Bad 457(b) vs Taxable

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jjstraub4
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Bad 457(b) vs Taxable

Post by jjstraub4 »

Bogleheads,

First off, thank you to everyone here for showing me the path.

Long time lurker here at Bogleheads, first time I've had a question that I didn't see an obvious answer to.

My wife has access to a 457(b) deferred compensation plan at work. It is a governmental plan. The fees are atrocious. At what point do you decide to invest in taxable over a poor 457(b)?

The lowest fee fund is also the one I would choose, a nationwide target date fund with a total expense ratio of 1.17%. There is also a $50 service charge per year.

Other relevant information-> my wife will likely be with this employer for the remainder of her career (approx. 25 years). We fill my (low fee) 401k and 2 Roth IRAs each year. This will be our first year making close to this amount of money, we have both gotten promotions in the past 6 months.

Family Income is about 200k/year.

What would you do here?

Thank you,
Joe
runninginvestor
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Re: Bad 457(b) vs Taxable

Post by runninginvestor »

Which state? Some don't tax retirement distributions which can help.
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retired@50
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Re: Bad 457(b) vs Taxable

Post by retired@50 »

jjstraub4 wrote: Fri Jul 01, 2022 1:51 pm ... At what point do you decide to invest in taxable over a poor 457(b)?
The Bogleheads wiki page on 401k plans has a section that addresses what to do with expensive or mediocre choices in a workplace plan.
The logic may extend from the 401k situation to your 457b situation.

See link: https://www.bogleheads.org/wiki/401(k)# ... re_choices

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senex
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Re: Bad 457(b) vs Taxable

Post by senex »

Ouch, 1.17% expense ratio really hurts.

I haven't done the full math, but my gut sense is that taxable probably wins. The reason is that the "tax advantage" of tax-advantaged plans is largely in treatment of dividends & capital gains; it doesn't actually avoid income tax on your contributions (which are taxed either on the way in or way out).

Capital gains distributions can be avoided entirely via etfs; dividends are relatively low; and you already have tax-advantaged money that you can use for tax-free rebalance (if that's important to you).

Dividends are currently about 2%.

In taxable, you pay (depending on tax bracket and state) 0-36% tax on dividends. So actual cash flows (+dividends, -expenses, -tax) is worst case +1.28%/year, and could be as high as +2%/year.

In your crappy plan, you pay 0% tax on dividends, but pay 1.17% expenses. So actual cash flows (+dividends, -expenses, -tax) is around +0.83%/year.

Taxable wins on that score. Retirement plans often have better protection from lawsuits and such. Not sure how to value that. If it were me, I'd go taxable.
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David Jay
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Re: Bad 457(b) vs Taxable

Post by David Jay »

senex wrote: Fri Jul 01, 2022 2:08 pmRetirement plans often have better protection from lawsuits and such.
This is state-by-state, I would recommend that you find out how your state treats IRA accounts versus employer (ERISA) plans. In my state (Michigan) there is no difference between the treatment of IRAs and ERISA assets.
Last edited by David Jay on Fri Jul 01, 2022 2:18 pm, edited 1 time in total.
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jjstraub4
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

runninginvestor wrote: Fri Jul 01, 2022 2:03 pm Which state? Some don't tax retirement distributions which can help.
Iowa!
BerkeleyChris
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Re: Bad 457(b) vs Taxable

Post by BerkeleyChris »

1) How long does she plan to keep the job? If it is not for many years, it may make sense for her to hold her nose with investment choices for a bit and then roll to an IRA when she separates.

2) Any chance there is a brokerage link, perhaps for a small fee, that will allow her to invest in ETFs and Mutual Funds outside the plan choices?
ivgrivchuck
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Re: Bad 457(b) vs Taxable

Post by ivgrivchuck »

Let's run some numbers

Case 1: taxable

You get $1000 today. Your marginal tax rate is 24%. That makes $760.

Stock market return 6% for 25 years.

Profit before taxes $760 * 1.06^25 - $760 = $2501.

Assuming cap. gains tax rate of 15%. Adjust it slightly upward to 17% for non-qualified dividends and non-compounding.

