30 sec brief
One of the mainstays of employer benefits packages, the 401(k) and its cousin, the 403(b), are this generation of employees’ retirement workhorses. Updated by Congress under the Pension Protection Act of 2006 (“PPA”), employers can opt you into the plan, initiate automatic deposits from your payroll and even increase the percentage over time, all in…
One of the mainstays of employer benefits packages, the 401(k) and its cousin, the 403(b), are this generation of employees’ retirement workhorses. Updated by Congress under the Pension Protection Act of 2006 (“PPA”), employers can opt you into the plan, initiate automatic deposits from your payroll and even increase the percentage over time, all in your best interest.
Before becoming alarmed, you can always opt out. However, before rushing to do so consider “out of sight, out of mind” is a very powerful behavioral tool. Used appropriately, employees can accumulate large, sometimes very large, balances over the course of a career, feeling nearly effortless along the way. Acknowledging this, the PPA created new guardrails to help protect both employees and employers, boosting this retirement program.
How much should you contribute?
Many employers, and most large ones, offer employee contribution matching, essentially “free” money to the employee. All employees have to do is contribute some of their own. Many programs offer what’s known as a “dollar for dollar” match up to some maximum, meaning for every $1 an employee contributes, an employer will deposit the same.
Good financial planning suggests employees should contribute at least up to the maximum match. For example, if an employer offers a dollar for dollar match up to 3% of your salary, and you make $80,000 per year, your employer will deposit up to $2,400 into your 401(k) alongside your corresponding contributions.
Rarely is money free, but in this case it is, provided you invest your own dollars as well. You should do this up to your maximum match level if your financial situation allows.
Sometimes these amounts have vesting schedules, meaning if you terminate employment your employer can remove the unvested portion of their deposits in your account. Employers do this to encourage you to stay with them. Other employers have a “Safe Harbor” plan where they automatically deposit a percentage into your account without any contributions from employees.
Contribute Beyond Your Employer Match?
After maximizing your “free” money – courtesy of your employer match contribution or Safe Harbor plan – now you have another decision: Should you contribute beyond the maximum match level, potentially up annual contribution limit ($18,500 for 2018)? Or should you direct the next dollars elsewhere?
The answer depends on a number of variables, some of which only you can answer. However, many financial planners encourage clients to consider making the next pre-tax contributions to their Health Savings Account (HSA).
The reasons are as follows:
- Tax-free vs. Tax-deferral. While you really can’t do better than “free” money, the next best is “tax-free.” Keep in mind the 401(k)/403(b) simply delays your tax bill, but does not actually eliminate it. HSA contributions, on the other hand, are tax-free, provided you use the funds for medical expenses.
- Payroll tax. HSA deposits are pre-payroll tax, meaning there is another 7.65% savings for both you and your employer (15.3% total) for your contributions. Retirement savings programs are pre-income tax, but not pre-payroll tax. To compare, a $3,000 contribution to your HSA could save you another $229.50 in payroll taxes, an amount you would otherwise pay were you to deposit into your 401(k).
- Medical inflation. Unfortunately health care costs continue to escalate, both near term and long term, retirement-related out of pocket projections. Traditionally the recommended savings approach for long-term goals is through participation in the stock market, as the returns over time generally outpace inflation. HSAs with brokerage features allow savers to harness higher returns from the market.
Consider the HSA as a medical 401(k). With out-of-pocket health care costs taking up to 1/3 of social security payments, according to a recent study, planning for this portion of your future cash outlays can be wise.
Investment Alternatives beyond the HSA
IRA. In addition to HSA options, savers could also look to investing in an Individual Retirement Arrangement (IRA) as an alternative to investing in their employer’s 401(k). While contribution limits are significantly lower ($5,500 in 2018), you may want the flexibility of choosing your own provider and potentially lower fees options.
Roth IRA. Similar to an IRA, a Roth IRA allows savers to deposit after-tax dollars in exchange for tax-free withdrawals. This is particularly useful for wage earners who are in lower income tax brackets today and expect to be in higher income tax brackets at retirement. Note not all taxpayers may be eligible, as Roth contribution requirements include maximum income limits over which taxpayers may not contribute. For 2018 those income phase-out limits start at $120,000 (single) and $189,000 (married filing jointly).
Non-tax deferred brokerage. Beyond the tax deferred savings programs, savers could also consider a traditional brokerage account for their long-term goals. One of the disadvantages to the retirement savings programs (Roth exception) is withdrawals are taxed at ordinary income rates, regardless of type of gain inside the account (dividends, long term capital gains, etc.). In practice this means account growth largely due to stock price appreciation would turn what would be 15% or perhaps 20% long term capital gains rates to income rates of 28, 33% or even 39.6%, so double what the tax payer might have otherwise paid.
As an alternative, many funds and ETFs are very tax efficient and create minimal taxes for their owners who follow and “buy and hold” investment strategy. When the owners do eventually sell most, if not nearly all of the gains, would be characterized as long-term capital gains. For some investors this could cut their tax bill by 50% or more.
Nothing Wrong With Maximizing Your 401(k) beyond the Match
The downside to each of those other alternatives is they require an additional step, often more. One of the most powerful features of the 401(k) is the ease of use – set it and forget it (for decades). Contributing to your employer’s retirement program can be the single most important long-term financial decision for many. So while other programs offer flexibility, few offer the convenience of establishing and reviewing once a year.
About the author
CFP®, EA About Aaron Benway. Aaron is a Certified Financial Planner (CFP) and IRS Enrolled Agent (EA). He co-founded HSA Coach, a digital tool to educate consumers on HSAs, track health expenses and other documents, and provide individual financial calculators, to help consumers get the most from their HSA and other savings. To help individuals directly with their financial planning and wealth management requirements he founded AB Financial Planning. Prior to co-founding HSA Coach, Aaron was the CFO of ventured backed fintech startup HelloWallet, acquired by Morningstar. Aaron has an MBA from Harvard Business School and is a graduate of the US Naval Academy.