In Millionaire Expat, I wrote about international teachers’ Roth 401(k) plans for Americans.  I did so on pages 141-146.  I concluded that, over short-durations, the Roth 401(k) comes out slightly ahead of a lower-cost, taxable equivalent.  I also concluded that, over long durations, the high fees in the 401(k) outweigh the tax-free advantage.  Over longer time periods, a low-cost taxable account would win.

 Embarrassingly, however, I made a mistake.  Regardless of the time duration measured, the lower fee taxable account would beat the tax-free 401(k).  I based these calculations on dividend taxes, short-term capital gains taxes, and long-term capital gains taxes.  Thank you, Morningstar, for providing the post-tax returns for such funds. 

 If you are curious about the mistake that I made in Millionaire Expat, I assumed the taxable portfolio would incur a long-term capital gains tax of 15 percent on the total end-value.  That was silly.  It would only incur a 15 percent long-term capital gains tax on the actual profits earned, not on the total end value of the portfolio.

 As such, I’ll be correcting this section in Millionaire Expat.  It will soon be reflected in the Kindle editions and in the next print run.  That said, such corrections presented a challenge.  I couldn’t alter paginations or change anything that would alter the index.  So…here’s my attempt at what the changes will look like.  I can’t write more words than this.  But please let me know if you think this is clear.

 

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Starting From Page 142, Millionaire Expat

 

At First Glance, The Rewards Are Worth It

The investment gains from an American international teachers’ Roth 401(k) account can grow tax-free.  It offers a dream scenario.  The teachers don’t pay capital gains or dividend taxes when they withdraw.  It’s just the kind of thing that would make stateside Americans drool.

Teachers who are below the age of 50 can contribute $18,000 USD per calendar year.  Teachers over the age of 50 can contribute $24,000 USD per calendar year. ¹²

 

Does the Tax-Free Status Outweigh the High Fees?

Sometimes, high fees overpower the benefit of tax-free gains.  Such is the case with Roth 401(k)’s that are offered to international teachers.  They are much more expensive than the typical stateside 401(k).

              According to The Wall Street Journal, the average small company 401(k) in the United States costs 1.27 percent per year.  That includes fund costs and all administrative charges.  Companies whose investors have a combined $10 million to $100 million in their plan get charged an average of 0.82 percent. ¹³

              International teachers pay about 1.6 percent per year for a Roth 401(k).  Ian Ayres is an economist and a lawyer at Yale Law School.  In March 2015, he and Quinn Curtis (a professor at the University of Virginia School of Law) published, Beyond Diversification: The Pervasive Problem of Excessive Fees and “Dominated Funds” in 401(k) Plans in the Yale Law Journal.

              They wrote, “A lengthy menu of varied funds all charging management fees of 1.5% [which is] well above the industry average, would not lead to good outcomes for the investors who must hold these funds.”¹⁴

              Table 6.1 lists total charges for three 401(k) investment platforms sold to international teachers.  The fees that I listed for Jon Levy’s plan came from the documents he offered to the International School of Prague.  Raymond James’ came from the documents their firm offered to the American International School of Vienna. 

 

Table 6.1

International Teachers 401(k) Total Annual Charges Including Fund Fees and Administrative Expenses

 

Jon Levy	Raymond James	The Investment Center (TIC Retirement Care)	Average US Small Company 401(k) costs
1.54%	1.61%	1.75%	1.27%

 

Costs for The Investment Center (TIC Retirement Care) came from email exchanges with program administrator, Lance Roberts, and documents that he was kind enough to send me. 

              It might look like the Investment Center’s fees are highest.  But don’t be fooled by an average.  The Investment Center offers Vanguard’s Target Retirement Funds.  If investors select such funds, they would pay total annual fees of about 1.6 percent per year, including The Investment Center’s administrative charges.

 

Pretax Returns Would Be Much Higher Outside the 401(k)

Assume an American investor opened an account with Vanguard before moving abroad.  They would have direct access to Vanguard’s Target Retirement Funds.  These are complete portfolios of indexes, wrapped up into single funds.  They are the same products offered by The Investment Center’s 401(k) plan.