Final balance after taxes: $760 + $2501 * 0.83 = $2835

Case 2: 457(b)

You get $1000 today and put it into 457(b)

Stock market return 6% for 25 years minus 1.17% fee makes 4.83% return for 25 years.

$1000 * 1.0483^25 = $3252

Assuming that your retirement marginal tax rate is 12%.

$3252 * 0.88 = $2861

conclusion

The results are very close $2861 vs. $2835. Any changes in assumptions (your current marginal tax rate (24%), your retirement marginal tax rate (12%), time horizon (25 years), impact of non-qual. dividends) could change the result.

Make your own assumptions and run your own simulation... probably you'll find out that there is no huge difference in your case either way...
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jjstraub4
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

BerkeleyChris wrote: Fri Jul 01, 2022 2:31 pm 1) How long does she plan to keep the job? If it is not for many years, it may make sense for her to hold her nose with investment choices for a bit and then roll to an IRA when she separates.

2) Any chance there is a brokerage link, perhaps for a small fee, that will allow her to invest in ETFs and Mutual Funds outside the plan choices?
20+ years. Best guess - 25 years. The job she has will probably be the last job she'll ever have. Excellent job all the way around, very close to home, good money, excellent benefits--I would be shocked if she ever took another honestly.

No, unfortunately not.
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jjstraub4
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

ivgrivchuck wrote: Fri Jul 01, 2022 2:44 pm Let's run some numbers

Case 1: taxable

You get $1000 today. Your marginal tax rate is 24%. That makes $760.

Stock market return 6% for 25 years.

Profit before taxes $760 * 1.06^25 - $760 = $2501.

Assuming cap. gains tax rate of 15%. Adjust it slightly upward to 17% for non-qualified dividends and non-compounding.

Final balance after taxes: $760 + $2501 * 0.83 = $2835

Case 2: 457(b)

You get $1000 today and put it into 457(b)

Stock market return 6% for 25 years minus 1.17% fee makes 4.83% return for 25 years.

$1000 * 1.0483^25 = $3252

Assuming that your retirement marginal tax rate is 12%.

$3252 * 0.88 = $2861

conclusion

The results are very close $2861 vs. $2835. Any changes in assumptions (your current marginal tax rate (24%), your retirement marginal tax rate (12%), time horizon (25 years), impact of non-qual. dividends) could change the result.

Make your own assumptions and run your own simulation... probably you'll find out that there is no huge difference in your case either way...
Thank you!
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Re: Bad 457(b) vs Taxable

Post by retiredjg »

Ordinarily, I would suggest using a poor plan, at least some. But there are a few reasons not to in this case.

1. She (apparently) is also contributing to a pension plan and will have a pension. People with a pension do not need as much in tax-deferred accounts as people without a pension. You are filling yours. With the pension, I do not believe it is important to also fill hers.

2. You said she plans to stay with this employer for many years. Using a bad plan for 5 years (or whatever) is worthwhile because the money eventually gets put into a lower cost plan. That apparently is not what is expected in your case.

David Grabiner has a formula for how long one can use a bad plan and still benefit. See "expensive or mediocre choices" in this link. https://www.bogleheads.org/wiki/401(k)

3. There is rarely a match on a 457 deferred comp plan. So it is unlikely she is losing any free money if she does not use the plan.


I don't think it would hurt much to use it a little bit. But My feeling (unless you two are way behind on tax-deferred savings) is that you will not need it in retirement and that saving in taxable is as good a choice or a better choice.
senex
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Re: Bad 457(b) vs Taxable

Post by senex »

jjstraub4 wrote: Fri Jul 01, 2022 2:53 pm
The results are very close $2861 vs. $2835. Any changes in assumptions (your current marginal tax rate (24%), your retirement marginal tax rate (12%), time horizon (25 years), impact of non-qual. dividends) could change the result.

Make your own assumptions and run your own simulation... probably you'll find out that there is no huge difference in your case either way...
Thank you!
Agree, good model, and it shows near-equality (compared to mine, where taxable wins) because it assumes retirement tax bracket is way lower than current. For lots of people I know that isn't/wasn't true, so I model equivalent tax bracket in retirement as now. That's why my analysis differs from his.
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jjstraub4
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

retiredjg wrote: Fri Jul 01, 2022 2:53 pm Ordinarily, I would suggest using a poor plan, at least some. But there are a few reasons not to in this case.

