Which Retirement Plan Benefits Are You Missing Out On?

April 06, 2017

This week, we’re recognizing Employee Benefits Day on April 3rd by writing about ways to appreciate and “benefit from your benefits.” One of the most common benefits that is often underappreciated and underutilized is your employer’s retirement plan. In particular, here are some features that you may not be taking full advantage of if you’re fortunate enough to have them in your plan:

Employer’s match. According to our research, 92% of employees are contributing to their plan but almost a quarter aren’t contributing enough to get the full match from their employer. At the very least, make sure you’re contributing enough to not leaving any of this free money on the table.

Contribution rate escalator. If you can’t afford to save enough to hit your goal, try slowly increasing your contributions by one percentage point each year. This tends to be less than cost of living adjustments so people generally don’t even notice the difference in their paychecks, but after just a few years, they may be saving more than they ever thought they could. A contribution rate escalator can do this for you automatically.

Roth contributions. Unlike pre-tax contributions, you get no tax benefit now, but Roth contributions can grow to be tax-free after 5 years and age 59 ½. This is especially useful if you’re worried about paying higher tax rates in retirement or if you’re planning to retire early since tax-free Roth distributions won’t count against you in calculating the subsidies you would be eligible for if you purchase health insurance through the Affordable Care Act (assuming the subsides are still in place) before becoming eligible for Medicare at age 65. Roth contributions are also more valuable if you max out your contributions since $18k tax-free is more valuable than $18k that’s taxable. (Yes, you could technically invest the tax savings from making pre-tax contributions, but then you’d still have to pay a tax on those earnings too.)

After-tax contributions. If you max out your normal pre-tax and/or Roth contributions, you may be able to make additional after-tax contributions. These aren’t as advantageous since the money goes in after-tax and the earnings are taxed at distribution, but you can convert them into a Roth account to grow tax-free, either while you’re still at your job if the plan allows it or by rolling it into a Roth IRA after you leave. You can also generally withdraw after-tax money while still working at your job (subject to taxes and a 10% penalty on earnings before age 59 1/2).

Asset allocation funds. To simplify your investing, retirement plans will often provide you with fully-diversified asset allocation funds that can be a one-stop shop. Some, called target date funds, even automatically become more conservative as you get closer to the target date so you can simply “set it and forget it.”

Online retirement and investing advice. Some plans provide access to a free online retirement planning and investment tool that can tell you whether you’re on track for retirement and make specific investment recommendations based on your particular risk tolerance and time frame, typically using the lowest cost funds in your plan.

Brokerage window. If you’re looking for an investment not otherwise available in your plan, see if you have a brokerage option that will give you access to thousands of other funds and in some cases, even individual stocks.

Employer stock. While you don’t want to put too much in any one stock (no more than 10-15% of your overall), especially your employer’s, there can be a tax benefit for doing so when you eventually cash out the account. If you transfer the employer stock directly to a brokerage firm in-kind, you can pay a lower capital gains tax on the growth instead of the higher ordinary income tax rate that you would normally owe on distributions.

Retirement plan loans. If you need a loan, borrowing from your retirement plan doesn’t require a credit check and the interest goes back into your own account. However, you miss out on any earnings that money would have received and if you leave your employer, you may owe taxes plus possibly a 10% penalty (if you’re under age 59 ½) on any outstanding balance after 60 days. (Some plans do allow you to continue making loan payments though.) Also, be aware that retirement plan loans are paid back from your paycheck so there’s no possibility of default and you can’t discharge them through bankruptcy.

Financial wellness. Some plans offer free, unbiased financial wellness coaching to help you plan, save and invest for your retirement. This is an important benefit since it can help you take advantage of all the others.

Which of those benefits are you not taking advantage of? See which ones are offered by your plan and start utilizing them. Your future self will thank you.

 

 

 

Why I’m Making Pre-Tax 401(k) Contributions

December 22, 2016

Last week, I wrote about how I’m investing in our company’s new 401(k) plan. That wasn’t the only decision I had to make though. Another choice was between making traditional pre-tax versus Roth contributions. Here are three reasons why I chose the former:

I expect my tax rate to be lower in retirement. The choice is basically between paying taxes now versus later. I’m currently in the 28% federal income tax bracket and the 6.65% NY state income tax bracket for a total marginal tax rate of 34.65%.

When I retire, my tax brackets are likely to be lower and I may end up living in a state with a lower state tax rate or even no state income tax at all. This is partly because I’ll need less income in retirement (especially since I won’t be saving for retirement anymore) and also because some of my retirement income will be coming from a tax-free Roth IRA. If I do end up being fortunate enough to retire in a higher tax bracket, I won’t mind paying the higher tax rate on my 401(k) as much since those additional dollars will be less valuable to me at that point.

