Many 401k Participants Shouldn’t be Contributing
Most of us have known a distinguished, mature trusted family member who had our absolute best financial interest at heart. And this sage advisor likely offered the following advice about retirement planning: “Pay yourself first!” Good advice!
Conventional wisdom has long held that if a company offers a retirement plan, employees should contribute all they can to the plan from day one. This guidance was very sound advice at one time; but things change. In today’s tax code environment, the same advice delivered with the best of intentions can be misleading.
When we break down the “contribute as much as you can” advice, we start to see this approach presents strengths and weaknesses. First, the advice to “pay yourself first” is wise advice indeed. We all have a certain standard of living complete with the requisite expenses to maintain that standard. Trying to live off of wages first and then save whatever is left usually means little money is left over as we pay for “standards” such as subscription TV services, club memberships, etc. On the other hand, making savings a first priority means the “extra” dollars aren’t available to support “lifestyle” purchases. That’s the strength inherent in the “contribute all you can” advice. Save early and save often!
The problem with the advice doesn’t rest in the investment planning but rather the tax code and changes to the code. When 401k plans first originated they were all tax deferred plans. Roth IRAs and options that tax the money at the time of contribution did not exist. Additionally participants in company plans who had modest incomes were not eligible to contribute to an IRA. I taught my students at Purdue University that it’s the rare individual who understands both the “taxation” and “investing” sides of retirement planning.
I’ll use Pat and Deb as an example. Pat earned $16 an hour working at a small company in the Midwest and Deb stayed home with their three kids. Pat worked overtime and saved $9,000 a year in his company 401k plan. He showed up to discuss his investment allocations with his plan’s advisor. Pat knew his stuff! He understood market capitalization and how the international bond fund worked. I was impressed but also confused.
I knew where Pat worked and that his employer didn’t offer a Roth option. Sadly, most employer-sponsored plans still do not offer a Roth option. I asked Pat why he was contributing anything, let alone $9,000 a year to the company plan. Stunned, he looked at me and said he had to save for retirement. “Yes, Pat and you are doing a great job of saving, but you are deferring at a zero percent tax rate.” Pat then loudly and proudly proclaimed he paid taxes and that is when the light bulb came on. “Yes, you do pay taxes weekly, but you also get a big check back in April.”
A number of taxes are withheld on workers’ paychecks. These taxes may include state, local and Federal taxes as well as FICA for social security. When workers defer taxes with their employer contributions, they do not defer the social security portion; and for many families in Pat’s situation that is the majority of the tax they pay. Looking at his tax return we find $46,000 and change on line seven reporting earned income. He had no other income but was able to itemize. When it was all said and done, with credits and exemptions, his tax liability was zero. He had effectively deferred $9,000 at a zero percent tax rate in order to withdraw and pay taxes in the future. That’s a sad but true situation.
Many of my students at Purdue accepted jobs in the $30,000 range. Just like Pat, many of them will pay very little in federal tax when they begin working. The wise counselor’s advice to pay yourself first should be their plan of action. Employees should determine what they can save and then figure out the best place to save the funds from both an investment and tax perspective. If an employer matches a 401k plan contribution, employees should always accept free money up to the amount of the match, and then pray the employer will offer a Roth option in the future. Roth contributions will be taxed today and can be withdrawn later tax free when the account holder will likely be in a higher marginal tax bracket. Any money beyond the employer’s match belongs in a Roth IRA.
In Pat’s case there was no match. He should have put $5,500 in a Roth for himself and contributed $3,500 for his wife. The Roth option is the way to go for people in lower tax brackets. Alas, there is one other consideration – remember, things change! The Affordable Healthcare Act is income based and as such, there are times when tax deferral is inefficient for retirement purposes, but very important for securing insurance credits.
Every situation is different but we must consider both the investment and the tax implications of our decisions.
Joseph “Big Joe” Clark is a Certified Financial PlannerTM and the Managing Partner of the Financial Enhancement Group, LLC, an SEC registered Investment Advisor. He is the host of “Consider This” found on WQME Saturday mornings at 9am. Securities offered through World Equity Group, Inc., member FINRA/SIPC, a broker dealer and SEC registered Investment Advisor. Advisory Services can be provided by Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated and are not affiliated. Tax advice provided by CPAs affiliated with Financial Enhancement Group, LLC. Big Joe can be reached at email@example.com, or (765) 640-1524.