Let’s face it, for most people, the first half of 2022 has not been the best from a financial perspective. Inflation has been around 8% for some time, with little signs of slowing down so far, empty shelves are becoming the norm, and your savings may have taken a nosedive! What can you do?
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Understanding the breakdown of your pay stub will help you better understand your tax withholding and optimize your savings. So here is a breakdown of the major items in your paystub, from your gross pay to your take home income. Everyone is different, so little differences may apply to you.
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A common piece of advice is to start saving for retirement early and do it through your employer plan, like a 401(k) plan or similar. Employer-sponsored plans are tax-advantaged and the employer typically matches at least a portion of your contribution. The common advice is great advice if you work for a company that offers such a plan. But what if you are self-employed or work for a company that does not offer a retirement plan? What can you do then?
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Open enrollment affects several areas of your overall financial plan, including health care costs and benefits, life and disability insurance, retirement planning, tax planning, and more. So why only devote a few minutes right before the deadline to it? It’s worth doing some homework, using the suggestions we provide below as a start. We think these decisions are so important that we created an open enrollment service.
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One of the hardest questions for anyone planning for retirement is to translate what their savings plans mean for their ability to replace income in retirement. You have money in your 401(k), IRAs, and taxable accounts. But what does all that mean in terms of the retirement income that you can expect it to deliver when you retire? Are you contributing enough for the retirement you want? Will you have enough by your desired retirement age? Or when will you accumulate enough to sustain your needs in retirement?
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A big concern for people seriously thinking about retirement is whether they are on track for the retirement they want. The question is particularly relevant today as finance gurus talk about a possible new normal, with low interest rates potentially indicating low future returns. Consider this situation: You set a goal, estimate your annual savings towards retirement, and have a target year in mind. You use a retirement calculator and find that at the current rate of savings, you fall short of your goal. What do you do?
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More and more plans offer the ability to make Roth and after-tax contributions. But what are these options and when does it make sense to use them?
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A key goal when you retire is to generate a steady level of spending and not run out of money too soon. For many, the retirement spending strategy involves a combination of social security, taxable accounts (T), tax-deferred accounts (TD) like 401(k)s or IRAs, and tax-exempt accounts (TE) like Roth accounts. Because of the different taxability across accounts, how you withdraw from them can make an important difference to the level and longevity of your retirement spending. Research shows large differences in ending account balances or expected number of sustainable years across different strategies.
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Having a strategy to optimize our current resources is crucial to successful retirement outcomes. When it comes to choosing savings accounts, there are many options available, including 401(k), IRA, Roth accounts, and HSA. But how do you choose among them? Read more to find how. Review their key features and how to combine them to improve your retirement plan.
All information in this post is provided for illustrative and educational purposes only and should not be considered tax or investment advice, or a recommendation to buy or sell any type of securities.
There are a number of accounts designed to help you grow your retirement savings. Some are offered through your employer, and others you can open on your own. There are at least two versions for each type, giving you at least four options. Then you have Health Savings Accounts. Yes, a health account can be used for retirement purposes. If you are lucky, you may have a pension plan or a cash benefit plan. Making the best allocation decisions can have a big impact on the growth of your nest egg. Consider that your retirement horizon is long and it includes all your retirement years. So, how do we navigate through this maze and which type of account should we consider?
Let’s start with your employer retirement plan. This is the so called 401(k) plan, or 403(b) for non-profit employers. Why start from this plan? Contributing to the 401(k) is always a good idea because it is tax advantaged. You put money in the account before it gets taxed. This lowers your tax bill this year. After that, your money grows tax free. When you take the money out, the entire amount is taxed as ordinary income. The ability to defer taxes until after you retire helps you grow a larger nest egg.
Tax-Free Contributions ⟶ Taxable Withdrawals (tax deferral)
In addition, many companies offer a “match” for part of the money you contribute to these accounts. A typical scheme is for the employer to match 50% of your contribution until you contribute 6% of your salary. That means the employer will contribute up to 3% of your salary. If you make $50,000 a year and contribute $3,000 (6%), your employer contributes $1,500, under this scheme. So your total contribution (employee + employer) will be 9%, or $4,500 in this example. Some companies may have a greater match, and others may contribute even if you don’t put anything in it.
