A dad recently asked me if his 20-something daughter should save in her 401(k) and save into a Traditional IRA? I asked him if she was planning to save more than $19,000 (the statutory 401(k) savings limit in 2019). He said no. He, along with others I’ve spoken to, are unaware of how much they can save in their 401(k). That leads to another misconception. Some people I meet believe they are maxing out their 401(k). They think they can only save to the maximum their company matches, rather than what the government allows. If your company doesn’t offer a 401(k), you may want to lobby for one to take advantage of the higher tax-advantaged savings limits.
What You Can Save
In 2019, the government will allow you to save up to $19,000 in a 401(k) retirement savings plan. If you are over 50 years old, you can save another $6000 in catch-up contributions for a total of $25,000. That limit extends to the 401(k) cousins- 403(b), most 457 plans, and the federal government’s Thrift Savings Plan. That’s a significant boost to the Traditional IRA (pretax) and Roth IRA (post tax) limits of $6,000 and $1,000 catch-up. Many people like Roth IRAs because they’re not taxed when the money is withdrawn after age 59-1/2. If your 401(k) has a Roth option, you can elect to use your $19,000 limit inside of it. In both cases, you still receive the employer match; however, the match is considered pretax or traditional 401(k).
Let’s illustrate for clarity. Let’s say you make $100,000 and want to save 10 percent of your pretax salary (Roth savings are post-tax). If your company offers a 401(k) then the limit of $19,000 allows you to save that 10 percent. However, if your company does not offer a 401(k), you can save $6,000 in a Traditional IRA. The balance would have to be saved in a non-pretax account. You would be wise to adjust your savings rate to accommodate the tax hit you will take from capital gains taxes on your investment returns. That typically means that you would have to save more than the 10 percent of your pretax salary to get a similar pretax savings rate.
Let’s look at another example. You are over 50 and find that to have adequate income when you retire you will need to have saved $25,000. If you participate in a 401(k), you can plan on saving that amount without being concerned about the company’s ability to match. (Note: There are some rules that your company needs to follow as there is a potential savings claw back. That discussion is beyond the scope of this article.) Any matching savings from your employer simply sweetens the deal. A company match gives you options to back off on your savings, reduce your investment risk, or benefit from some extra compounding of savings. Without a 401(k), Traditional IRA limit leaves you short from the amount you need to save. Saving without the benefit of tax deferral will add to and compound your savings need. You will be faced with some difficult decisions, such as working longer or taking on more investment risk in order to make that catch up.
So far, we have examined the savings limits. The income phase-out rules for employees covered by a workplace retirement plan and Roth IRA savers further complicates matters. Once your income exceeds the lower limit, your savings are reduced by a percentage until it is completely phased out at the higher end of the range. The income limits differ for Traditional IRA and for Roth IRA.
For single taxpayers covered by a workplace retirement plan, the phase-out range is $64,000 to $74,000. Married couples filing jointly, where the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is $103,000 to $123,000.
An IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $193,000 and $203,000. A married individual filing a separate return who is covered by a workplace retirement plan, the phase-out range is $0 to $10,000.
Contributors to a Roth IRA that are single or head of household face an income phase-out range of $122,000 to $137,000. For married couples filing jointly, the income phase-out range is $193,000 to $203,000. The phase-out range for a married individual filing a separate return is $0 to $10,000.
What Should You Save?
The previous discussion highlighted how much you can save within the rules to receive tax advantaged retirement savings. This section focuses on what you should save. A 401(k) should be viewed as a source of money to be used to create retirement income. There are a couple of savings approaches based on creating retirement income. The first method is based on income replacement. It is the approach taken by defined-benefit pension plans. (A 401(k) is a defined contribution pension plan) In a defined-benefit pension, an actuary develops a plan to provide a payout of a certain percentage of an employee’s income at retirement. This may or may not include a cost-of-living increase throughout the employee’s retirement. Actuaries consider factors such as how long the employee or employer will contribute to the plan, how long an employee is likely to live, and what return rate will be targeted. The monies are pooled together rather than separated into individual accounts. Once the employee and their beneficiary die, the money is not distributed to beneficiaries. This money is reallocated to pay retirement income to those employees who are still owed a benefit.
Similar actuarial-type calculations can be done using your 401(k) savings plan. This starts with what percentage of income you want to replace. From that amount, you subtract income from Social Security, pensions and annuities. That gives the gap to be filled. A retirement needs assessment can be done to highlight percent you should save, given various assumptions, such as investment return, inflation, and pre- and post-retirement. These are complicated calculations. On the bright side, as opposed to the defined benefit pension plan, if you have money left over it will go to your beneficiaries.
The other approach to determine how much to save is based on the lifestyle you want during retirement. I refer to this as goals-based. First, clarify your goals and lifestyle. Second, you accurately estimate your lifestyle expenses. In my experience, most people like dreaming about goals but hate the tediousness of costing it out. Third, equipped with these costs, the savings rate, investment returns, and other factors can be estimated to pay for them. This approach will likely cause an increase in savings rate and or a decrease in current spending as compared to the income replacement approach.
Most web-based calculators I’ve checked out, are designed to help with the income replacement approach. If you choose the goals and lifestyle approach you may find it beneficial to seek out the help of a retirement planner with advanced retirement planning software and credentials.
If you’re like many people, you have either struggled with paying for college, paying for student loans, overcoming debt challenges and the like. You may have felt or feel you have nowhere to go. Your only option is to work until you drop. Hopefully, you now have hope. You can use the savings approach to retirement income that is right for you. Then you can use an IRA or, if necessary, supercharge your savings with a 401(k) savings plan.
The views of the author of this article do not necessarily represent the views of Gradifi. We make no claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained here. Readers should consult their own attorneys or other tax or financial advisors to understand the tax, financial and legal consequences of any strategies mentioned in this article.