## Excel Hint 6: The FV function and 401(k) fees

Hint 6: The Excel FV function is used to calculate the future value of a dormant 401(k) or IRA when the only difference between the two accounts is the level of fees.

The situation:    Finance tip #6 considers potential benefits realized by rolling over funds from a high-cost 401(k) to a low-cost IRA.   The retirement account is not accepting new contributions. The person at age 50 will either leave \$500,000 in a 401(k) or move \$500,000 to a Roth for 15 years.  The pre-fee annual rate of return on both the 401(k) and the IRA is 6.0 percent.  The 401(k) has an annual fee of 1.3 percent.   The IRA has an annual fee of 0.03 percent.

Question on use of Excel:  How does one calculate the value of the retirement account after 15 years?

Analysis:

This calculation can be completed with the FV function.  The FV function has arguments – Rate, Nper, Pmt, Pv, and Type.

• The Rate is .047 for the 401(k) and 0.057 for the IRA.
• The Nper or holding period is 15 for both accounts.
• The PMT is 0 for both accounts.   (The worker is no longer making contributions.)
• The PV is the initial account balance, \$500,000.
• The type is 0 because the \$500,000 exists in the account at the beginning of the period.

Results

• FV(0.047,15,0,500,000,1) is \$995,796.
• FV(0.057,15,0,500,000,1) is \$1,148,404.

Remember to go to finance tip 6 for a more complete discussion of factors impacting the choice between a high-fee 401(k) and a low-fee IRA.

## Financial Tip #6: Rollover 401(k) assets to IRAs

Employees changing jobs with funds in a high-cost 401(k) need to consider rolling funds into a low-cost IRA.

Tip #6: An employee leaving a firm can substantially increase retirement wealth by moving

401(k) funds to an IRA.   Be careful though!  Protections against creditors are stronger for 401(k) plans than for IRAs in many states.

Examples of potential gain from rolling over assets in a high-cost 401(K) to a low-cost IRA

Example One:  A worker leaving her firm at age 50 can keep \$500,000 in 401(k) funds in the firm-sponsored retirement plan that charges an annual fee of 1.3% or can move the funds to a low-cost IRA that charges an annual fee of 0.3%.   The return on assets prior to fees in both the 401(k) plan and the IRA is 6.0 percent per year.

What is the value of the account at age if assets remain in the high-cost 401(k) and if assets are rolled over into the low-cost IRA?

• Account value of high-fee 401(k) plan is \$995,796.
• Account value of low-cost IRA is \$1,148,404.
• Gain from rollover is \$152,609.

Example Two: A worker changing jobs at age 30 can keep \$20,000 in the firm 401(k) or move the funds to a low-cost IRA.  The annual fee for the 401(k) is 1.3 %, the annual fee for the IRA is 0.3%. The underlying returns prior to fees for both assets in the 401(k) and assets in the IRA is 8.0%.

What is the value of the account at age 60 if the person keeps assets in the high-cost 401(k) or moves funds to a low-cost IRA?

• Account value of high-cost 401(k) plan is \$139,947.
• Account value of low-cost IRA is \$185,140.
• Gain from rollover is \$45,194.

Note: The impact of financial fees on the future value of the account can be calculated with the FV function in Excel.  The arguments of the FV function are the rate of return after fees, holding period in years, and the initial balance in the 401(k) plan.

• Most roll overs from 401(k) plans to IRAs occur when a worker leaves a firm for another employer.  Some firms allow for some in-service rollovers.
• Some workers, in need of cash routinely, disburse funds from their 401(k) plan.  The disbursement of funds from a traditional 401(k) plan prior to age 59 ½ can lead to penalties or tax.   A roll over of funds from a 401(k) plan does not lead to additional tax or any financial penalties.
• One motive for moving funds from a 401(k) plan to an IRA is the desire to place funds in a Roth account when a firm only offers a traditional retirement plan.   The act of rolling over funds from a 401(k) to an IRA and the act of converting the new conventional IRA to a Roth IRA are separate and do not have to occur together.  Conversion costs are lowest when a worker has low marginal tax rate.  Several future posts will examine the costs and benefits on converting traditional retirement accounts to Roth accounts.
• The federal bankruptcy code protects both 401(k) plans and IRAs. However, 401(k) plans offer stronger protection against creditors than IRAs outside of bankruptcy.  Whether IRAs are protected from creditors is determined by state law.  ERISA, a national law, provides protection against creditors for 401(k) plans.  This difference can persuade some people to keep funds in a 401(k) plan, rather than covert funds to an IRA.  Go here for a state-by-state analysis of protections against creditors for owners of IRAs.
• The calculations, presented above, of greater wealth from the rollover assumes identical pre-tax returns for the high-cost 401(k) plan and the low-cost IRA.  Most financial experts believe that low-cost passively managed funds tend to outperform high-cost funds.  Interestingly, Warren Buffet, probably the best active investor of all times suggests passive investing in low-cost funds is generally the better approach.
• Factors other than transaction costs can impact the decision to rollover 401(k) funds or stay.   Some 401(k) plans allow investors to purchase an annuity at retirement.  The existence of automatic enrollment from a 401(k) plan to an annuity could induce some workers to keep funds in a 401(k) rather than roll over funds into an IRA.

