Financial Advisor Insights

Is it always best to max out a 401(k)? Exploring the downside of tax-deferred growth

Updated for 2019. In personal finance, there aren't too many universally applicable hard and fast rules. Although some might reasonably argue that always maxing out annual pre-tax contributions to a retirement account such as a 401(k) or 403(b) qualifies as such a rule, that isn't necessarily the case. Tax-deferred retirement plans offer significant benefits: investors can reduce their taxable income in the current year while their nest egg enjoys the advantage of compounding at higher, pre-tax contribution levels. The trade-off is that in retirement, withdrawals will then be fully taxable as ordinary income. For wealthier retirees or individuals with a sizeable pension, it may not be in your best interest to max out contributions to a traditional 401(k). 

Is it ever a bad idea to max out a 401(k)?Why there isn't one 'best way' to plan for retirement

As a CERTIFIED FINANCIAL PLANNER™ professional, I'm often asked what's the 'best way' to save and invest for retirement. For many individuals, it begins with maxing out their annual contributions to their workplace retirement plan. But just like any other strategic plan, it may be necessary to adapt over time as your situation and benefits at work change. 

Universal rules are scarce in financial planning is because everyone's financial circumstances are different. There are many ways one investor's situation will vary from another's: amount and type of retirement assets, expectations of a pension, other assets such as real estate or an inheritance, access to different types of retirement plans and ability to contribute, current cash flows, expected income needs in retirement, legacy goals, and so on.

Using accounts with different tax treatment to save for retirement 

The three most common types of accounts used to save for retirement are:

Investing outside of a retirement account

Tax-deferred account

As previously discussed, tax-deferred retirement accounts offer a number of benefits. However, there are also some downsides which some individuals may be unaware of. The most notable drawback is the requirement to take distributions from your accounts starting at age 70 1/2, called required minimum distributions (RMDs).

At a high level, the amount you'll need to withdraw annually is the sum of your savings in traditional IRAs and tax-deferred retirement accounts (e.g. 401(k) or 403(b)) divided by the life expectancy factor listed in the IRS' Uniform Lifetime Table, which is based on your age. (This article has more on RMDs and how they're calculated.)

Of course, as the numerator grows (e.g. your pre-tax savings), the amount you will be required to withdraw annually will also increase. Since required minimum distributions will be taxed as ordinary income, it can push wealthier retirees into a higher tax bracket, particularly when considering how other aspects of your tax situation may change in retirement.  

For example, during working years many individuals have various pre-tax deductions from their paycheck: retirement contributions, additions to a health savings account or flexible spending account, or contributions to a deferred compensation plan or SERP. In retirement, these ways to reduce your taxable income disappear. After considering the impact of social security income and whether you're able to continue itemizing your deductions (particularly if you no longer have a mortgage), retirees may find themselves with few options to 'hide' from a tax perspective. 

Tax-free Roth

Depending on your situation, it may be advantageous for investors to redirect a portion of their savings from a tax-deferred account to a taxable or tax-free account to help reduce the tax impact in retirement. One of the benefits of using a Roth account is that the investment returns will not be taxed annually and withdrawals in retirement can be made tax-free, assuming at least 5 years have passed since your first Roth contribution was made. Another benefit is that there are no required minimum distributions on Roth IRAs.

Regardless of income, any taxpayer can make one Roth IRA conversion per year. If you're in the middle of a job transition, it may be the right time to discuss your options for your old 401(k) plan and whether a full or partial Roth conversion makes sense.

Some employers also offer a Roth 401(k) in addition to their traditional 401(k). With a Roth 401(k), investors at any income level are able to make after-tax contributions up to the IRS annual limit, $19,500 in 2020 (if under age 50). This is compared to the $6,000 limit for regular Roth IRA contributions for individuals under age 50, assuming your income doesn't exceed the thresholds to make the contribution in the first place. In 2020, the phase-out range for single filers in 2020 is between $124,000 - $139,000 and for married couples filing jointly $196,000 - $206,000.

