Retirement plan decisions made easy
Drill Down: Taxes, Fees and Investment Returns
Taxes and fees can take a big bite out of your investment returns. It’s important for you to have a feel for just how big these issues are.
There are only a couple of good ways to avoid taxes on your investment returns, and one of them requires that you die. The other requires you to give your money away. The third way to avoid taxes is to buy municipal bonds, but the returns are so low that “munis” are not suitable for your core retirement investments.
I sometimes hear stories about people who make truly stupid investment decisions in an effort to avoid taxes. In the case of your retirement funds, though, avoiding taxes becomes very important over time.
Dee and Tex both started saving for retirement at age 25, when each was earning $20,000 a year. They set aside six percent of their income, even as they got raises through out their careers. They invested in identical mutual funds and had exactly the same investment returns. The only difference was that Dee’s money was tax deferred through her 401k plan, and Tex’s money went into a fully taxable account. (Dee’s story would have been the same if she had invested in an IRA, because her employer does not offer a matching contribution.)
Look at how much they each have at age 65:
Dee: $989,642
Tex: $500,837
Dee did so much better because her early investment returns went back into her account. Much of Tex’s returns were taxed each year.
When they start withdrawing money for retirement, Dee has to pay regular taxes on all of her distributions. If she starts off by taking four percent of her assets in the first year, she has $39,586 of income. After taxes she nets $27,710. (I’ll explain how to figure how much you can safely withdraw each year in Chapter 7.)
If Tex decides, like Dee, to take out four percent of his account balance, his withdrawal will be $20,033 before taxes. Surprisingly, that will be taxable initially. Tex already paid taxes on the money he invested, but at age 65, his account will be earning slightly over $20,000 of taxable interest and capital gains.
Let’s be optimistic and assume that when Tex retires, Congress is still taxing dividends and capital gains at a lower tax rate. Tex will net, after taxes, $14,848. Let’s summarize:
After-tax income first year of retirement:
Dee: $27,710
Tex: $14,848
Tex’s relative position improves over time. Both Dee and Tex will increase their withdrawals every year to match inflation, and soon Tex will be selling some stock in addition to using his interest and dividend income. When he sells the stock, he only pays taxes on his gain, not on the value of the stock when he first purchased it. When he does pay taxes on his stock gains, it will be at the lower capital gains tax rate.
Tex’s benefit in the long run will not make up for his worse starting position. He’ll never catch up with Dee. That’s why tax deferred accounts are so important to financing your retirement.
Investment fees also play a dramatic role in your overall returns, though somewhat smaller than the role taxes play. Individual investors may pay commissions to their stockbrokers, and may also pay advisory fees to a financial planner or investment manager. Investors in mutual funds—including 401k participants—pay a management fee that covers the costs of trading and investing the fund. The very lowest fees I have seen are nine cents per $100 invested. (Investment professionals would say “nine basis points.”) The average mutual fund charges about one dollar per $100, and there are many funds that charge between $1.50 or $2.00. You will not see the fees listed in your account statement, but you can find them buried in the fine print in the mutual fund’s prospectus.
The United States Securities and Exchange Commission says, “For example, a 1% increase in a fund’s annual expenses can reduce an investor’s ending account balance in that fund by 18% after twenty years.”
Let’s walk through a calculation. Rich pays a management fee of $1.25 per $100. His friend Chip pays only 25 cents per $100. Surprisingly, Rich’s mutual funds perform no better before considering fees than do Chip’s funds. That’s exactly what the research on mutual fund performance and fees has found: higher fee funds do not do any better than lower fee funds, on average.
So how do Rich and Chip end up when they retire? Using the same assumptions as I used for Dee and Tex above, here’s what I calculated:
Total account value at age 65 for Rich: $728,557
Total account value at age 65 for Chip: $930,065
Chip’s cheapness has paid off handsomely.
I don’t mind paying high fees when I’m receiving good value. I use a very expensive attorney when I need legal advice, and my accountant is not cheap either. But paying high mutual fund management fees will not leave you better off, just poorer.
Paying a fee to a financial planner to help you with all of your investment needs may be money well spent. However, don’t get locked into a high-fee program if you are not receiving valuable help.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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