The 401(k) retirement plan turns 44 this year. Don’t break out the champagne too soon, there are still a lot of problems with this popular retirement savings plan. The 401(k) has grown a bit over the years and refinements made. However, even with the changes, it still roughly helps only about the top fifth of income earners according to Time.com, as of 2018. Originally, the 401(k) plan was meant to have a negligible impact on workers and was targeted at executives only. For all its complexity and problems, it still remains the most popular way to save for retirement; and for many, the only way to save. I am going to point out a few disadvantages around this plan and a general recommendation for younger workers on how they might avoid such problems. Prepare yourself for some nerdiness.
The big draw of the 401(k) plan has been that it reduces your taxable income. That’s true as long as you are making pre-tax contributions (which most people do). That buy now, pay later theme resonates with most Americans more deeply than we imagine. We all like the idea of not paying taxes to Uncle Sam while we are working. Sounds great, right? Not so fast. It may not be your best approach.
For starters, when you retire and/or become of an eligible distribution age (there’s more than one age actually), you’ll pay ordinary tax (but not Social Security or Medicare) on your total distribution. Think about that for a second…your total distribution. That distribution of course includes the portion you voluntarily put aside and escaped taxation on while working. Which makes sense. However, it also includes any dividends and of course (we hope) investment growth! Generally speaking, had you made post-tax investments in a taxable brokerage account, that growth would be taxed at preferential long-term capital gain rates, and your dividends could be qualified dividends. Not so with 401(k) distributions. That is, your distribution isn’t parsed for contribution, dividends by type (if any), and growth.
The traditional rebuttal has been that one would be in a much lower taxable income bracket in retirement. That may no longer be the case once you consider your other income streams such as Social Security, any required minimum distribution (RMD) you have from other plans, pensions, rental income, and if you were a diligent saver and your 401(k) account has grown for decades. You see where this is going? Also, don’t forget that with a 401(k) you will at one point have a RMDs to contend with as well. If your account has performed well, not only are you paying ordinary income tax on your total distribution, it could add enough income for the year that your Social Security is now taxable!
A couple of other downers with regard to the 401(k): spouse inheritance, and Congress. It’s great if you leave your spouse a nice, fat 401(k) balance if you die. They’ll have money to live on. But consider this, you are going from a more preferential married filing jointly (lower), to ultimately filing single (higher) tax status for the surviving spouse. Thus, over time more of your hard-earned nest egg is taxed. Then there’s Congress always trying to find ways to tax more. There’s no guarantee that we won’t see some form of new tax or reversion to higher tax rates in the future. This is mostly out of your control. Already the current tax rates and income brackets for personal federal income are scheduled to sunset in 2025 thanks to the Tax Cuts and Jobs Act, 2017. Yes, the TCJA did temporarily reduce the tax rates, and expand the applicable income brackets. It is highly unlikely this will remain for individuals even though the TCJA made the corporate rate permanent.
Does this mean I am advocating to dump the 401(k) plan? Am I anti-401(k)? Absolutely, not. For the majority of Americans, the 401(k) is their only option to save for retirement given that companies have nearly eliminated pensions. I do think there are planning opportunities available, especially for the under age 50 crowd. Mentioned in the opening paragraph was that plan enhancement has occurred over the years. One such enhancement is the ability for participants to contribute to both pre-tax and Roth accounts in their plan. Just a quick reminder, pre-tax means tax-deferred and paid later, and Roth means you are making a post-tax contribution. Currently, this post-tax contribution has the advantage of growing so that future earnings and growth are tax-free!
Right now, given the current federal tax rates, and that new legislation is circulating in Washington, D.C., that may limit, or prohibit middle- and higher-income earners from accessing a strategy known as the backdoor Roth IRA ($6,000 or $7,000 age 50+), it’s a good time to look at utilizing the Roth side of your 401(k). Especially if you are young. If you are one of the lucky folks who can max out their 401(k) annually, you could potentially be adding $20,500 per year in Roth savings for retirement. All which grows and can be withdrawn tax free in retirement and will not count as income with regard to Social Security and Medicare. This amount far exceeds the $6,000 backdoor Roth amount. Even if you split your 401(k) contribution to hedge your bet by putting $10,250 in pre-tax and $10,250 in the Roth side of you plan, you are still ahead. Vanguard found that only 12% of participants in 2019 hit their maximum annual contribution ($20,500 or $27,500 age 50+ for 2022). The downside? You guessed it, paying tax now. But remember, we are in a lower tax rate environment. For example, if you are married and earning $175,000 you are in the 22% federal tax rate. Previously, this was 28% and if the TCJA provisions do sunset, it’s anyone’s guess as to which rate Congress will go with. We’re actually in somewhat of a pay now, save now situation.
Most participants are not maxing out their annual contribution. Furthermore, unless they are in the lower income range of their federal tax bracket, they are also not contributing enough to drop themselves into that next lower tax bracket. The upshot is, if you are young putting more in Roth now and paying the current tax rates likely far outweighs any future tax advantage of simply deferring your tax. Taxes only seem to get more complicated and only seem to increase. Pay now while rates are lower and don’t let the tax-tail wag your life plan.
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