Sequential Saving

One of the most widely adopted personal finance decisions is saving for retirement through a workplace retirement plan. Many people see this step as the first item on their personal finance “to-do list” because of the general media coverage of the benefits of 401(k) plans. The workplace retirement plan has its proper place in the sequence of savings just like the emergency fund, Health Savings Account (HSA), IRA, etc. but this “proper place” might not be where you think. In the last three blogs we dissected the first three accounts on the sequential ladder and today we discuss 401(k)s and 403(b)s.

  1. Initial Emergency Fund and Debt Payoff Planning
  2. Fully Funded Emergency Fund
  3. Health Savings Account
  4. Employer Retirement Plans – 401(k)s and 403(b)s
  5. Individual Retirement Accounts (IRAs) & 529 College Savings Plans
  6. Taxable Brokerage Accounts

We already discussed the need for an emergency fund of an adequate size to fit your household’s earning, spending, and risk profile. Further, we demonstrated how the HSA is of more importance than the 401(k) in many situations. Once the emergency fund and HSA boxes have been checked and funded it is time to look at the employer retirement plans. The most adopted employer sponsored retirement plans are 401(k)s. 403(b)s for all intents and purposes are just 401(k)s for non-profits. When the term 401(k) is used here it is meant to encompass its non-profit twin the 403(b) as well.

Defined Contribution Plans

In days of old, employers provided defined benefit plans to their employees. Defined benefits plans often came in the form of a pension and as the name describes, the annual retirement benefit to the employee was guaranteed and fully funded by the employer. Not to your surprise with the aid of hindsight, employers tried to fund these plans with as little dollars as possible counting on large investment returns inside the plan to be able to make the promised benefit payments to future retirees. Many of these plans went upside down because employers could not fund the plans with enough assets to pay the guaranteed benefit originally promised.

Employer’s began to look for an alternative retirement incentive and across the board they turned to defined contribution plans. As the name implies, the contribution maximum amount is defined but the benefit in retirement is not defined or guaranteed. These plans such as 401(k)s and 403(b)s often provide upfront incentives such as employer matching contributions or profit-sharing payments to employees but it is up to the employee to save enough for retirement and make appropriate investment decisions. The move from defined benefit plans to defined contribution plans shifted the burden of funding retirement from the employer to the employee.

Benefits of 401(k)s and 403(b)s

While 401(k)s are largely employee funded, there are still numerous benefits that employees should be aware of and take advantage of in the proper sequence of their financial plan. 401(k)s are highly customizable by the employer and each plan is governed by a plan document setting the rules for that specific plan. While customization is prevalent there are common benefits among most plans.

  • Employer Match
  • Income Tax Savings
  • Profit Sharing Contributions (less common)

We will discuss the tax benefits later when looking at the ROTH vs Traditional decision but more important than the tax savings of employer retirement plans are the employer benefits. According to a Deloitte study, 92% of plans offered an employee match or a profit-sharing contribution in 2019. The most common matching arrangement in 2019 was employers agreeing to contribute $0.50 for every $1 the employee contributed up to 6% of the employee’s salary.

David started a new job on January 1st with a $60,000 salary. David decides to defer 10% of his salary into the ROTH 401(k) at work and his employer offers a 50% match up to 6% of compensation. David’s contributions for the first full year will total $6,000 and his employer will contribute $3,000 ($6,000 x 50%). If David had contributed $10,000 the limit of 6% of David’s salary would kick in and the employer match would be capped at $3,600.

Profit sharing contributions to 401(k)s are nothing more than discretionary contributions by the employer to the employees 401(k) accounts. There are various testing rules that employers are required to pass to make sure the profit-sharing contributions do not disproportionately benefit the owner or certain key employees. These contributions are discretionary and not influenced by employee deferrals.

How Much to Contribute?

The very first question when you enroll in a workplace plan is how much should I contribute? Frist, have you fully funded your emergency fund and HSA? If not, 401(k) contributions can still be made but there needs to be a plan focusing funding the emergency fund and HSA. The standard recommendation is to defer 10%-15% of your salary into your 401(k). The two primary factors that should determine your annual contributions are your available cash flow and the specifics of your employer matching program.

If your household cash flow enables a 12%-15% deferral then you most likely do not need to worry about maximizing your employer match program. This is because a 12% deferral hits the matching limit for a plan with a 50% match up to 6% of compensation. If you do not have the cash flow to reach a 12% contribution begin looking at the employer match program to not leave any dollars on the table. Some plans match 100% of employee contributions up to 3% of compensation so in those cases deferring at least 3% (where practical) is wise. The average deferral percentage for the 12 months ending June 30, 2020 was 8.6% according to Fidelity. These average contributions by employees came to $7,190 with employers contributing an average of $4,030 for the same period.

2020 401(k) Contribution Limits

Under Age 5050 or Older
Employee Deferral Limit$19,500$26,000
Employee + Employer Contribution Limit$57,000$63,500

ROTH vs. Traditional

No different than IRAs, 401(k)s also come in two tax flavors, ROTH and Traditional. The Traditional 401(k) offers a tax deduction upon contribution at today’s tax rates but subjects all distributions to income tax upon withdrawal. The ROTH functions as the mirror image with no tax benefit today upon contribution but qualified distributions from the account are not taxable upon withdrawal. This decision hinges primarily on your marginal tax rate today versus your marginal expected tax rate upon withdrawal. Tax rates and the U.S. Congress have been called many things but predictable is not one of them, making this decision difficult.

The ROTH 401(k) is extremely underutilized with only 12% of participants contributing to the ROTH even though roughly 73% of plans offer a ROTH option. The general rule of thumb for 2020 is if your marginal tax rate is below 30% you should consider the ROTH account. This means married couples with less than $322,000 of taxable income.

Long-Term Compounding & Investment Decisions

Employer matching and tax incentives are great but the primary benefit to the 401(k) is far less tangible. The 401(k) removes many of the prevalent investing behavioral mistakes from the equation. Once contributions are set to be deducted from the paycheck this money is often forgotten about. The biggest secret to investing is forgetfulness. Setting up automatic contributions, investing those contributions in low cost diversified funds, and forgetting is the secret sauce to let the 401(k) work its tax-free compounding magic.

Step by Step Action Items

  • Make sure you have considered your debt paydown strategy, emergency fund, and HSA before sitting down to decide your 401(k)-contribution deferral.
  • Look at your available cash flow that can be set aside for retirement.
  • Gain an understanding of your employer match programs to not leave any accessible dollars on the table.
  • Decide whether to pay taxes today or wait until retirement by selecting either the ROTH or Traditional plan option.