1. She (apparently) is also contributing to a pension plan and will have a pension. People with a pension do not need as much in tax-deferred accounts as people without a pension. You are filling yours. With the pension, I do not believe it is important to also fill hers.

2. You said she plans to stay with this employer for many years. Using a bad plan for 5 years (or whatever) is worthwhile because the money eventually gets put into a lower cost plan. That apparently is not what is expected in your case.

David Grabiner has a formula for how long one can use a bad plan and still benefit. See "expensive or mediocre choices" in this link. https://www.bogleheads.org/wiki/401(k)

3. There is rarely a match on a 457 deferred comp plan. So it is unlikely she is losing any free money if she does not use the plan.


I don't think it would hurt much to use it a little bit. But My feeling (unless you two are way behind on tax-deferred savings) is that you will not need it in retirement and that saving in taxable is as good a choice or a better choice.
1. Yep, she has a State pension.
2. I would be shocked if she ever took another job. Her position is quite safe.
3. No match.

Given what you have said, we may go with the taxable plan.

Her employer is small (less than 300 employees), I will look into changing the 457(b) choices offered. Any idea on low cost 457(b) providers? I know there are a number of well thought of 401k providers out there, but you see less about governmental 457(b)s.
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jjstraub4
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

senex wrote: Fri Jul 01, 2022 2:58 pm
jjstraub4 wrote: Fri Jul 01, 2022 2:53 pm
The results are very close $2861 vs. $2835. Any changes in assumptions (your current marginal tax rate (24%), your retirement marginal tax rate (12%), time horizon (25 years), impact of non-qual. dividends) could change the result.

Make your own assumptions and run your own simulation... probably you'll find out that there is no huge difference in your case either way...
Thank you!
Agree, good model, and it shows near-equality (compared to mine, where taxable wins) because it assumes retirement tax bracket is way lower than current. For lots of people I know that isn't/wasn't true, so I model equivalent tax bracket in retirement as now. That's why my analysis differs from his.
I appreciate you both running the numbers like I did. Any ideas on low cost 457(b) providers I could lobby her HR about?
retire2022
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Re: Bad 457(b) vs Taxable

Post by retire2022 »

Op

31 year in NYSDCP left with 1.7 million, retired August 2021.

My plan was managed by Nationwide and they do other states and local government nationally.

Look up the 457 plan board members and start writing letters.
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Re: Bad 457(b) vs Taxable

Post by retiredjg »

I have a friend with a county gov 457 from Prudential. Low expenses.

A couple of ideas.

1. That seems like a small plan (just 300 employees) for a governmental plan and that might be part of the problem. In some situations (like a school district) employees are allowed to use a state 457 plan. The state 457 plans I've seen in the last few years are pretty low cost. She might see if that is available.

2. If a high deductible health plan is appropriate for your family, an HSA (health savings account) can be used to save a nice amount of tax-deferred dollars each year.

3. If #2 does not work for you, an FSA (flexible spending account) might be available with your employer /insurance (I don't know which). With an FSA you can save some tax-deferred each year but you have to spend it on medical costs (including over the counter products) - you cannot carry it over to future years like an HSA.
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jjstraub4
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

retiredjg wrote: Fri Jul 01, 2022 3:29 pm I have a friend with a county gov 457 from Prudential. Low expenses.

A couple of ideas.

1. That seems like a small plan (just 300 employees) for a governmental plan and that might be part of the problem. In some situations (like a school district) employees are allowed to use a state 457 plan. The state 457 plans I've seen in the last few years are pretty low cost. She might see if that is available.

2. If a high deductible health plan is appropriate for your family, an HSA (health savings account) can be used to save a nice amount of tax-deferred dollars each year.