Unless you have a particular situation and cannot afford it, contributing up the match amount is a no brainer. If you leave your company, you can take the money with you. You can keep the same account, roll the money over to your new employer’s 401(k) plan, or to an IRA, which we discuss below. The money your employer contributes may be yours or not. It depends on the so called vesting schedule. In some companies, employer contributions vest right away, so they are yours to keep. At other companies, vesting can occur over a number of years. Check your employer vesting schedule to find out. There is a 10% penalty (in addition to income taxes) for withdrawing your money before you reach the age of 59 and ½. So it’s never a good idea to simply cash out your 401(k) money.
For some people, saving in their 401(k) account is all they need. Estimate your monthly expenses in retirement (subject of a forthcoming blog), then use a calculator like this to figure out how much you need to save. There is a limit on how much of your salary you can contribute every year. For 2019, the limit is $19,000, plus an additional $6,000 if you are 50 years of age or older, called the catch-up contribution.
If your are enrolled in a high deductible health plan, you may be eligible to contribute to an HSA account. Why do I include the HSA as part of retirement savings? Because the tax advantage of the HSA can be better than any of the other retirement accounts. Contributions to HSA are tax exempt. Like 401(k) contributions, they help you reduce taxable income. But there is more. While you pay Social Security and Medicare taxes on your 401(k) contributions, HSA contributions are exempt from those, so the tax advantage is greater for HSA contributions.
What happens when you retire? You can withdraw from your HSA savings tax-free to pay for approved health care expenses, including Medicare part B, supplemental health, and long term insurance premiums. Health care expenses can be relatively large in retirement, so having a tax-free source to draw from is great. If not used for health care, your withdrawals are taxed as ordinary income.
For households with enough income and saving capacity, contributing the maximum amount to an HSA plan is generally good practice. Increasing your HSA contribution is also a good year-end tax planning tip to lower your taxable income. Access to an HSA plan is a good reason to choose a high deductible plan over other options with lower deductibles. Plus, many companies contribute to employee HSA accounts. The key in these accounts is to have your HSA savings invested, so check the investment options of your provider.
If you don’t have a 401(k) account or an HSA, you still have options to help you save for retirement. The IRA is one such option. Everyone with earned income can contribute to a traditional IRA. So you can start contributing to an IRA when you are a student and working half time. It’s never too early to start thinking about retirement. If you don’t have earned income but your spouse does and you are filing jointly, you can contribute to a spousal IRA.
Your contributions are fully tax deductible if you and your spouse are not active participants in a qualified plan, like the 401(k). If you are an active participant and income is below certain thresholds, you may be able to deduct part of your contribution. When you retire, any withdrawals above your after-tax contributions are taxed as ordinary income. If you only made tax deductible contributions, your entire withdrawal amount is taxed. There is a penalty of 10% for early withdrawals (before 59 and ½ of age) from IRA accounts. The penalty can be waived in some cases (to pay for certain education expenses, first time home purchase, some medical expenses, and other cases).
You can contribute up to the smaller of either the earned income, or the annual contribution limit, which is $6,000 for 2019 and 2020, with an additional $1,000 for people who are 50 years or older.
There are Roth counterparts to the traditional 401(k) and the traditional IRA. In a Roth account (from the last name of the guy who came up with these accounts) the taxation works differently. Your contributions to a Roth are part of your taxable income. Once you are taxed on the contributions, you are done. You don’t have to pay taxes again on anything you withdraw from the account in retirement.
Taxable Contributions ⟶ Tax-Free Withdrawals in Retirement
Roth 401(k) are newer and not all companies offer them. So you need to check with your company if your plan offers these accounts. Whether you can contribute to a Roth IRA depends on your income. For married filing jointly, the threshold is $193,000 for the maximum allowed contribution. The allowed contribution is then phased out between $193,000 and $203,000.
Any money you contribute directly to a Roth IRA can be taken out without any taxes or penalties. So if you need that money for a wedding or a new bike, you can withdraw it, in principle. Not suggesting you do that, but you could. The point is that the Roth IRA can act as an emergency fund. Penalties and taxes apply to the gains (with some exceptions as we saw for the IRA).
