Getting Started Series Part 8: What are expense ratios and why they matter

GettingStartedSeriesPart8

This is a series intended to answer the question “I’m covering my bills, now what?” It’s for people who have a steady source of income and have a vague notion that they should be doing something more with their money, but don’t really know how to begin. This will go through what to do with that money post-bills, from setting up an emergency fund, to debt management, retirement, and investment. Although most of this information is applicable to civilians, we’ll also be providing resources and information specifically geared toward military servicemembers and their families.

This will probably be the last post to our Getting Started Series for a bit. I have another idea or two that I may add at another date, but in the meantime we’re going to move on to some other topics. In case you missed it, check out the rest of the series here.

I will admit, the Mr and I were pretty naïve about expense ratios until recently. I think that when you’re a beginner investor you are so worried about choosing the right investment and looking at the growth of the fund over time and so overwhelmed with the task of choosing that the expense ratio gets overlooked. And then you are just so proud of yourself for socking away your money for retirement and investing. And while saving and investing is better than nothing, minimizing your expense ratio will get you the most bang for your buck.

An expense ratio is like the commission that the fund charges for owning and maintaining the fund. It’s a percentage of your money that they keep to offset their own costs. You can think about it as the “price” of owning the fund (although it’s important to note that this isn’t the fee for buying the fund).

We were pretty happy because Davin rolled over some old 401ks and I got my Roth IRA set up with our bank that I won’t name. We picked our funds and were very happy with ourselves for being on the right path to retirement.

And then we saw the expense ratio. Oh. Suddenly, we weren’t so happy with ourselves.

It turns out that our Roth IRAs were in an account with a .18% expense ratio.  We moved them to a different brokerage company and to a fund with a 0.05% expense ratio. Let’s take a look at the impact that this change in expense ratio has on our retirement savings using this expense ratio calculator.

In the calculator below, I’ve entered our annual contributions as $11,000 ($5,500 each). Our initial contribution (what was already in the accounts) was about $20,000. I left the expected return at the default value of 6% in order to stay conservative.  We are invested in the S&P 500 which typically returns closer to 9%, so the difference between the two funds would probably be more dramatic. We have a bit of an age difference between us, but I have almost exactly 30 years until I’ll be 59 ½ and eligible to withdraw from my Roth IRA without penalty so that’s the number reflected in the investment calculator.

ERCalc1

As you can see, by changing from our higher expense ratio account to an account with a lower expense ratio, we have saved $21,496.89. Will this make or break our retirement? Doubtful.  But over $20,000 is still a lot of money and I’ll be damned if I’m just going to let the bank have it.

And here’s the numbers if our investments actually return 9%:

ERCalc2

Isn’t it shocking? This is why expense ratios matter. They really add up over time!

I’ve often discussed how awesome the TSP is (link) and one of the best perks of the TSP is the low expense ratio- only 0.029%. Most 401ks and 403bs through the workplace have a shockingly high expense ratio- mine is a whopping 0.29% . That’s 10 times more expensive than Davin’s TSP!  So to emphasize what a great deal the TSP is I compared Davin’s TSP with my 403b. I only put the calculator at 18 years, the number of years that Davin will continue to be in the military.

ERCalc3

Big difference, right? And that’s only over the course of 18 years. We would let these accounts continue to grow, so the difference would become even more exaggerated.  This is why it’s so important to contrubute to your TSP first before other retirement accounts. The expense ratios simply save you so much money.

Don’t overlook the expense ratio when shopping for an investment fund. As we’ve seen here today, those expenses can really add up over time. In my example we could’ve wasted at least $20,000 on the expense ratios of our Roth IRAs  if we hadn’t noticed and changed our account.

And secondly, invest first in the account with the lowest expense ratio. We eventually maxed out all of our retirement accounts including our Roth IRAs, Davin’s TSP, my 403b, and my 457 (like a 401k that’s offered to state employees). But before we were ready to make that jump, we prioritized Davin’s TSP and maxed out that fund first before even contributing a dime to mine. His fund is significantly cheaper than mine, in fact we’ve seen that over the course of 18 years it’s over $13,000 cheaper. So maximize the cheapest funds first before moving to more expensive funds.

 

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