The 401(k) is the first account in the Phippen Tax Accounts You Need Next series because it helps you save for retirement, provides tax advantages by either reducing your taxable income or allowing tax-free withdrawal in retirement, and may even give you a raise through an employer match. To refresh your memory about this account, here is why you need one:
The 401(k) is your biggest retirement account if you are employed by someone else, and it is still a powerful investment tool for the self-employed. If you are an employee with an employer that offers an employer match, a 401(k) provides you both tax advantages and free money.
As a warning, this is truly a deep dive. Focus on the information that pertains to your financial situation!
First, Help with These Letters and Numbers!
Throughout this article, I will refer to the 401(k), 403(b), 457, and TSP plans as “401(k)s” since 401(k)s are the most common. All these accounts share their tax-advantaged qualities, but their differences hinge on the type of employer offering the plan:
401(k): An employer-sponsored retirement plan offered by for-profit employers in the private sector. Self-employed individuals may also open a solo-401(k) to save for retirement.
403(b): An employer-sponsored retirement plan offered by nonprofits and public-sector employers.
457: An employer-sponsored retirement plan offered by state and local public-sector employers.
Thrift Savings Plan (TSP): An employer-sponsored retirement plan offered specifically for federal government employees.
Why a 401(k)?
A 401(k) is a tax-advantaged account to help employees save for retirement. Fewer jobs now offer pensions, and those that still offer pensions often offer lower pensions. As an alternative, employers offer 401(k)s to help employees fund their own retirement, often with some employer contributions to assist.
Some folks prefer the pension model because they view it as safer. Many pensions are safe and effective, assuming the employer offering the pension retains a financially stable business model well after your retirement. My parents have a terrific pension as former teachers in a state that highly values education. Other pensions can be risky if the future of the employer is in question.
Regardless of the risk, I personally prefer the 401(k) model over the pension model because it offers freedom in a particular area: retirement age. While some pensions offer tiered retirements where you get at least a bit of money after a certain number of years of service, few offer full retirement pay until regular retirement age. If you may want to retire, or even reduce your work hours significantly, in your 50s, 40s, 30s, or even 20s (hey, fellow FIRE folks!), the 401(k) model offers a greater potential to front-load your retirement investing so you can achieve financial freedom at a younger age.
Even if you do plan to work into your 60s, the 401(k) model frees you from staying at a company where you no longer have growth opportunities, no longer find yourself valued, or just no longer like your boss. Pensions can keep folks in toxic situations or underpaid jobs. Meanwhile, you can always transfer the funds in a 401(k) to another 401(k) or an IRA, so you are never stuck in a particular job.
Get a Raise!
While 401(k)s are typically offered to replace the pension model or offset a lower pension, having a 401(k) does not mean your employer is not funding your retirement. Many employers provide a 401(k) match. This means if you contribute to your 401(k), your employer will too!
Matches can vary in complexity. For example, my employer automatically contributes 4% of my salary to each employee’s 401(k) and then will match my contributions up to 3% of my salary. This means, the employer will contribute 7% of my salary as long as I contribute at least 3% of my salary.
Other more complicated matches that are common include an employer matching 50% of your contributions up to 10% of your salary. In short, that means if you contribute 10%, your employer will contribute 5% of your salary. If you contribute 4% of your salary, the employer will contribute 2% of your salary. Employers may also combine these methods. For example, an employer may 100% match your contribution up to 3% of your salary and then match 50% of your salary up to 10% of your salary. This means that the employer would contribute a maximum of 6.5% of your salary if you contribute 10%
If these percentages sound small, think again. If you make $50k a year with a 5% match, that is $2,500 in free extra dollars your employer will give you as long as you also contribute 5% of your salary to your 401(k). When you get to a six-figure salary, employer contributions can become huge. You also receive this money immediately, invest it, and let it experience compound interest. That $2,500 you contributed when you were 25? It will be worth approximately $80,000 due to compound interest if you invest the money and retire at age 60.*
Matches can be confusing, so here is the important takeaway: Matches are free money, so you should contribute whatever you have to in order to get the entire match your employer offers. Let me emphasize:
EMPLOYER MATCHES ARE FREE MONEY.
If you have not been contributing enough to receive the full employer match, increase your contributions to give yourself a raise today!
Traditional or Roth?
Some employers provide the opportunity to choose between either a traditional 401(k) or a Roth 401(k). If your mind has already been completely blown and you are just scrambling to contribute enough to get your full employer match, do not worry about the complexities: Just open a traditional 401(k). If you are looking to maximize every dollar and create a creative retirement plan, it may be worth weighing your options.
First, here is the difference between a traditional 401(k) and a Roth 401(k):
Traditional 401(k): You contribute pre-tax money, meaning taxes are not taken out of the money contributed to the 401(k). Your money grows tax-free until you withdraw it in retirement. Instead of paying taxes up front, taxes are finally collected when you take out the money to use it. At that point, the money will be taxed based on your income bracket when you are using the money, not the tax bracket you were in when you contributed it.
This has the added benefit of lowering your current taxable income. For example, if your salary is $100,000 in 2023, and you contribute the full $22,500 in 2023, your 2023 W-2 will say your salary is only $77,500, and you will owe fewer taxes.
Roth 401(k): You contribute post-tax money, meaning your contribution is taxed according to your current tax bracket. Your taxable salary remains the same. However, from the time of contribution, that money grows completely tax-free. You can also then use the money, both the contribution and the growth, completely tax-free in retirement because you already paid the required taxes back when you contributed the money.
The tax benefit here is on the back end. In a non-tax-advantaged brokerage account, you typically have to pay taxes on any growth. In a Roth 401(k), that growth can be withdrawn tax-free.