## Financial Tip #5: Maximize the 401(k) match and then contribute to IRAs

Maximize the employer matching contribution then save additional funds in an IRA!

Tip #5:  A worker at a firm with a 401(k) plan that has high fees should maximize receipt of the employer match and divert additional funds to a low-cost IRA.

Analysis:

The Situation:

• Worker has access to a 401(k) plan that matches contributions equal to 5.0% of salary.
• The 401(k) plan has an annual fee equal to 1.3% of assets.
• Vanguard and Fidelity offer a deductible IRA with an annual fee of 0.3% of assets.

The Choice:

• Choice One: Contribute 10 percent of income to a 401(K)
• Choice Two: Contribute 5% percent of income to a 401(K) and 5.0% of income to an IRA.

• The person earns \$75,000 per year for 35 years.
• The return on investments prior to fees is 6.0% per year.
• Contributions are bi-weekly

The Outcome:

• Choice One:  Wealth at Retirement \$998,933 all in a 401(K).
• Choice Two: Wealth at Retirement \$1,083,089, with both 401(K) and IRA.
• Additional wealth from diverting funds to an IRA is \$83,876.

Concluding Remarks:   Many financial advisors ignore fees and recommend maximizing contributions to a 401(k) plan.  A better solution is to maximize the employer match and divert additional savings to a low-cost IRA.

## How to minimize the impact of 401(k) fees

• Retirement plan fees vary substantially across firms.
• Annual fees appear trivial but small differences in the annual fee have a substantial impact on retirement wealth.
• A median-wage worker at a firm with a high-cost retirement plan can pay more than \$100,000 in retirement plan fees over her lifetime.
• Workers can reduce lifetime retirement fees by moving to a job at firm with a low-fee plan, moving retirement funds to a low-cost IRA when changing jobs, greater use of IRAs, and greater use of investments outside retirement plans.

Background on impact of high retirement plan fees:  A report by the Center for American Progressrevealed that 401(k) fees are a substantial expense and drain on retirement income for many workers.  On average, annual 401(k) fees are 1.0 percent of assets.

There is substantial dispersion in the annual fee percentage across firms.   A 2011 survey cited in the report found the average annual 401(k) fee for firms with fewer than 100 participants was 1.32%.   The report found that a well-managed retirement account could have a fee as low as 0.25%.

The report calculates lifetime 401(k) fees for workers at three different annual fee rates – 0.25%, 1.0%, and 1.3%.   The scenarios assumed the worker contributes 5% of salary and receives a 5% employer match. The findings indicate that relatively small annual differences in fees as a percent of asset leads to large differences in lifetime fees paid by workers to the sponsor of their retirement plan.

• Lifetime 401(k) fees for a median-wage worker starting her career are \$42,000 at a 0.25% annual fee, 138,000 at a 1.0% annual fee, and \$166,000 for a worker at 1.30% annual fee.

The report also contained lifetime fee calculations for a higher wage worker.  Results were proportionate to income.

Higher retirement fees were associated with a higher likelihood of ending up with insufficient retirement income.

• An increase in retirement plan fees from 0.5% of assets to 1.0% of assets will reduce the likelihood a worker will have sufficient retirement income from 69% to 57%.

The reported annual fee as a percent of retirement plan assets appears to be small, almost trivial.   However, the fee is applied each year.    The annual fee becomes large for older workers with larger amounts accumulated in the account.