3. If #2 does not work for you, an FSA (flexible spending account) might be available with your employer /insurance (I don't know which). With an FSA you can save some tax-deferred each year but you have to spend it on medical costs (including over the counter products) - you cannot carry it over to future years like an HSA.
1. I will look into participating in a different 457 , if possible.
2. No hsa for us, doesn’t work financially for us (many children under 10, one with chronic conditions)
3. We use full fsa for childcare and healthcare.


Thank you for the response.
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Re: Bad 457(b) vs Taxable

Post by grabiner »

jjstraub4 wrote: Fri Jul 01, 2022 1:51 pm
The lowest fee fund is also the one I would choose, a nationwide target date fund with a total expense ratio of 1.17%. There is also a $50 service charge per year.


Other relevant information-> my wife will likely be with this employer for the remainder of her career (approx. 25 years).
Do you pay state income tax?

If not, then this comes close to my break-even rule of thumb; a taxable stock investment is probably about as good, but only for the next one or two years, and only if she actually stays for 25 years and the plan doesn't get any better. (The $50 service charge is thus irrelevant, as she will pay it anyway when she does start using the plan in a few years.)

If you do pay state income tax, then the 457(b) is better than a taxable account even now, because that means a higher cost for a taxable account but no higher cost for the 457(b).
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Re: Bad 457(b) vs Taxable

Post by krow36 »

K-12 school districts in Iowa are able to use the Iowa state 457 plan that is meant for state employees. It uses 4 different vendors, and there is a 0.20% administration fee added to each fund's ER. Voya for an unknown reason has not included the 0.20% fee on their Vanguard Total Stock Market Institutional fund, ER 0.03%. I wonder if her state employer is aware of this alternative? https://das.iowa.gov/sites/default/file ... AG_SOI.pdf
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Re: Bad 457(b) vs Taxable

Post by IowaFarmWife »

krow36 wrote: Fri Jul 01, 2022 10:31 pm K-12 school districts in Iowa are able to use the Iowa state 457 plan that is meant for state employees. It uses 4 different vendors, and there is a 0.20% administration fee added to each fund's ER. Voya for an unknown reason has not included the 0.20% fee on their Vanguard Total Stock Market Institutional fund, ER 0.03%. I wonder if her state employer is aware of this alternative? https://das.iowa.gov/sites/default/file ... AG_SOI.pdf
I use the Iowa 403(b) plan, invested with Horace Mann. I didn't know we could also use the 457 plan too?
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Re: Bad 457(b) vs Taxable

Post by krow36 »

I may be wrong in thinking school districts can use the state 457, maybe it's only the 403b? It certainly looks like Iowa state employees can use the 457 with a possibility of a match. I think it's worth checking out, anyway.
https://das.iowa.gov/RIC/SOI/basics
Statistical
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Re: Bad 457(b) vs Taxable

Post by Statistical »

If you buy and hold passive equity index funds in taxable it wins hands down.

We can look at it as a 457b "bonus, and then expenses while accumulating and taxes upon retirement.

457b tax deduction
We can treat this as 28.2% (1/(1-0.22) upfront bonus. You get a 22% tax deduction so 1280 into the 457b costs you $1k out of pocket same as the $1k into taxable

Expenses while accumulating
Most people don't think of taxes as an expense ratio but for taxable accounts it is effectively that and called tax drag or tax ratio. If you use passive index ETFs (i.e. VTI) you only get dividends as distributions and only taxed on those and most of those are qualified (15% rate). If you are in the 22% bracket we can assume a combined tax rate of 17% The market can go up 10% but if VTI is paying a 1.5% dividend you are paying taxes as you go on the Portfolio Value * 1.5% * 17% = Portfolio Value * 0.26%. Effectively taxable has an AUM "tax fee" of 0.26%. VTI has an ER of 0.03% so combined expenses are 0.39% vs 1.17% in the 457b. I am going to ignore the $50 while annoying eventually it will be a rounding error. So with a 7% real return the taxable account will grow at 6.61% and the 457b at 4.83%.

Taxes upon retirement
Depending on your marginal income tax rate you will either be paying 0% or 15% on LTCG as you draw the taxable account down. 22%+ marginal tax rate would be 15% LTCG, 12% or lower marginal tax rate would be 0%. The 457b is always the marginal rate. So the withdrawals will be taxed at 0% vs 12% or 15% vs 22%. I am going to assume 0% vs 12%. If you did assume 22% vs 12% remember it is only taxes on the gains for a taxable account subtract the basis ($1k in the example below) when computing the taxes.