I’d rather invest the tax savings outside my 401(k). With the pre-tax contributions, I get that 34.65% that would normally go to Uncle Sam if I made after-tax Roth contributions. I can then invest those tax savings in practically anything I want. Yes, I’ll have to pay taxes on the investment earnings, but I estimate that my higher expected returns in those outside investments will outweigh the taxes.

I can convert to a Roth later. One thing I love is keeping my options open. When I eventually leave the company, I can convert my 401(k) into a Roth IRA. (I’ll have to pay taxes on anything I convert so hopefully my tax bracket will be lower in at least that year.) However, if I choose the Roth option, there’s no way to go back and recover the benefit of lower taxable income.

Does this mean everyone should make pre-tax contributions? Absolutely not. If you expect your tax rate will be higher in retirement or if you’re maxing out your contributions and want to shield as much of it from taxes as possible, the Roth option would probably make more sense. As always, the best choice depends on your particular situation. Just remember that either choice is better than not contributing at all (or delaying due to analysis paralysis).

 

 

Should You Contribute Pre-tax or Roth?

September 15, 2016

That’s one of the most common questions we get. For example, I recently received the following email: (My response follows.)

I am a 26 year old in my fourth year as a police officer. I’ve been contributing to my employers 401a and deferred comp programs for about 3 years. My contributions have been Roth and after reading your article, I’m wondering if that’s the best option for me. I have a part time job at the local mall that matches 5% of pre tax contribution and I max out there as well. I don’t plan on using the money until retirement, so should I switch my main employer to pre tax as well? This year I’ll make around 60-70k, but next year I’ll probably make around 80k. My goal is to save near a million dollars for retirement and I’m not quite sure how to figure my retirement income. Can you guide me in the right direction?

First of all, great job on contributing to all those retirement accounts at such a young age! The earlier you can save for retirement, the longer that money will be working for you. This will definitely put you in a much better position for retirement.

The basic decision is whether you’d rather pay taxes on your savings now (Roth) or when you take them out of your retirement account (pre-tax). Assuming you’re single, you would currently be in the 25% tax bracket so every dollar you put in those retirement accounts pre-tax is avoiding a 25% tax rate. If you retire with a million dollars, you could safely withdraw about 4% or $40k a year. In addition to the $28k of Social Security benefits you’re projected to receive at your normal retirement age of 67, your $68k of total retirement income would put you in the same 25% tax bracket at retirement.

Not all your retirement income would be taxed at 25% though. Based on your total retirement income, only 85% or about $24k of your Social Security benefits would be taxable. At least about $10k of your income wouldn’t be taxed because of the personal exemption and standard deduction so your taxable income would be no more than about $54k. Using today’s tax rates (which are adjusted for inflation), the first $9,275 of taxable income would be taxed at 10%, the next $28,374 would be taxed at 15%, and only the last $16,351 would be taxed at that 25% rate. As a result, your average or effective tax rate in retirement would actually be about 17%.

Of course, this assumes that you don’t have a lot of deductions like mortgage interest that would go away by the time you retire. It also assumes that the tax code stays the same. If your effective tax rate ends up being higher in retirement, you would be better off with a Roth account.

Confused? One simple solution would be to diversify by contributing pre-tax to your employer’s retirement accounts as well as to a Roth IRA. That’s because the Roth IRA has the additional benefit of the contributions being available anytime without tax or penalty. It may also be helpful to have some tax-free money in retirement to qualify for higher health insurance subsidies if you decide to retire before you’re eligible for Medicare at age 65.

Don’t overthink it though. Whichever option (or combination of options) you choose, the most important thing is that you’re contributing for retirement. The less optimal option is still much better than not saving at all.

 

 

 

In Defense of the Traditional 401(k)

August 14, 2014

Should you make pre-tax or Roth 401(k) contributions? I recently read this article by Penelope Wang called “The Great Retirement Account You’re Not Using” that argues for Roth contributions. However,  I still think pre-tax contributions make more sense for most people. Here is my response to each of her main arguments: Continue reading “In Defense of the Traditional 401(k)”

Does the 401(k) “Suck?”

May 09, 2013

A friend of mine recently sent me an article titled “It’s a 401(k) World and It Sucks.” I realize that the 401(k) is not perfect (but what is?) and the author does make some good points. But that being said, “sucks” is a pretty strong word about the vehicle that has encouraged more retirement saving than anything else, especially considering how much we need to increase those retirement savings. Let’s take a look at each of the author’s main arguments: Continue reading “Does the 401(k) “Suck?””