High retirement fees are an especially important issue when interest rates are low.  When the fee percentage is larger than the bond interest rate, the de-facto interest rate is negative. This is currently the case with a two-year Treasury rate stands at 0.16% below the level of even a low-cost retirement fund.

The Center for American Progress argues that a key solution to problems created by high retirement plan fees is better information about the fees.  Workers are not explicitly billed for retirement fees.  The retirement plan fee is an indirect charge deducted from investment returns.   Workers would be much more cognizant of retirement fees if they were directly charged the service.

Investment managers charging high fees claim their fees are justified because their fund realizes higher returns.  The finance literature indicates that passive funds with low returns tend to outperform active funds with higher fees.  Moreover, Warren Buffet, arguably the best active stock picker of all time, argues sticking with the S&P 500 will lead to better returns than active management.

Workers would be better served if they were automatically placed in low-cost funds unless they opted out.  The current default retirement plan is the plan chosen by the worker’s employer.   However, workers at firms that choose a high-cost retirement plan with inadequate options can and should take several steps to reduce fees and work towards a secure retirement.

Mitigation of the adverse financial impact on high retirement fees:

A worker who is aware that a retirement plan at her current or prospective job imposes high fees can take several steps to reduce fees.   These steps include, moving to a job with a better retirement plan, rolling over funds from the high-cost plan to a low-cost IRA when changing jobs, greater use of individual retirement accounts, and increased savings outside of retirement plans.

Moving to a firm with a better retirement plan:  A person with multiple job offers should consider the quality of the retirement plan when weighing different offers.  Factors determining the quality of a firm’s retirement plan include – whether the firm matches employer contributions, the level of the match, whether the firm offers a Roth 401(k) option and as shown above the level of fees.

Change jobs and rolling over retirement funds:  The existence of high retirement fees should motivate a person with assets in a retirement plan to look for a new gig.  Preferably the new job would have a retirement plan with a lower-cost plan; however, even if it does not the worker can take her funds out of the high-cost plan and place them in a low-cost IRA.

Consider, a 45-year-old worker with \$300,000 in a retirement plan charging a 1.3 percent annual fee.   The person is paying \$3,900 in retirement fees in her current year.  She could quit her job and move the retirement funds to a low-cost IRA with a fee at perhaps 0.5 percent.   The current-year annual fee would be \$1,500.

The annual leakage from high fees grows over time in tandem with the growth of assets.  One of the worse mistakes a person can make preparing for retirement is to leave assets in a high-cost plan once you move to a new position or retiring.

Investment related fees at reputable firms like Vanguard, Fidelity and Schwab have fallen in recent years and with a little research you can roll funds into a low-cost IRA when you leave your current position.    The impact on your retirement wealth is considerable and I see no advantages in keeping funds with a high-cost retirement funds after you move to a new position.

Use of IRAs to replace or complement firm retirement plan savings: The person who accepts a job at a firm with a high-fee retirement plan must decide whether to contribute to the retirement plan, contribute to an individual retirement plan instead of the IRA or contribute to both the firm retirement plan and an IRA.

There are some limitations with IRAs.  Contribution limits are lower for IRAs than for 401(k) plans.  The contribution limit for IRAs in 2020 is \$6,000 for people under 50 and \$7,000 for people 50 and over.  The contribution limit for 401(k) plans in 2020 is \$19,500 for people under 50 and \$26,000 for people 50 and over.

Tax rules link eligibility for Roth IRAs to household income.  Tax rules also link the tax deductibility of traditional IRAs to both household income and whether a person and/or spouse contributes to a 401(k).  These rules limit but do not eliminate advantages associated with a strategy of complementing investments in a firm-sponsored retirement plan with investments in a lower-cost IRA.

A person at a firm with a high-cost retirement plan might choose to contribute to the plan if the firm matches employer contributions.   The employee could take full advantage of the matching contribution and divert any additional savings to accounts outside the retirement plan. The employer match will lead to a generous return in the year the contribution is made, however, the annual fee will erode the fund over time.  The use of the IRA for contributions over the match can result in increased retirement wealth if the IRA has lower fees.

The employee contributing to both the firm 401(k) plan and an IRA may have to place funds in a non-deductible IRA rather than a Roth or deductible IRA depending on her household income.  This allows for deferral of tax.  The worker may be able to convert the conventional IRA to a Roth IRA in a future year but this is a topic for another day.

