One of the easiest and probably most straightforward way to save for retirement and save on taxes is to contribute to your employer sponsored 401(k) or other similar plans (e.g. 403(b), 457 and thrift savings plans). I think almost everyone I know who has access to a 401(k) contributes something to it, but I’d like to argue that high income earners should ideally be maxing it out every year.
First, what is a 401(k) and similar plans? 401(k)’s and similar plans (e.g. 403(b), 457 and thrift savings plans) are retirement savings accounts offered by an employer that allows you to contribute money from your paycheck before it gets taxed through paycheck deductions. For simplicity I’m just going to refer to all employer sponsored plans as 401(k)’s (usually offered by the private sector) even though I actually have a 403(b) (usually offered by tax-exempt organizations). All these plans work more or less the same but there are definitely slight differences of each plan. Still most of the general principles offered here will most likely apply to these plans too. If you’re not sure, you can always do more research on your own.
Anyways, contributing to a 401(k)plan reduces your taxable income allowing you to save on taxes, at least for now. The money in the account gets to grow tax free or rather tax-deferred, because yup you probably guessed it, you will have to pay taxes on the money later when you start to take distributions from it. Hence 401(k)’s are often described as tax-deferred accounts. For 2016, the contribution limit by an employee is $18,000. The total contribution limit including employer match is $53,000. You can withdraw from your 401(k) penalty-free starting at age 59 1/2 but prior to then you’d have to pay federal and state income taxes and a 10% early withdrawal penalty.
Why high income earners should max out their 401(k)’s. There are two issues high income earners will most likely face when saving for retirement: (1) saving a sufficient amount and (2) saving tax-efficiently. If you make more money, you have to save more money for retirement to continue a similar standard of living. Additionally high income earners are taxed more, so being able to shelter their money from taxes should be a high priority. After all there’s a saying that goes “it’s not what you make, but what you keep that matters” and taxes play a huge role in what you end up keeping. If you make $150,000/year you should be ideally saving around $30,000/year (20% of your gross income). If $18,000 of that money isn’t going into your 401(k) (up to $24,000 if your age 50 and older), then you’re left with a limited amount of options for socking away your money tax-efficiently. You actually make too much to contribute to a Roth IRA, but you could do the backdoor Roth IRA. Still that only takes care of $5500 (for 2016, $6500 if your age 50 and older). After that you only pretty much have a taxable account left to grow your money and they don’t really offer much of a tax advantage, especially not better than a 401(k). Not only is all the money going to be after-tax money, but as it grows in a taxable account, the interest earnings and dividends will get taxed. You might get a slight tax break on long-term capital gains, but still tax, tax, tax! If you make at least $117,500, you should probably be maxing out your 401(k) every year.
Tax-savings overall: In my example above, if the person making $150,000 put $18,000 into their 401(k), they’d reduce their taxable income to $132,000. By reducing your taxable income from $150,000 to $132,000, you end up saving around $5000 in taxes today. If you pay state income taxes, you’ll save even more.
So you saved on taxes now, but what about later? You’ll have to cough up those taxes later right? Yes, but you’ll probably pay less in taxes later than you would now. Say whaaaat? While I certainly have no crystal ball to know whether the government will raise taxes significantly or even lower them in the future, it’s still very likely most of us will fall into a lower effective tax rate in retirement. If you think about it, you should have less overall expenses when you reach 65 years old, with no children to take care of (hopefully, I see kids now a days living with their parents even after they get married and have their own kids!) and little to no house payments, etc. (again hopefully you’re close to paying off your home by retirement). A reasonable estimate of how much you’ll need in retirement is about 75% to 85% of your current income. So assuming taxes remain about the same, you’ll pay less in taxes overall by contributing to a 401(k) plan now. Now, if you believe taxes will increase significantly in the future then this logic won’t hold true. But still, at least I’ll get a certain tax break now. If you believe taxes will go up significantly you should definitely be contributing to a Roth IRA front door or back. You may also want to consider a Roth conversion of your 401(k) if you end up with that opportunity.
Employer match is free money for you. Another major reason to contribute to a 401(k) is for the employer match if you get one and many companies do offer at least a small match. They say there’s no such thing as a free lunch, but when it comes to an employer match there is. It’s literally free money. I know people who’ll drive 10 miles out of their way to get cheaper gas or shop around to save $50 maybe, but they don’t contribute to their 401(k) to get hundreds to thousands of dollars free from their employer. If your employer offers any kind of a match, it is worth your money to at least contribute to your 401(k) to maximize the match. Since each employer matches differently, login to your HR website or call your 401(k) plan administrator to find out how to maximize your match. For example, in my plan, my employer matches a small percentage by my monthly contribution. If I reach the contribution limit of $18,000 too early by contributing too much per month, I’ll miss out on the match for the later months. Therefore, I have to adjust my 401(k) deductions to $1500/month or less ($18,000 ÷ 12 months) to ensure I get the full employer match. If I was taking out $1800/month, I’d reach the contribution limit in 10 months and miss out on 2 months of match.
