If your employer matches your 401(k) contributions, you have likely heard that your best move is to contribute up to the level your company is willing to match. Most workers follow this mantra, and for good reason. A 50 cents on the dollar match essentially gives you a 50 percent return on the first year of contributions, assuming no growth in your investments. A dollar for dollar match means you double your money in year one.
OK, so that part is easy. But what happens once you’ve reached the employer match limit? Should you contribute to your IRA or Roth IRA, or put money into an emergency fund? Should you contribute to a taxable brokerage account, or should you just keep plowing the money into your 401(k) plan up to the 2019 dollar amount limit ($19,000 if you are under 50 years old)?
The advisable path will depend on your life stage, your liquid savings and the 401(k) plan to which you have access. Let’s look at four different hypothetical examples with four different recommended paths.
Bill, 45, IT programmer:
The situation: Bill is 45 years old and works for a large company as an IT programmer. His 401(k) matches him 50 cents on the dollar up to 6 percent. Bill’s wife is a psychologist and they earn a combined taxable income of $245,000. Because they are high earners, they won’t qualify to deduct an IRA contribution. They feel they will be in a lower tax bracket in the future, especially when Bill’s wife slows down her practice. His wife doesn’t have a retirement plan at her job. Bill has contributed 6 percent to his plan for years, but recently got a large raise, allowing him to now save an additional $6,000 per year. Should he increase his contribution, or put the extra money in his taxable brokerage account in mutual funds?
The recommended path: In this case, Bill, who has a solid emergency account set aside, should contribute his additional savings to his 401(k) on a pre-tax basis in order to maximize tax savings, while he and his wife are in the 32 percent federal tax bracket.
Nancy, 40, warehouse supervisor
The situation: Nancy is 40 years old and works for a small company as a warehouse supervisor, earning $72,000 per year. Her company’s retirement plan makes a dollar for dollar match up to 4 percent. Her plan only has five investment options, and is very expensive for a 401(k), charging over 1.5 percent in fees without access to much advice or guidance. Nancy also has a Roth IRA and taxable brokerage account she holds through a local financial advisor. Nancy doesn’t plan to retire for over 20 years. Should Nancy contribute to her 401(k) beyond the match?
The recommended path: From a tax standpoint it would be tough to determine if an after tax Roth IRA or pre- tax 401(k) contribution would net Nancy more in retirement. Therefore, she should focus on balancing the tax status of her retirement resources. Because her 401(k) is expensive and not a great value when compared to her IRA she uses with her advisor, she would be better off getting a wider range of investment options in the Roth IRA (assuming her advisor has those options available), and simply using her 401(k) for the match only.
Jim, 57, Executive Director
The situation: Jim works for a large company that matches his contributions 50 cents on the dollar up to 6 percent. He recently received a $40,000 per year raise, and wants to play catch up to be able to retire in five years at 62. He also has an IRA and some CDs at his local bank. He has calculated that he needs another $200,000 to retire comfortably. His 401(k) plan allows for after tax contributions, as well as Roth Conversions. How should Jim set aside the money he wants to save in a tax advantage manner in order to retire in five years?
The recommended path: One of the attractive strategies in plans that allow for “after tax” contributions and Roth Conversions is the ability to contribute pre-tax up to the limit imposed by the IRS, which is $24,000 for an over-50 participant in 2015. Jim could then contribute on an “after tax” basis up to a total limit of $59,000 between the company match, his pre-tax contribution and his “after tax” contribution. He could then convert the after tax contributions to Roth, so that all future growth will accumulate tax free.
Jane, 25, Account Manager
The situation: Jane is single, renting an apartment, and would like to own a home in the next five years. Her company offers a match up to 3 percent of her income, which is $36,000. She has less than $2,000 in her savings account, with her 401(k) being her largest asset. She feels she could contribute up to 10 percent, but should she?
The recommended path: As increasing her 401(k) contributions beyond the 3 percent match might put her in a cash poor position, Jane should focus the extra 7 percent on building an emergency fund or investing conservatively in a liquid brokerage account, until she has built sufficient savings to meet her intermediate needs. An unforeseen emergency or a down payment on a home might result in a 401(k) loan, which is always a risky proposition. For instance, a job change with an outstanding loan could result in penalties and taxes, which would put her behind the eight ball in her financial planning.
Do you know the best path for you as you set your financial and retirement targets? Customized financial planning to reach your goals is Legacy’s specialty. Contact us to schedule a complimentary consultation today. We’d love to help you reach your goals.