Putting it all together with assumed 7% real returns

457b: $1280 * 1.0483^25 * 0.88 = $3663 (real) in retirement (after taxes)
taxable: $1000 * 1.0661^25 * 1.00 = $4953 (real) in retirement (after taxes)

(note in taxable we are modeling the taxes as coming out of taxable to simplify things and keep it apples to apples. Treating the taxes as a drag which reduces growth. In reality you would pay the taxes in accumulation by outside funds meaning taxable would be larger although with a higher outside cost but doing it this way makes it simpler to model)

All this assumes you put ONLY low cost low drag passive equity index funds in the taxable account. If you use bonds, bond funds, cd, or reits in taxable the tax drag can be massive. If you want those assets put them in tax sheltered accounts and leave taxable only for equity funds. If you want international equity fund (i.e. VXUS) is another good option. The dividend is higher but you will get a foreign tax credit which partially offsets the taxes. Tax drag is a big higher around 0.4% (after credit) annually but it still comes out ahead.
Last edited by Statistical on Sat Jul 02, 2022 7:49 am, edited 1 time in total.
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

krow36 wrote: Fri Jul 01, 2022 10:31 pm K-12 school districts in Iowa are able to use the Iowa state 457 plan that is meant for state employees. It uses 4 different vendors, and there is a 0.20% administration fee added to each fund's ER. Voya for an unknown reason has not included the 0.20% fee on their Vanguard Total Stock Market Institutional fund, ER 0.03%. I wonder if her state employer is aware of this alternative? https://das.iowa.gov/sites/default/file ... AG_SOI.pdf
Municipal government employer, not a school district! Too bad 0.03 sounds pretty good compared to 1.17!!!
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Re: Bad 457(b) vs Taxable

Post by jjstraub4 »

Statistical wrote: Sat Jul 02, 2022 7:11 am If you buy and hold passive index funds in taxable it wins hands down.

We can look at it as two phases expenses while accumulating and taxes upon retirement.

457b tax deduction
We can treat this as 28.2% (1/(1-0.22) upfront bonus. You get a 22% tax deduction so 1280 into the 457b costs you $1k out of pocket same as the taxable

Expenses while accumulating
Most people don't think of taxes as an expense ratio but for taxable accounts it is effectively that and called tax drag or tax ratio. If you use passive index ETFs (i.e. VTI) you only get dividends as distributions and only taxed on those and most of those are qualified (15% rate). If you are in the 22% bracket we can assume a combined tax rate of 17% The market can go up 10% but if VTI is paying a 1.5% dividend you are paying taxes as you go on the Portfolio Value * 1.5% * 17% = Portfolio Value * 0.26%. Effectively taxable has an AUM "tax fee" of 0.26%. VTI has an ER of 0.03% so combined expenses are 0.39% vs 1.17% in the 457b. I am going to ignore the $50 while annoying eventually it will be a rounding error. So with a 7% real return the taxable account will grow at 6.61% and the 457b at 4.83%.

Taxes upon retirement
Depending on your marginal income tax rate you will either be paying 0% or 15% on LTCG as you draw the taxable account down. 22%+ marginal tax rate would be 15% LTCG, 12% or lower marginal tax rate would be 0%. The 457b is always the marginal rate. So the withdrawals will be taxed at 0% vs 12% or 15% vs 22%. I am going to assume 0% vs 12%. If you did assume 22% vs 12% remember it is only taxes on the gains. If your portfolio is 80% gains then the withdrawals are effectively taxed for comparison at 0.80*15% = 12% vs 22%.