Easier to save for retirement. Most people are bad savers, this includes high income earners. Don’t believe me google credit card debt and you’ll see spending up to and more than you have is not just an affliction the poor suffer from. Look at pro football players who spent all their millions of dollars and end up with nothing or remember TLC the popular R&B group from the 90’s who sold over 65 million records worldwide? They ended up filing for bankruptcy. The point is from a psychological standpoint, maxing out your 401(k) makes it easier for you to save. You never see the money because it’s taken out of your paycheck before you get it and prevents you from being able to spend it.
That’s not to say there aren’t some limitations or cons of investing in a 401(k).
Fees. Some 401(k)’s have exorbitant fees. Enough so that employees have actually sued their 401(k) providers. While extreme situations like this are probably rare, I definitely recommend taking a look at the fees you are being charged in your 401(k). Here’s a quick and dirty free fee calculator by CNNMoney. But maybe you are one of the lucky ones like me who has a low fee provider. My total expense ratio for my 403(b) fund is 0.52% and taking a scan at my 403(b) account statements, I don’t see any other fees I’m being charged. Generally the expense ratio(s) is the largest fee but there might be other fees such as plan administrative fees, operating fees, record keeping fees, purchase/redemption fees, etc. Try looking in depth at your retirement account statement or fund prospectus.
Limited investment options. Generally 401(k)’shave limited investment options. For the DIY investor who prefers to construct their own portfolio this is very frustrating. I tried to construct my own portfolio too to mimic my target date fund but with my specifications and hoped to lower the overall expense ratio which was already fairly low, but hey if I can get if lower, that’s better right? only to find that there wasn’t much else I could work with. There’s also been criticisms of target date funds which a large majority of 401(k)’s use such as they are associated with high fees, or not personalized enough for individual investor needs with a one size fits all approach. What if you’re 45 years old but you have a high risk tolerance and want to tilt your portfolio more towards international stocks and emerging markets? Or you’re 25 years old but are very risk averse and you don’t want to exposed to 90%+ stocks? Forcing you to be in your target date fund by age might push you into asset allocations that doesn’t meet your individual goals. Luckily you can mitigate some of that by choosing a target date fund outside your retirement date. Most target date funds are named by the date you’re expected to retire. For example, if you’re 30 years old currently in 2016 and you plan on retiring at age 65, the default fund for you would probably be target date fund 2050. But if you wanted to invest more conservatively, you could change your target date fund to 2045 or 2040 even, since generally these funds get more conservative as you approach the retirement date and visa versa.
Limited liquidity. Could be a con or a pro, but either way it’s pretty difficult to access the funds in your 401(k) before age 59.5. The government makes it this way to discourage you from pillaging your retirement nest egg, which is a good idea if you think about it. But if you really need to access the money you could take a loan out against your 401(k) or if you switch jobs and leave your employer, you can cash it out early, both of which are mostly bad ideas. With a taxable account or even a Roth IRA (your contributions only) you can access the money at any time without penalty.
You expect your income to increase significantly over your lifetime and/or expect you’ll retire in a higher income tax bracket than you are currently in. This is an excellent situation where if you have access to the newer Roth 401(k), you might be better off contributing at least some of your money to the Roth 401(k) over a traditional 401(k). With Roth 401(k)’s, like a Roth IRA, you pay taxes on the money upfront, but once you do, the money in the Roth 401(k) grows tax free and the distributions from it are tax-free when you reach age 59.5 and the account’s been open at least 5 years. If you don’t have access to a Roth 401(k), well then maxing out your 401(k) is still a good idea. A select few may want to consider their other options, including non-stock market investments (i.e. opening a business, real estate, private REITS). Along a more paranoid thought process, there’s also speculation that the government might renege on the promise of tax-free distributions from a Roth and instead decide to tax even Roth money. I’ve read an interesting argument that Roth IRA’s are a bad idea because the government is tricking you into paying taxes now so they can get your money now. All interesting fodder for discussion, but if we start going down these roads we’ll just ascend into anarchy. After all, nothing is certain in life or investments. The stock market can tank tomorrow, A+ rated life insurance companies and fortune 500 companies can go out of business and yes it’s always possible the government could renege on their Roth promise or the US government could cease to exist! Anything’s possible, so don’t stay up worrying about it, just do the best you can. Save 20%, invest regularly, diversify your investments and relax.