Whether or Not to Invest in a 457

[Guest Nico]

I am new to this board but I am aware of the impact that fees have on retirement accounts which has led me to ask this question.

If an individual has access to a 457 plan but the plan has high expenses, is the individual better off taking advantage of his/her Roth Ira and after maxing that out, investing the remainder in a taxable index fund(s). Are the contributions a participant makes before taxes so significant that it outweighs the possible high expenses in the plan.

Here are the expenses in the 457 plan.

Bond Index .40

Int'l Stock Index .60

Midcap Index .50

S&P 500 Index .50

Small Cap Index .50

In addition to the above basis points, the plan also charges .57% for administration, no other fees.

This is not an annuity. It's a 457 offered thru AIG/Valic invested directly in mutual funds.

I have tried to google search a financial calculator to answer my question. Does one just pass up this 457 plan and invest directly in Vanguard's Index Funds that range from 19 to 32 basis points, and do so in a roth Ira first and then in a taxable account.

I am single, 25 years of age, earn between 40 and 45K and live in Florida.

Any help is appreciated.

[Guest DARNOLD]

You are correct. You have a low cost plan compared to many costing up to 5% with trading expenses. Although even you can buy the S&P index for 6 basis points from E-trade and save 1% per year.

Now consider tax differential. Most public employees are in a 15% bracket. At today's interest rates (4%) are you really getting benefit from tax deferral? There is no big advantage to just postpone taxes.

What you give up... liquidity, step-up basis, capital gains treatment, ability to gift shares w/o tax liability and of course you may cause double taxation on social security at retirement on each dollar taken back.

If you defer at 15% tax rate today and take back at 51% tomorrow [28% fed + 85% taxable Soc Sec] it takes you 15 years to break even on each dollar tax deferred assuming you earn a 5% annual return.

The 457 plan was fine for the early '80's in a 49% tax rate and 10% interest environment. Today it is almost useless for public employees and does more harm than good.

Note I was a salesperson for 457 plans for 20 years. One client who "deferred" 13K from taxes now has an account value over $700K....and will eventually pay the IRS over 250K for the priviledge. We all wish we had the ROTH-IRA back then.

Dave Arnold, CFP

[Guest mjb]

Dave: you want to explain the math for me. I dont see how 28% + 85% of ss benefits can equal a 51% tax rate since the max tax rate on 336k of taxable income for a married couple (168 single) is only 35%. I would also like to see how 700k in a 457 plan would be subject to 250k in fed tax since the payments can be paid out under the MRD rules for IRAs, rolled over to an IRA upon the death of the owner and streteched over 2 more suceeding generations while the earnings compund tax free.

Also the max contribuion to a roth IRA is 5,000 which is less than 25% of the max contribution for a govt 457b plan.

[Everett Moreland]

mjb:

What DARNOLD is referring to is that, when social security benefits are taxed, your marginal tax rate can be 1.85% of what you think it is. This is because $1 of other gross income can cause $.85 of social security benefits to be taxed, resulting in an additional $.518 of tax from $1 of other gross income, if your nominal marginal rate is 28%. The article at the following link (Hammer, "Minimizing the taxability of Social Security benefits," The Tax Advisor (September 1, 1997)) has a good discussion of this.

http://www.thefreelibrary.com/Minimizing+t...fits-a020031490

This can make Roth 401(k) or 403(b) contributions much more attractive that regular 401(k) or 403(b) contributions.

[Guest mjb]

That makes no economic sense. If 20,000 of SS benefits is paid only 17,000 is included for income tax which results in a marginal tax of $4,760 (17,000 x .28) or a marginal tax rate of about 24% on the ss benefits for someone in the 28% bracket, not 51%.

[Everett Moreland]

Both are correct. For planning purposes I find it more helpful to think of the marginal tax rate as 1.85% of the nominal marginal tax rate. This is because you can to some extent control the amount of your other gross income in retirement (such as by converting a traditional IRA to a Roth IRA) but you can't control the amount of your social security benefits. So, focusing on what you can control, I find it helpful to know that, if your nominal marginal tax rate in retirement will be 28% and your other income is in the range in which an additional 1$ of other income will result in an additional $.518 of tax, you can reduce your tax liability in retirement by $.518 for each dollar you receive in retirement that is nontaxable (because a Roth IRA distribution) rather than taxable (because a traditional IRA distribution).

[Guest mjb]

If the tax rate is 51% then 10,200 would be due on the ss benefits instead of $4760 which is not correct.

[joel]

You are correct. You have a low cost plan compared to many costing up to 5% with trading expenses. Although even you can buy the S&P index for 6 basis points from E-trade and save 1% per year.

Now consider tax differential. Most public employees are in a 15% bracket. At today's interest rates (4%) are you really getting benefit from tax deferral? There is no big advantage to just postpone taxes.

What you give up... liquidity, step-up basis, capital gains treatment, ability to gift shares w/o tax liability and of course you may cause double taxation on social security at retirement on each dollar taken back.

If you defer at 15% tax rate today and take back at 51% tomorrow [28% fed + 85% taxable Soc Sec] it takes you 15 years to break even on each dollar tax deferred assuming you earn a 5% annual return.

The 457 plan was fine for the early '80's in a 49% tax rate and 10% interest environment. Today it is almost useless for public employees and does more harm than good.

Note I was a salesperson for 457 plans for 20 years. One client who "deferred" 13K from taxes now has an account value over $700K....and will eventually pay the IRS over 250K for the priviledge. We all wish we had the ROTH-IRA back then.

Dave Arnold, CFP

How much more would this client have today if he did not pay you and your B/D a commission every two weeks to acquire the investment? $100,000, 200,000.

NICO: Having said that there is a bill in Congress that would authorize a Roth 457 Plan? Write to your Congresspersons!!