Once upon a time, a deposit to a traditional 401(k) gave you a powerful wealth building tool. Today, things are a little different.
First, let’s review all the good reasons to participate in the 401(k) when it’s offered at your work.
1.) FREE MONEY. Most, but not all. 401(k) plans offer matching money from your employer. (Check your company 401(k) Summary Plan Description for details on matching offered for you.)
Typically, 4 percent of your gross pay will be added to your 401(k) account by your employer if you save a specific amount of your own money. Sometimes you need to save 6 percent of your pay to receive 4 percent added, but that’s still at 66.67% return on day one. Pretty good.
2.) SYSTEMATIC SAVINGS. Your 401(k) deposits are made as part of payroll, so you make a deposit each pay period, before you have a chance to spend the money. Behavioral finance experts can quote tons of research illustrating how effective this technique is for accumulating savings.
And, during volatile times, these regular deposits mean that you will systematically buy shares during market UPS and during market DOWNS. This is call dollar cost averaging. It means that you will buy more cheap shares than expensive shares and, mathematically you will have a lower average cost of your shares than the average value of your shares. A great investment compounding technique.
3.) A BIGGER BUCKET. If you are trying to save more for retirement, and most Americans need to save more, a 401(k) can be very helpful because it gives you a bigger bucket. In 2020, the maximum deposit to a self-directed Individual Retirement Account (IRA) is $6,000. If you are older than 50 you have the option of adding $1,000 in catch-up for a total of $7,000.
The maximum employee deferral to a 401(k) plan in 2020 is $19,500 and, again, those older than 50 years of age can add $6,500 for a total of $26,000 per year. When you add the employer match, that’s often a few thousand dollars more.
One big benefit to a 401(k) has shrunken over the years. The tax-reduction benefit is mostly gone. In 1980, the first year that a 401(k) was available to a worker, a median-income married couple with two children other reasons to save into a 401(k):
• The marginal federal income tax rate was 43% in 1980. So, a traditional 401(k) deposit saved 43% tax.
• The likely retirement bracket tax rate was 15% in 1980. So, the saved money, and the growth on that money would likely be taxed 28% less.
• Today the typically family pays a marginal tax rate of 12%. So, the tax reduction today is much less.
• And, the typical retired couple today, pays a tax rate of about 12% so there is no reduction in the tax rate for money saved and for the growth.
So, what should you do. Generally, I recommend the following:
1.) If your 401(k) plan matches your savings, save enough to get all the match. Free money is free money.
2.) Since the tax savings, is no longer significant, MOST people should save into a ROTH 401(k) account. This account requires you to pay income tax on the money now, as part of your payroll deduction and then the account balance, and any growth, is TAX FREE when you spend it in retirement. For my retired clients, tax-free retirement savings is a great convenience. They usually hate paying income tax on retirement savings distributions.
Of course, every family is different, and it’s a really good idea to review your entire financial planning situation before your make big changes in the 401(k). I recommend you start by talking with a couple CERTIFIED FINANCIAL PLANNER™ professionals.
To find a CFP® professional near you, start your search here.
As you visit with financial planners, I suggest a couple things to check:
• Is the advisor always the client’s advocate – a fiduciary advisor?
• Is the advisor only paid by clients, not any financial product manufacturer or distribution network? That would be a fee-only advisor.
These two points help assure that you are working with a professional who is committed to your best interest at all times. It seems sort of obvious to me that a professional would work in this way, but it’s not automatic.
A fiduciary, fee-only, CFP® professional can help you make great retirement income choices and develop a comprehensive financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I only work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office at firstname.lastname@example.org. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.