Once the worker leaves the firm, the entire retirement fund should be rolled over to a low-cost IRA.  Brokerage firms may allow you to combine funds in the two accounts.

A person with at a firm with a high-cost retirement plan that does not match employer contributions should consider and should probably choose a low-cost IRA instead of the firm’s high-cost retirement plan.   This strategy limits contributions and retirement income for some workers because as noted contribution limits are substantially higher for firm-sponsored 401(k) plans than for independent IRAs.  However, the difference between IRA and 401(k) contribution limits may not matter for most workers because many companies, in. a response to IRA non-discrimination rules, limit contributions to a 401(k) plan to a percent of income.

Use of Low or No-Fee Bond Purchases Directly from the U.S. Treasury:  The current market environment is challenging.  The valuations of popular stocks like Microsoft and Apple are at historic highs.  Interest rates are low and for some maturities below the annual 401(k) fee. The actual investment return on many bonds in 401(k) accounts after accounting for the annual fees is negative.

Investors improve outcomes by purchasing I and EE Bonds directly from the Treasury.  The purchases can be done inside or outside of retirement accounts.

There are several advantages associated with the greater use of I-Bonds and E-Bonds directly from the U.S. Treasury.

• There are no fees on bonds purchased through Treasury Direct and no fees on the purchase of I and EE bonds as stated in these FAQs.
• Tax is deferred on I and EE bonds until the instrument is sold.
• The tax on matured bonds is limited to deferred interest or capital gains while all funds distributed from conventional retirement accounts are fully taxed as ordinary income.
• Individual bonds can be redeemed at maturity at their par value while the value of the bond fund is determined by the prevailing interest rate.

Advantages of use of bonds as part of an overall retirement strategy and advantages associated with the purchase of bonds from Treasury Direct deserve and will get future analysis.

The point stressed here is that investments in bonds at Treasury Direct can reduce lifetime retirement fees.

Concluding Remarks:   Virtually all financial planners emphasize the importance of taking full advantage of retirement plans.  The advice starts as soon as a person enters the workforce even if the person has substantial student debt and a strategy of rapid repayment of student loans would substantially reduce costs, financial risk and stress for the new worker.  The financial planners often don’t worry nearly enough about paying off the mortgage prior to retirement.

Financial planners often don’t mention or stress the importance of high fees, which as discussed here have a large impact on retirement wealth and the likelihood a worker will have a secure retirement.

The message presented in this post is that workers need to be aware of the retirement plan fees and the overall quality of the plan and come up with an alternative solution if the firm’s plan is inadequate.

## Complicated rules for inherited retirement accounts

The 2019 Secure Act changed rules governing distributions from inherited IRAs and 401(k) plans.  The new rules prevent some beneficiaries from stretching withdrawals across their lifetime.    This CNBC article does a good job explaining the rules.

The new rules require many people who inherit a 401(k) plan to take disbursements within a 10-year period. However, there are some exceptions for minors and spouses.

The clock for disbursements over a 10-year period starts at 18 for minors inheriting a Roth IRA.  However, prior to becoming 18 the minor must make a required minimum distribution RMD based on life expectancy.  The RMD for minors should be really small because minors have a large future expected life.  This rule might make sense if the IRA or 401(k) is huge but is it rational for people who inherited a small account?

The distributions from Roth accounts are tax free while the distributions from conventional accounts are taxed as ordinary income.   I guess the Treasury will gain some tax revenue from accelerated Roth distributions if the funds are invested in assets with taxable interest, dividends or capital gains.

The distributions over the 10-year window can occur in any year.  Since Roth accounts are not taxed it may make sense to distribute the funds in year 10.  Conventional accounts are taxed; hence, taxpayers may want to spread distributions across years.

Funds not distributed by year 10 are subject to a 50% tax.  Ouch!

Spouses who inherit an IRA do not have to take distributions until age 72.

The time frame for distributions for people who inherit an account through probate is 5 years not 10.  Hence, it is important to name a beneficiary on your 401(k) or IRA.

Many people who inherit IRAs or 401(k) plans have modest income.  This bill requires distributions even when the person might be better off saving for retirement.    Many people inheriting a small IRA or 401(k) are not wealthy.

The bill was passed during the Trump Administration.     Trump Administration and Republican tax policy was in general very generous to high-income people but not averse to using complicated rules to get a bit more tax from some people who may be middle income.