So what do you choose: traditional, Roth, or some combination of the two? That depends on a consideration of three variables:
Your income level now
Your anticipated income level at the time of withdrawal
Your beliefs regarding future tax brackets
Simply put, if you believe the income you are bringing in now will be higher than the income you will bring in during retirement (whether income from investments, a pension, passive income, a fun job, etc.), it makes more sense to contribute to a traditional 401(k) to lower your taxable income now. This means you will pay taxes on the money in the future when your income is lower, and you will be in a lower tax bracket.
If you believe the reverse, that the income you are bringing in now will be lower than the income you will bring in during retirement, it makes more sense to contribute to a Roth 401(k). That way, you pay the taxes now, let that money grow tax free, and let your future, wealthier self use it tax-free. Since you are in a lower tax bracket than you anticipate being in at the point of withdrawal, pay the taxes now.
The third variable is the complicating factor. The easy formula regarding whether your income is higher now or will be in the future works, assuming tax brackets stay the same.
Do you think tax brackets will remain constant over your entire life?
I personally contributed to a Roth 401(k) heavily over the past few years, despite being in a household with two salaries because I do not think tax brackets will remain the same by the time I retire. Why? While I think our income will be less in retirement than it was in 2022, I think taxes will be higher. The United States has relatively low tax brackets relative to other democratic republics and democracies, and I do not think the low-tax model is sustainable given the progression of social safety nets and programs folks are increasingly demanding. In my opinion, Americans’ taxes will go up over time.
Whether or not you agree or disagree with taxes going up to provide additional social services, you should plan for what you expect to happen. In short, while Patrick and I could happily exist in what was the 12% tax bracket in retirement, I anticipate that the current 12% bracket will be taxed at a much higher rate in 2052.
Contributing to a Roth 401(k) is also a more conservative option to make your money more predictable if you do not want to take a speculative economic deep dive. By contributing a lot of money to Roth accounts in my 20s and early 30s, I know I have an excellent foundation of money that I can withdraw completely tax-free in retirement. Much of that money will have time to double five times before I withdraw it, giving me a huge safety net someday 30+ years from now. Maybe the tax rates will be higher. Maybe they will be the same. But I will sleep better for those 30+ years since I knew my money would be there, tax-free, in my 60s and beyond.
Logistics: What You MUST Contribute and What You Can Contribute
The 401(k) has an annual employee contribution limit each year. In 2023, the limit is $22,500. This limit does not include any employer contributions, which vary based on each employer’s benefits package. Keep in mind that the $22,500 limit is an aggregate amount: If you change employers during the year and/or have both traditional and Roth accounts, you can only contribute a maximum of $22,500 total across all 401(k) accounts.
While there is no legal requirement to invest in your 401(k), from a financially responsible perspective, you absolutely must contribute enough to receive the full employer match offered to you. If you are not contributing enough to acquire the full match, you are turning down free money from your employer. If your employer will match 5% of your salary if you contribute 10%, contribute that 10% to make your salary go up by 5%!
Ideally, you should work to increase your 401(k) as quickly as possible until you maximize your contributions. At a minimum, get your free money with the full employer match.
Catch-Up Contributions
If you are age 50 or older, you are also eligible to contribute “catch-up” contributions, an additional $7,500. If you started saving for retirement later in life or realized salary increases later in your career, this is a great option to provide you an extra safety net in retirement.
Alternatively, if you enter your 50s with a solid financial position and enough money to start spending a bit more and saving a bit less, these catch-up contributions should not make you feel obligated to invest more. Do what feels right for your situation. These just provide another option for those starting later to still build a financially sound retirement.
2x Bonus: You May Have Two of These Accounts
While you can only contribute the maximum amount to a 401(k) or 403(b), meaning you can contribute up to $22,500 to either but not both, you can contribute to a 457 in addition to either a 401(k) or 403(b) plan. Very few individuals have access to both, but some employers, particularly locally focused nonprofits or certain positions in education, may offer both a 401(k) or 403(b) and a 457.
If you are lucky enough to work for an employer that offers both a 401(k)/403(b) and a 457 plan, your potential contributions are higher. You can contribute the maximum to both accounts:
401(k) or 403(b): $22,500
457: $22,500
Total Contributions: $45,000
That is an impressive $45,000 in tax-advantaged retirement contributions!
You may have noticed that the professions that generally have access to both accounts are not known for their high salaries. That said, you do not necessarily have to maximize your contributions to both accounts. For example, if you have the ability to contribute $27,000 to employer-sponsored retirement accounts, it is worth opening both and contributing well below the maximum in one account.
Additionally, you may be able to get creative within a household. If one spouse has a high salary but only has access to a 401(k), they may cover the majority of household expenses while the other spouse maximizes both a 403(b) and a 457, receiving less than half of their salary in take-home pay after their contributions.
Having additional access and options is never a bad thing. Cobble these accounts together in a way that works for your household, and do not feel bad about not being able to maximize contributions to all accounts!
*This assumes approximately 10% growth, or doubling approximately every seven years, since the average market return rate for the S&P 500 index over the last 100 years has been approximately 10%. A more conservative perspective, assuming around 7% growth would safely account for fluctuations and any maintenance fees, would still result in that $2,500 becoming $40,000 by age 65. In reality, the results will likely be somewhere in the middle after market fluctuations and account fees are considered.
About the Financial Accounts Series: The Financial Accounts Series is a four-part series discussing financial accounts that can improve the health of your finances. The Phippen Tax & Financial Services team will provide a deep dive on each of the accounts listed in Part 2, Accounts You Need Next, before releasing Part 3, Accounts You Want. If you missed Part 1, Accounts You Need First, start there! If you would like to seek additional guidance about your personal finances or the specific organization and composition of your financial accounts, please contact Patrick Phippen or complete a new client form if you have not worked with Patrick in the past.
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