Putting it all together assume 7% real returns

457b: $1280 * 1.0483^25 * 0.88 = $3663 (real) in retirement (after taxes)
taxable: $1000 * 1.0661^25 * 1.00 = $4953 (real) in retirement (after taxes)

(note in taxable we are modeling the taxes as coming out of taxable to simplify things and keep it apples to apples. In reality you would pay the taxes in accumulation by outside funds meaning taxable would be larger although with a higher outside cost)

All this assumes you put ONLY low cost low drag passive equity index funds in the taxable account. If you use bonds, bond funds, cd, or reits in taxable the tax drag can be massive. If you want those assets put them in tax sheltered accounts and leave taxable only for equity funds. If you want international equity fund (i.e. VXUS) is another good option. The dividend is higher but you will get a foreign tax credit which partially offsets the taxes. Tax drag is a big higher around 0.4% (after credit) annually but it still comes out ahead.

Thank you for running the numbers. I’m thinking more and more taxable might be the answer, at least for the next few years as I lobby for a lower cost 457(b) provider.
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Re: Bad 457(b) vs Taxable

Post by Outer Marker »

jjstraub4 wrote: Fri Jul 01, 2022 1:51 pm The lowest fee fund is also the one I would choose, a nationwide target date fund with a total expense ratio of 1.17%. There is also a $50 service charge per year.
Not even an S&P 500 option? That's usually the lowest.

I'd be inclined to make the contributions and lobby hard for change and more reasonable cost options.
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Re: Bad 457(b) vs Taxable

Post by grabiner »

Two major issues corrected. There was a math error which subtracted 1% too much for 457(b) expenses; also, state tax was ignored. With those conclusions, the 457(b) and taxable accounts are close even now, and I would recommend the 457(b) because it is not certain you will be stuck with those high expenses for 25 years.
Statistical wrote: Sat Jul 02, 2022 7:11 am If you buy and hold passive equity index funds in taxable it wins hands down.
And you should be able to do this. The 457(b) is not your entire retirement portfolio; you have two IRAs, and the other spouse's employer plan. And once retirement gets closer, the 457(b) will be the best place to invest, despite the higher fees.
We can look at it as a 457b "bonus, and then expenses while accumulating and taxes upon retirement.

457b tax deduction
We can treat this as 28.2% (1/(1-0.22) upfront bonus. You get a 22% tax deduction so 1280 into the 457b costs you $1k out of pocket same as the $1k into taxable
Number corrected to $1000/.78=$1282 below.
Expenses while accumulating
Most people don't think of taxes as an expense ratio but for taxable accounts it is effectively that and called tax drag or tax ratio. If you use passive index ETFs (i.e. VTI) you only get dividends as distributions and only taxed on those and most of those are qualified (15% rate). If you are in the 22% bracket we can assume a combined tax rate of 17% The market can go up 10% but if VTI is paying a 1.5% dividend you are paying taxes as you go on the Portfolio Value * 1.5% * 17% = Portfolio Value * 0.26%. Effectively taxable has an AUM "tax fee" of 0.26%. VTI has an ER of 0.03% so combined expenses are 0.39% vs 1.17% in the 457b. I am going to ignore the $50 while annoying eventually it will be a rounding error. So with a 7% real return the taxable account will grow at 6.61% and the 457b at 4.83%.
The 4.83% should be 5.83%, and 6.61% should be 6.71%. (I usually assume 2% dividends, almost all qualified, which is closer to the historical yield; that would make the number 6.67%, but that won't make a significant difference.)

And the $50 should be ignored; if you don't use the 457(b) now, you will use it soon and start paying the $50 anyway.
Taxes upon retirement
Depending on your marginal income tax rate you will either be paying 0% or 15% on LTCG as you draw the taxable account down. 22%+ marginal tax rate would be 15% LTCG, 12% or lower marginal tax rate would be 0%. The 457b is always the marginal rate. So the withdrawals will be taxed at 0% vs 12% or 15% vs 22%. I am going to assume 0% vs 12%. If you did assume 22% vs 12% remember it is only taxes on the gains for a taxable account subtract the basis ($1k in the example below) when computing the taxes.
If you pay any taxes on qualified dividends and long-term gains in retirement (either you don't retire at a 0% marginal rate, or you retire in a state with an income tax), the 457(b) has a further advantage because you won't withdraw the entire balance as soon as you retire. Once you leave the employer, you can roll the 457(b) to an IRA where it will grow tax-deferred, so the returns become 6.97% on any stock there versus 6.71% on any stock in the taxable account. On the other hand, this is offset by the higher tax on 457(b) withdrawals if you retire in a higher bracket.
Putting it all together with assumed 7% real returns
Nominal returns, actually. (For tax purposes, you need to use nominal returns, since you pay tax on gains even if the gains only match inflation.)
457b: $1280 * 1.0483^25 * 0.88 = $3663 (real) in retirement (after taxes)
taxable: $1000 * 1.0661^25 * 1.00 = $4953 (real) in retirement (after taxes)
Corrected with the numbers above:

