Expensive 401(k)? 4 things to consider

(Money Magazine) -- Question: I'm 40 years old and would like to know whether I should invest in my workplace's tax-deferred retirement plan where expenses average 1.1% for the various options, or put my money into an outside account funded with index funds that charge 0.21% a year. In the long run which option would give me more money? --Michael G., Orangeburg, South Carolina

Answer: It's definitely a drag when a retirement savings plan is larded with high fees. And I don't mean drag in the colloquial sense of irritating. I'm talking about something that actually impedes progress, in this case making it more difficult for you to build an adequate nest egg.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

If you have any doubt as to just how serious a barrier high expenses in a 401(k) or similar plan can be, I suggest you take a spin over to Brightscope.com, a site that rates 401(k) plans and offers free personal 401(k) fee reports.

If your plan is one of 30,000 or so Brightscope has info on, you'll not only see the fees you're paying for your plan, but also get a projection of how much those fees might whittle down your eventual account balance.

That said, even if you're saddled with an expensive plan, as you appear to be, you shouldn't automatically assume you should abandon it.

For one thing, even a 401(k) with overall high costs may have a few reasonably priced options. I noticed that you said your plan expenses "average" 1.1%. That means that some presumably carry lower expenses.

But even if a plan has high costs across the board, the decision to invest depends on a number of factors, including whether your plan offers matching funds, whether you qualify for other tax-advantaged accounts and current and future tax rates.

1. Matching contributions

You don't say whether your employer kicks in a match. But if that's the case, then you should almost certainly contribute enough to take full advantage of the match. Except for extreme cases -- i.e., a really miserly match and a very large discrepancy in fees -- the extra dough you get from the match should more than make up for the 401(k)'s fatter expenses.

But what if your company doesn't offer a match -- or, if it does, you've taken full advantage of it? Should you still invest in your high-cost plan or venture outside it?

In that situation, the first thing to do is to see if you qualify for a traditional IRA or a Roth IRA. If you do, then you should probably consider funding such an account rather than your 401(k).

2. Other tax-advantaged plans

Even though they're structured differently, a traditional IRA essentially offers the same tax benefit as a 401(k). So, barring a 401(k) match, a lower-cost traditional IRA should outperform a higher-cost 401(k), assuming your money is going into the same type of investments.

The analysis gets a little more complicated with a Roth IRA. That's because the tax rate you eventually face in retirement also determines whether a 401(k) or a Roth IRA is a better deal.

All else equal, a 401(k) is generally a better deal than a Roth if you expect to slip into a lower tax bracket. But given the difference in fees that you're talking about, you would have to make a fairly large step down in tax rates for the expensive 401(k) to come out ahead.

And, besides, there are other reasons you might want to consider a Roth IRA (not to mention the specific strategy of contributing both to a 401(k) and a Roth IRA.)

Remember, though, the max you can contribute to an IRA is $5,000, plus another $1,000 if you're 50 or older. (You can make a contribution for the 2009 tax year until April 15, 2010). So even if you decide to fund a traditional or Roth IRA (or split your contribution between the two), you may very well want to save even more for retirement.

If that's the case, then you've got to decide whether to put that money in a 401(k) with bloated expenses or instead stick it in a regular taxable account that has lower fees but none of the tax breaks of a 401(k), traditional IRA or Roth IRA.

Comparing those alternatives can get a little tricky, but you're probably still going to be better off sticking to your 401(k) since its tax benefits are likely to compensate for the high fees.

3. Your tax rates

Here's an example based on your situation.

Let's say you're in the 25% tax bracket and trying to decide whether you're better off investing $5,000 before taxes in your 401(k) where you'll pay 1.1% in expenses or in a taxable account with expenses of 0.21% a year. And let's assume your investments in both accounts earn 8% a year before expenses.

With the 401(k), you would invest $5,000 that would earn a net 6.9%. After 10 years, that would leave you with $9,744. That's before taxes, though. Assuming you're still in the 25% tax bracket when you withdraw the money, that $9,744 would be worth $7,308 after taxes.

If you go with the outside taxable account, on the other hand, you'll pay a lot less in expenses, resulting in a higher annual return -- 7.79% (8% minus 0.21% expenses) vs. 6.9% in your 401(k). But you'll also start with less money in the outside account since you're investing after-tax dollars, in this case $3,750 ($5,000 minus 25% in taxes, or $1,250).

There's also the issue of how often your investment earnings in this account will be taxed, which depends on how tax efficiently you invest. If your entire investment return each year comes in the form of interest or realized gains, you would owe tax on those investment earnings each year. Under such a scenario, your $3,750 would be worth just a bit more than $6,600 after 10 years, well below the $7,308 after-tax with the 401(k), despite its higher cost.

I think that, given the situation you've outlined, you're probably better off investing within your 401(k) than in an outside taxable account, even if you have to incur the higher costs.

4. Automatic investing

There's one other factor we haven't talked about that I think deserves a mention -- i.e., convenience. With a 401(k), payroll deductions assure that your contributions get into your account before you have a chance to spend them. You've got to be sure to get the money into an IRA or taxable account, however. Granted, you can have a mutual fund or other investment firm automatically transfer dough from your checking account each month. But, still, the onus is on you to fund the account.

If you think that might be a problem, then you're probably better off in the 401(k), where at the very least you know your contribution will find its way into your account.

There are plenty of other ways to deal with a less-than-ideal 401(k) than looking for the exit. You may find that your best shot at a bigger nest egg lies not in abandoning your plan, but in finding ways to get the most out of the options it offers or, even better, cajoling your employer to improve it.