              Total costs for Vanguard’s Target Retirement 2030 fund, for example, are 0.15 percent per year.  The Investment Center tags an additional 1.45 percent fee to cover administrative costs.

              In this case, the pretax difference between investing inside the tax-free vehicle, versus investing in a taxable account, would amount to 1.45 percent per year.  If we didn’t consider taxes, such a difference would be huge (see Table 6.2).

              If the fund averaged a compound annual return of 8 percent (before taxes) the same fund would gain 6.55 percent annually in the Investment Center’s Roth 401(k).

              But this ignores the benefit of the Roth 401(k)’s tax-free status.  According to Morningstar, taxes deduct about 0.64 percent per year from Vanguards’ Target Retirement 2030 fund’s pretax gain (based on an average calculation since the fund’s inception).  This would be a result of dividend tax and short-term capital gains tax. 

 

Table 6.2

$10,000 Invested per Year Annual Returns:  6.55% versus 8.0%

Time Duration	Growth at 6.55% per Year	Growth at 8.0% per Year
20 years	$415,931	$494,229
25 years	$631,928	$789,544
30 years	$928,556	$1,223,458
35 years	$1,335,918	$1,861,021

 

Let’s assume an additional, estimated long-term capital gains tax of 15 percent for the taxable portfolio.  Such might be the case if an investor liquidated an entire portfolio for a Virgin Galactic spaceship trip.  Investors would pay capital gains taxes of 15 percent on the long-term profits earned. 

Table 6.3 shoes how it would look.

Table 6.3 When Fees are High, Taxable Portolios Beat Tax-Free Portfolios

		Roth 401 (k) Tax-Free Account	Taxable Account
Pretax Annual Growth Rate		6.55%	8.0%
Estimated Annual Tax Deficit (as a result of dividend taxes and short-term capital gains tax)		0%	-0.64%
Estimated Post Tax Annual Return		6.55%	7.36%
Time Duration	Total Invested (assuming $10,000 per year)	End Value of High-Fee Roth 401(k)	End Value of Low-Cost Taxable Account After All Taxes (short-term capital gains taxes, dividend taxes and 15% long-term capital gains taxes)	The Low-Cost Taxable Portfolio Wins By
20 years	$200,000	$415,931	$425,432	$9,501
25 years	$250,000	$631,928	$657,889	$25,961
30 years	$300,000	$928,556	$987,964	$59,408
35 years	$350,000	$1,335,918	$1,457,913	$121,995

 

As seen in Table 6.3, the low-fee taxable portfolio would beat the high-fee Roth 401(k) if they both averaged 8 percent per year, before fees.  And if stocks performed poorly, the high-fee Roth 401(k) would look even worse.

For example, assume a diversified portfolio averaged an annual return of 4 percent.  If investors paid total Roth 401(k) fees of 1.60 percent per year, they would be giving up 40 percent of their annual profits to fees.  If a portfolio averaged 1.60 percent per year, investors paying annual fees of 1.60 percent would relinquish 100 percent of their annual profits to fees.

The stock market can be generous.  But sometimes it’s stingy.  For example, from January 2000 to December 31, 2012, a globally diversified portfolio of index funds (45 percent U.S. stocks, 25 percent international stocks and 30 percent U.S. bonds) averaged a compound return of just 4.14 percent per year.  Over those same 13 years, U.S. stocks averaged a compound annual return of just 2.14 percent.

If such returns occurred again, an expensive Roth 401(k) might not beat inflation.

I’m not saying international teachers shouldn’t contribute to a Roth 401(k). There are plenty of pros and cons. And people’s personal situations vary. For example, such money would be designated as a retirement account. As such, it wouldn’t jeopardize a parent’s chance of earning financial aid for their children’s education. And when international teachers leave their current employer, they might be able to roll over their Roth 401(k) into a low-cost IRA, if their new employer doesn’t offer a Roth 401(k).

But these Roth 401(k)s are expensive. And they might not be as legally solid as those offered to stateside employees. Ask your provider this: “If the IRS challenges these things, many years from now, will you legally stand by your Roth 401(k) for international teachers?” I asked the lawyer who represented one of these firms. He firmly said, “No.”