Should You Increase Your 401k Savings Due To Tax Reform?
February 22, 2018Have you noticed a little boost in your paycheck recently? That’s probably because employers have just started updating their employees’ withholding based on the new tax law, which reduced tax brackets across the board. So what should you do with the extra money?
Should you contribute more?
It may seem like the responsible thing would be to contribute it to your 401(k). After all, if you’re like the average American, you may not be saving enough for retirement and this would be a painless way to get closer to that goal. (You can use this calculator to see how much you should be saving.) Here are a few questions you may want to ask yourself first:
Is the tax bill really saving you money?
While rates have come down, some deductions have also been reduced or eliminated, including the state and local tax deduction. If you pay high state, local or property taxes, you may actually see your taxes go up. You don’t want to find that out at tax time next year and have to borrow from your 401(k) to pay the IRS. You can use a calculator like this to estimate your tax liability under the new law and compare it to what you owed previously.
Do you have adequate emergency savings?
Even if you are saving money, your 401(k) may not be the best place for those savings. Financial planners typically recommend having enough emergency savings to cover at least 3-6 months’ worth of necessary expenses. Otherwise, you may be forced to raid that 401(k) (with possible taxes and penalties) or borrow at high-interest rates in the event of an emergency.
If you can’t bear the thought of neglecting your retirement savings for even a short period of time, consider contributing to a Roth IRA. You can withdraw the sum of your contributions at any time and for any reason without tax or penalty so it can double as your emergency fund. (If you withdraw earnings before age 59 ½, they are subject to possible taxes and penalties but the contributions come out first.)
Just be sure to keep the Roth IRA money someplace safe like a savings account or money market fund until you have enough emergency savings somewhere else. At that point, you can invest the Roth IRA money more aggressively to grow tax-free for retirement.
Do you have high-interest debt?
It probably doesn’t make sense to contribute more to your 401(k) if you have a credit card balance at 19% interest. Those 401(k) contributions would have to earn 19% after-taxes just to break even. That’s something I certainly wouldn’t count on, especially with many financial experts forecasting future returns in the low to middle single digits due to historically low interest rates and high stock valuations. For that reason, my rule of thumb is to pay off any debt with interest rates above 4-6% before investing extra money (unless you haven’t maxed your employer’s match).
Are you planning to buy a home?
If so, consider stashing the extra money in savings. You’ll need cash for the down payment, closing costs, and any furnishings and renovations you want to add. This is on top of your emergency funds, which will be even more important when you can’t call a landlord anymore for home repairs.
If you’re saving money from the tax bill, have adequate emergency savings, no high-interest debt, and aren’t looking to buy a home anytime soon, your 401(k) can get be a great place for those extra savings. Go ahead and adjust your contributions before you start getting used to the bigger paychecks. After all, many said the tax law favors the rich so the quicker you can get there, the better!
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