Last year, I went cycling with a couple of friends in Italy. One of them, Dan, had been a chef. When he was young, he picked and sold wild mushrooms. After a long day of riding, Dan walked into the forest with a bucket. He plucked part of our dinner off the mossy ground. When he came back, he made delicious mushroom pasta with fresh baked trout.

The mushrooms were free. But that doesn’t mean everyone should eat fungi off the ground. They might make you sick or worse.

A 401(k) could hurt you too. The tax-advantage is like a free meal. But it might cause some trouble if the fees are too high. That’s according to researchers Ian Ayres and Quinn Curtis. In 2014 they published Beyond Diversification: The Pervasive Problem of Excessive Fees and “Dominated Funds” in 401(k).

They looked at 3,500 401(k) plans. They said that 401(k) plans with funds that cost 1.5 percent or higher “would not lead to good outcomes for the investors who must hold those funds.” The authors assumed a 35-year time horizon for a young employee. They compared different 401(k) plans. They wanted to see if high fees eroded the advantage of a tax-deferred plan. They asked whether, in some cases, a taxable portfolio of low-cost index funds might make the investor more money.

The researchers said that in 16 percent of the 401(k) plans studied, it would have been better for young employees to invest in a lower-cost taxable account. They found that the most expensive 10 percent of 401(k)s charged fees that were 1.46 percent higher than those of a low-cost index fund portfolio.

That might not sound like much. But fees compound over time­–much like a house wrecking snowball that rolls down a hill.

Last fall, a company administrator asked me to look at their Roth 401(k). I was curious. I had read the study by professors Ayres and Curtis. In this case, employees could choose from a variety of R-2 class American Funds. Their costs averaged about 1.40 percent per year. In other words, they were in the nosebleed zone. In fairness to American Funds, the expense ratio for the same fund in a qualified plan can range considerably, from 1.46 percent to 0.37 percent, according to their website. But this company is small, so the fees will likely remain high. The business didn’t match a percentage of the employees’ salary.

Like the research professors, I assumed a time horizon of 35 years. I looked at all of their available funds with ten-year track records. I compared their performances with equal-asset class index funds from Vanguard.

The index funds won by a compound annual difference of 2.05 percent. I then removed one of the outlier categories (where the American funds stank). After doing so, the index funds still beat their actively managed counterparts by 1.66 percent per year.

This supports what the Economic Nobel Prize winner, William F. Sharpe, says in his paper The Arithmetic of Active Management. Actively managed funds, on average, will lose to their benchmark indexes in direct proportion to the fees charged.

If such a difference were to continue over 35 years, young employees would have 46 percent more money if they invested every month in a portfolio of low-cost index funds.

8 Percent Compound Annual Return 6.34 Percent Compound Annual Return
$5000 Invested Annually For 35 Years $930,510.74 $637,177.31

But what about taxes? With a Roth 401(k), after-tax contributions can grow tax-free. I needed to deduct three things from the taxable account: dividend taxes, short-term and long-term capital gains taxes.

Morningstar estimates how dividend taxes and short term capital gains (which are unavaoidable in a taxable account) would affect an index fund’s performance.

Total Stock Market Index
Morningstar Tax-Adjusted Returns To October 31, 2016

Vanguard’s Total Stock Market Index (VTSMX) averaged a 9.26 percent compound annual return since its inception. Morningstar estimates that its after-tax return would have been a compound annual return of 8.66 percent. This assumes dividends are taxed and short-term capital gains tax, as a result of stock turnover.

This would deduct about 0.60 percent per year from the index fund’s posted annual return. After making this deduction, and subtracting a long-term capital gains tax of 15 percent, the lower-cost taxable account still won.

I assumed that the past ten-year performance difference (between the active and the passive portfolios) would be similar in the future.

Hypothetical 8 Percent Pre-Tax Return*

Taxable Index Fund Account Tax Free American Funds R2 Class
Minus Underperformance (of the actively managed funds) 0% -1.66%
Minus dividend tax/capital gain drag -0.60% 0%
Annual Return, post dividend tax (not including long term capital gains taxes) 7.40% 6.34%
Overall Difference
$5000 Invested Annually Would Grow To:
Over 35 years $810,293.60 $637,137 27.17%

This scenario puts the low-cost taxable portfolio ahead by 27.17 percent over 35 years. After paying long-term capital gains taxes of 15 percent, the taxable portfolio might win by 12.17 percent.