The Tax Cuts and Jobs Act passed at the end of 2017 may present significant Roth planning opportunities for high-earning investors until the lower tax rates expire in 2025. But before utilizing a Roth account, discuss your situation with your financial and tax advisor, as there could be unintended consequences.

For example, reducing your deductible contributions may push you into a higher marginal tax bracket, causing more of your income to be taxed in the highest bracket. Further, as your adjusted gross income (AGI) increases, you may no longer be eligible for certain tax deductions or credits. Also, if you're currently in the highest tax bracket or do not expect to stick with the strategy long enough to make Roth assets a meaningful part of your overall portfolio, the strategy may not produce meaningful benefits.

Taxable brokerage account

brokerage account allows investors complete flexibility: there are no contribution limits, eligibility criteria, or rules about when you may access the funds. There are, however, no tax benefits associated with this type of investment account. A brokerage account is taxable annually, including any dividends you receive and if you incur capital gains (or losses) throughout the year. 

A brokerage account can serve a variety of purposes, particularly for high-earning investors with a high savings rate, or individuals looking for a way to invest proceeds from a windfall or lump sum.

In exchange for the loss of tax-deferred growth, a brokerage account can be a great way to help bridge the income gap early on in retirement, especially if you're looking to retire early and either cannot, or prefer not to, dip into your retirement account. If one of your main goals is to leave an inheritance to your children or family members, a brokerage account can offer unique tax benefits from an estate planning perspective.

Assets in a brokerage account will receive "stepped-up" cost basis when passed to heirs; meaning the securities in the account will be valued as of the date of your death instead of your cost basis for tax purposes, which is typically much lower if held for a long time. Assets receiving this "step-up" treatment will also be taxed at more favorable long-term capital gains rates, regardless of the actual holding period. As this is not a type of retirement account, there are no requirements for you - or your heirs - to take distributions.

By shifting retirement assets from fully concentrated holdings in tax-deferred accounts to being more evenly distributed among taxable and/or tax-free accounts, retirees may be able to have more control over their tax situation in retirement. 

Other complexities to consider

Landing at the optimal retirement funding allocation for your specific situation is a complex analysis that can sometimes be more of an art than a science. Multi-year projections require assumptions to be made on income, expenses, tax laws, goals, family situation, and so forth. Further, the strategy that yields the greatest overall expected wealth may not be the route best suited to accomplish unique planning goals, particularly philanthropic wishes and lifetime giving.  

In most situations, it will be beneficial to max out a workplace retirement account and save in another type of investment account. However, there are circumstances where it may be worth considering other avenues outside of traditional pre-tax deferrals, especially if you expect pension income or have access to a deferred compensation plan.  

For individuals with the means to diversify their retirement savings, it may be advantageous to consider a comprehensive financial plan to incorporate all of your goals, the particulars of your finances, and what-if scenarios to compare one strategy over another. For example, here are a few other considerations we'll discuss with clients during this process:

  • Matching contributions: if eligible to receive matching contributions, determine how contributing enough to receive the full match may impact projections.
  • Saving style: keeping lifestyle spending in check isn't easy for everyone. If you have a propensity to overspend, it may be in your best interest to keep automatic 401(k) deductions in place to ensure at least baseline retirement contributions are made. 
  • Before-tax vs after-tax ability to save: depending on your tax situation, it may cost you significantly more to save on an after-tax basis. Whether considering ongoing after-tax contributions or a one-time Roth conversion, if your cash flows are too tight, it may not be worthwhile. 
  • Other alternatives: depending on your objectives, there may be other ways to achieve your goals. For example, if you're charitably inclined, you may wish to consider a qualified charitable distribution from an IRA if you are over age 70 1/2. At a high level, a qualified charitable distribution allows individuals to make a payment directly to a qualified public charity from their IRA, to avoid including the distribution in your taxable income for the year. Although further planning would be required, for some, it may help offset the tax impact of RMDs while furthering efforts in planned giving. 

To learn more about what retirement planning strategy may be best for you and your individual situation, please contact us to speak with an advisor. 

Wealth Management Financial Planning Advisor

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