457b: $1000/.78 * 1.0583^25 * 0.88 = $4652 in retirement (after taxes)
taxable: $1000 * 1.0671^25 * 1.00 = $5071 in retirement (after taxes)

So with these assumptions, the 457(b) is worse for the first ten years; changing the exponents from 25 to 15 makes them break-even, in a state with no income tax.

But you live in Iowa, so we now need to adjust for the Iowa tax rate. Iowa allows federal tax to be deducted from state tax, so I will assume a 7.44% Iowa tax which is an actual marginal rate of 7.44%*.78=5.80% on ordinary income and 7.44%*.85=6.32% on qualified dividends, and 6.25% which is an actual marginal rate of 6.25%*.88=5.50% in retirement on IRA withdawals, and a full 6.25% on dividends and long-term gains since there is no federal tax. The return of the taxable account thus drops to 6.62% after the Iowa tax on the dividends, both before and after retirement.

Suppose that the average withdrawal is taken ten years after retirement. For those ten years, the 457(b) will be rolled into an IRA earning 6.97%, while the taxable account will earn 6.62%.

457b: $1000/.722 * 1.0583^25 * 1.0697^10 * 0.825 = $9241 in retirement (after taxes)
taxable: $1000 * 1.0662^35 * 1.00 = $9427 before sale

Of that $9427, $1000 is basis, and the remaining annual growth is 5.5% unrealized gain and 1.12% reinvested dividends, so the capital gain is $8427*(5.5/6.62)=$7001. After the Iowa tax of $438, the taxable account is $8989, so the 457(b) is better even now.

Alternatively, suppose that you retire in a state with no income tax. The years after retirement become irrelevant again, because the taxable account grows tax-free (no tax on dividends or capital gains) and the 457(b) has been rolled into an IRA growing at the same rate. But now the 457(b) gets a bigger advantage for the difference between tax rates on contributions and withdrawals:

457b: $1000/.722 * 1.0583^25 * 0.88 = $5025 in retirement (after taxes)
taxable: $1000 * 1.0671^25 * 1.00 = $5071 in retirement (after taxes)

So with this assumption, taxable is better only for the first year. And I would prefer the 457(b) even in the first year, as it isn't certain that you will be stuck with the 457(b) for 25 years; you might change jobs, or the plan might add lower-cost options.
(note in taxable we are modeling the taxes as coming out of taxable to simplify things and keep it apples to apples. Treating the taxes as a drag which reduces growth. In reality you would pay the taxes in accumulation by outside funds meaning taxable would be larger although with a higher outside cost but doing it this way makes it simpler to model)
Actually, this simplification is almost correct. The outside funds that are used to pay taxes are funds you won't be able to invest. If you would otherwise be investing in a taxable account, then every dollar of tax paid decreases your taxable account balance by a dollar, just as a dollar of expenses does. And that is likely to be what happens for most of those dollars. Sometimes, there will be a slight advantage if you invest in the 457(b) rather than in the taxable account, but you may already be maxing out the 457(b) by then and need to invest in a taxable account.

(edited to fix quoting)
Last edited by grabiner on Wed Jul 06, 2022 8:33 am, edited 2 times in total.
Wiki David Grabiner
Statistical
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Joined: Tue Jul 06, 2021 1:08 pm

Re: Bad 457(b) vs Taxable

Post by Statistical »

grabiner

very good corrections. The basic subtraction error was particularly bad of me. I agree with the conclusions. Even with the high fee due to state income tax I would use the 457(b) over taxable. The high fee cuts heavily into the advantage which is annoying but it still comes out ahead.
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