That’s why employees should consider fees and matching contributions before investing in a company 401(k).

American Funds R-2 Fund Performances Offered By Sample 401(K) Plan
10 Year Period Ending September 30, 2016

U.S. Equity Funds:
Fund Expense Ratio 10 Year Annual Performance
AMCAP Fund (RAFBX) 1.48% 7.14%
American Funds Fundamental Investors (RFNBX) 1.35% 6.21%
American Funds American Mutual (RMFBX) 1.37% 5.74%
American Funds Investment Company of America (RICBX) 1.36% 5.36%
American Funds Washington Mutual Investors Fund (RWMBX) 1.36% 5.36% (noted, same return as the above fund)
Vanguard Total Stock Market Index (VTSMX) 0.16% 7.41%
Vanguard S&P 500 Index (VFINX) 0.16% 6.69%
American Funds Category Performance Average 5.96%
Vanguard Category Performance Average 7.05%
U.S. Growth
Fund Expense Ratio 10-Year Annual Performance
The Growth Fund of America (RGABX) 1.35% 6.18%
American Funds New Economy Fund (RNGBX) 1.57% 6.79%
American Funds New Perspective Fund (RNPBX) 1.55% 5.56%
Vanguard Growth Index (VIGRX) 0.22% 8.17%
American Funds Category Average 6.17%
Vanguard Category Average 8.17%
U.S. Broad Market Bonds
Fund Expense Ratio 10-Year Annual Performance
American Funds Bond Fund of America (RBFBX) 1.34% 2.64%
American Funds U.S. Government Securities Funds (RGVBX) 1.38% 3.11%
Vanguard Total Bond Market Index (VBMFX) 0.16% 4.62%
American Funds Category Average 2.88%
Vanguard Category Average 4.62%
U.S. High Income Bonds
Fund Expense Ratio 10-Year Annual Performance
American High Income Trust (RITBX) 1.48% 4.73%
Vanguard High Yield Corporate Bond Index (VWEHX) 0.23% 6.60%
American Funds Category Average 4.73%
Vanguard Category Average 6.60%
Intermediate Bonds
Fund Expense Ratio 10-Year Annual Performance
American Funds Intermediate Bond Fund of America (RBOBX) 1.40% 1.81%
Vanguard Intermediate Term Bond Index (VBIIX) 0.16% 5.84%
American Funds Category Average 1.81%
Vanguard Category Average 5.84%
Mixed Allocations
Funds Allocation Expense Ratio 10-Year Annual Performance
American Funds New World Fund (RNWBX) 14% U.S. Stocks
14% Bonds/Cash
72% Emerging Market Stocks
1.78% 3.70%
Vanguard Index Fund Equivalents 14% Vanguard U.S. Stock Index (VTSMX)
14% Vanguard Total Bond Market Index (VBMFX)
72% Vanguard Emerging Market Index (VEIEX) 74%
5.39%*
American Funds Capital Income Builder (RIRBX) 42% U.S. stocks
37% International Stocks
21% Bonds/Cash/Other
1.35% 3.77%
Vanguard Index Fund Equivalents 42% Vanguard U.S. Stock Market Index (VTSMX)
37% Vanguard International Stock Market Index (VGTSX)
22% Vanguard Total Bond Market Index (VBMFX)
5.49%*
American Funds Income Fund of America (RIDBX) 53% U.S. Stocks
17% International Stocks
30% Bonds, Cash, Other
1.36% 4.78%
Vanguard Index Fund Equivalents 53% Vanguard U.S. Stock Market Index (VTSMX)
17% Vanguard International Stock Market Index (VGTSX)
30% Vanguard Total Bond Market Index (VBMFX)
6.36%*
American Funds Category Average 4.08%
Vanguard Category Average 5.75%

Annual Performance Comparisons For Six Investment Categories

American Funds R-2 Class Vanguard Index Funds Annual Lower Cost Advantage 10 Year Pre-Tax Advantage For Lower Cost Funds
U.S. Equity 5.96% 7.05% +1.04% +11.45%
U.S. Growth 6.17% 8.17% +2.0% +21.89%
Broad Bonds 2.88% 4.62% +1.74% +18.2%
High Income Bonds 4.73% 6.60% +1.87% +19.3%
Intermediate Bonds 1.81% 5.84% +4.03% +47%
Mixed Allocations 4.08% 5.75% +1.67% +17.2%
Source: Morningstar.com

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.