The same annual limits that apply to traditional 401(k) and IRA apply to the Roth counterparts. In addition, the limits apply to the sum of the contributions across the traditional and Roth account. For example, the $19,000 401(k) limit applies to the sum of the amounts contributed to a traditional 401(k) and Roth 401(k). Similarly for the $6,000 IRA limit.
The main difference is in when you are taxed: Now vs. later. So as a starting point, if your income tax bracket is low, you should contribute to a Roth type of account. Younger workers with steep income trajectories are likely candidates for Roth contributions to their 401(k) and/or IRA. Chances are that by the time they retire, their income brackets are higher than today’s. As your income rises, you may need tax deferred contributions to lower your current tax rate. Contributing to a tax deferred account is a good idea. You have both the HSA and the 401(k) for this purpose.
If you are a high earner, you may need additional savings for retirement. Exhaust your HSA capacity, then look to both the traditional and Roth IRAs. Having your nest egg spread across Roth and traditional accounts has benefits in retirement. For example, while traditional IRA withdrawals are considered taxable income and can affect the taxability of your Social Security benefit, Roth withdrawals do not. If you can’t contribute to a Roth IRA because your income is too high, you can contribute to a traditional IRA and then ‘convert’ that contribution to Roth by rolling it over to a Roth account (a so called Roth conversion). You may have to pay income tax on your conversion (if the contribution was deductible), but will benefit from having the Roth in retirement. If you have a variable income, make Roth contributions or conversions in years when your income is lower.
The bottom line is that while it is great to have options, planning your savings across multiple accounts is not simple. Here are the general principles we reviewed:
If you are a DIYer, do your homework on each of these options, and consider how they fit within your comprehensive financial plan. For most people that need to look outside of their company’s 401(k) for their retirement needs, the difference between making optimal choices and suboptimal ones can be big. Remember our $10 a day calculation? If you find this complicated, I suggest you talk to a trusted fee-only financial planner. Your nest egg and your retired self with thank you.
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
With open enrollment approaching, it’s a good time to think about retirement planning, and a great chance to practice taking the long view. Consider some simple numbers about the importance of the long term for retirement. Say you start saving $10 a day from the day you turn 22 until you retire at age 65. Assuming an average return of 7% per year, you will retire with an additional $904,384. Yes, who knows if you’ll get 7%, but historically that’s not outside the norm with a moderate portfolio of stocks and bonds (like a 60/40). In contrast, if you wait until age 30 to start saving the $10, you end up with $504,656, assuming the same 7% return. That’s almost $400,000 less. Imagine the freedom the $400,000 can give you. You can retire earlier or you can spend more on things that matter to you. That’s how valuable the long view is.
OK, you ask, who saves that consistently from their very first paycheck? Not many people, but we can draw a number of lessons from this example.
The first lesson is that small amounts over long periods of time can make a big difference. This means that when making decisions about retirement, it is important you do some homework, or ask an advisor to help you. Listening to the recommendations of your HR person or your colleagues may be a starting point, but make sure that advice works for your situation.
Don’t stress out if you can’t save as much as you would like. Starting out early is more important than how much you save, at least at first. Getting started, even with low contributions, can help you develop good habits. You’ll be able to find ways to save more as your compensation increases. If you are switching jobs, don’t cash out your savings, or you may lose the progress you made. Make sure to transfer your balance (through a roll-over) to your new plan, so you have all your savings in one place.
Read and understand your plan’s employer match. Many employers will match at least part of your contribution, up to some limit. Matching 50% of your contributions up to 6% of your salary is a common approach. With this arrangement, if you make $100,000 and contribute $4,000 (4%), the company contributes $2,000 (50% of your contribution). In this case, you’d be leaving $1,000 on the table, which can mean a lot over a long period of time. By increasing your contribution to $6,000, the company would increase its amount to $3,000, for a total contribution of $9,000. At this point you have reached the max company contribution. Maximizing your employer’s match should be your first goal. If you are having a hard time doing it, study your spending patterns to find ways to increase your contributions to that amount. If that’s not achievable, start by contributing any amount you are comfortable with, and automate that level of saving. Then make it a goal to increase your savings percentage over time.
