money in a regular after-tax investment account would be better, even if I have to pay capital gains on the earnings (as long as the fund fees are fairly low).

I'm not sure if I'm thinking about this correctly -- it seems a little counter-intuitive to make preference on an after-tax investment account over a tax-deferred 403b. Is there something that I'm not thinking of?

[autoxer]

You are forgetting that the tax deferment will reduce this years tax bill. That is probably more valuable than the additional management fee, but it depends on the current and future tax brackets and how long you expect to keep the money invested. If you are in a lower bracket now, then you might be better off paying the tax now, but if you are in a higher bracket, then it's better to defer the tax. Also, the longer it compounds, the better off you are deferring the tax.

What is your current marginal tax rate?

[autoxer]

I just thought of two other factors. In a taxable account you can delay the capital gains tax, if you buy and hold, but you can't avoid paying the tax on the dividend income. If you tinker with the portfolio a lot, then taxes will become a bigger issue. Rebalancing within the 403b won't have any tax consequences.

Also the 403b could be rolled into an IRA when the spouse leaves that job, so you can reduce the fees at some point in the future.

I've wrestled with this decision and even made a spreadsheet to calculate the differences and for my situation it is marginally better to defer the tax. I also think I that after paying off my mortgage, I can maintain the same standard of living in a lower tax bracket, which makes the benefit of deferring the tax even better.

[Petunia 100]

You're saving at a good clip now in your 401k, plus you have a taxable pension. Your SS benefits are likely going to be taxable because of the pension. You'd need to crunch the numbers, but I wouldn't be surprised if you're going to be in a higher tax bracket down the road, especially when you hit 70.5 and RMDs kick in.

I think investing in a taxable account is an option worth considering. If you do go that route, choose tax efficient investments and plan to hold them long-term. Good candidates are broad market indexes, particularly foreign. Also, look for funds with "tax-managed" in the name. Don't assume they are necessarily doing a good job, but do give them a look.

[superstah]

autoxer: We're in the 28% bracket at the moment - not really near the edge either. If we went into a taxable account we would definitely buy and hold. I still struggle with the idea of paying $35 per year for every $10000. In a 5 years, we'll be paying over $300/year just to keep the account open.. that sounds crazy to me, when I know there are other lower cost options out there. (We're currently trying to contact the school district to see if they can establish relationships with lower-cost providers like Vanguard, etc.).

Petunia100: I guess one of the big unknowns is what tax bracket we would be in. (Or what the tax brackets will look like 35 years from now). You're correct though about potentially being in a higher tax bracket especially at 70.5 -- with today's bracket, the taxable pension alone would already put us in the 25% bracket.


Thanks for your input. I know it's not that simple of a question and there really is no right/wrong answer. It's just nice to throw the thought out there to make sure I'm not completely crazy.

[autoxer]

Option 1:

Put $18k in a 403b, let it grow for 35 years compounding at 7%, paying .52% in fees, you end up with $ 162,051.85, before tax. If you are still in the 28% bracket, then you have $116,677 to spend.

Option 2:

If you pay 28% tax now, then you can invest $12,960.00 in a taxable account, let it grow for 35 years compounding at 7%, paying .17% in fund fees and paying .53% in tax on the dividend, you end up with $ 109,968.74, then you have to pay 15% capital gains on the appreciation. The basis might have risen to about $20k, if the dividends are reinvested, so you'll end up with $ 96,473.43 available to spend.

Even if your future tax bracket is 39.6%, you would still come out slightly ahead by using the 403b, because it is sheltered from the yearly tax on dividends.

I saved the spreadsheet, so if you want to challenge any of my assumptions, then I can re-run the numbers.

[Petunia 100]

Option 1:

Put $18k in a 403b, let it grow for 35 years compounding at 7%, paying .52% in fees, you end up with $ 162,051.85, before tax. If you are still in the 28% bracket, then you have $116,677 to spend.

Option 2:

If you pay 28% tax now, then you can invest $12,960.00 in a taxable account, let it grow for 35 years compounding at 7%, paying .17% in fund fees and paying .53% in tax on the dividend, you end up with $ 109,968.74, then you have to pay 15% capital gains on the appreciation. The basis might have risen to about $20k, if the dividends are reinvested, so you'll end up with $ 96,473.43 available to spend.

Even if your future tax bracket is 39.6%, you would still come out slightly ahead by using the 403b, because it is sheltered from the yearly tax on dividends.

I saved the spreadsheet, so if you want to challenge any of my assumptions, then I can re-run the numbers.

How did you calculate .52% in expense ratio/admin fees?

[autoxer]

How did you calculate .52% in expense ratio/admin fees?

I was just guessing, I don't know what superstah's 403b actually offers. I just know they have a .35% administration fee on top of the fund expense, which I was guessing was .17%