You may have heard that in a good plan you should start with a goal. But if you are just starting out, it’s hard to know what your needs are going to be 30 or 40 years from now. So don’t worry about setting a goal today. Save as much as you reasonably can and follow the rules above. For more established households, one way to set a goal is to start with how much you make now, then subtract spending items you will not have when you retire, like saving for retirement, mortgage payments, etc. A simple rule of thumb is to take 80-90% of this amount as your starting income need in retirement. Social Security will cover some of this need. Covering the rest is the role of your savings. Use a calculator like this one to help you estimate how much income your savings may be able to support in retirement (full disclosure: I lead the development of this calculator in my prior career). You can change your savings, retirement date, or your goal to estimate what you need to be on track. Remember that you can contribute up to $19,000 for 2019, and $19,500 for 2020 (plus an additional $6,000 for 2019 or $6,500 for 2020 if you are 50 or older). If you believe you need to contribute more, it’s time to think about other sources besides the 401k plan.
Some 401k plans let you contribute to both a Roth and a traditional account. Roth contributions are after tax contributions, whereas traditional 401k contributions are pre-tax. Say you are in the 22% tax bracket. A $1,000 contribution to a traditional account is not taxable income. If instead you want to direct the same amount to a Roth, you’ll have a tax liability of $220, so your effective contribution will be $780. However, traditional 401k distributions in retirement are taxable income, whereas Roth distributions are tax free. Normally, you want to be taxed at the lowest possible rate during your lifetime. So, if you are in low tax brackets, Roth contributions make sense, because it’s unlikely your tax bracket will be even lower in retirement. As your income rises, directing some of the contributions to a traditional 401k can help you lower your marginal tax rate. So devote more to a traditional 401k as your tax bracket increases.
Because of the different tax treatment across saving accounts, including their effect on the taxability of social security benefits, it is useful to have multiple buckets to draw from in retirement. If you can’t contribute to a Roth 401k or a Roth IRA, consider converting part of your traditional IRA account into a Roth over time. Everyone with earned income can contribute to a traditional IRA, and if your spouse is covered by an employer plan, you can contribute even if you don’t have earned income. Your Health Savings Account, when properly considered within a plan, can be an excellent source of funds to pay for supplemental health or long-term care insurance in retirement.
Some 401k plans allow you to contribute after tax money to your 401k account, up to the annual total contribution limit for employer and employee combined. This can be a useful strategy for higher earners. Say you contribute $19,000, your employer contributes $5,000, so you have 24,000 in total contribution. For 2019 the total contribution limit (employer + employee) is $56,000. So you have $32,000 in potential contributions left. If your company plan lets you, you can contribute up to that amount after tax. The catch is that the earnings from these contributions are taxed as ordinary income (as opposed to long term cap gains). So, why would you do it? The answer is that you can roll over those after tax contributions to a Roth account over time, even if you can’t contribute to a Roth IRA directly (hence another name for this strategy is mega backdoor Roth).
It’s hard to say much about investment selection without knowing the options in your plan. But you should spend some time making the right elections, as mistakes here can derail your plan. Study your plan and the materials provided. What is the default option if you don’t make any investment election? Target date funds are becoming the option of choice, and the ones chosen by your company may be OK for you. But because these funds that are designed for average demographics, their risk characteristics may not work for you, particularly as you approach retirement. If you think you can build a portfolio from the line up of funds offered by the plan, make sure you take the right amount of risk for your goals, the stage of your career, and your risk preferences. Diversify broadly across global markets and, as always, choose low cost funds (you may find our guide here useful).
As you can see, making plan elections right for YOU requires some careful thinking. In our post we can give you some useful ideas, but seek expert help for best execution. The consequence of seemingly small mistakes, as our simple example illustrates, can be meaningful. Part of the value of hiring a trusted financial planner is that you can avoid costly mistakes while taking advantage of opportunities you may not know about.
At DESMO, we believe everyone should have access to a good plan, so we offer packages focused on getting you started with retirement planning, even if you aren’t ready for a comprehensive plan.
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
