(This article was co-produced with Hoya Capital Real Estate)
This article could be viewed as a prequel to my series on avoiding RMDs when the time comes:
Cutting Taxes By Converting To A Roth: An Analysis
The Tax Code Provides A Strategy IRA Converters Should Consider: QCDs
IRS Allows A One-Time Transfer From Your IRA To Your HSA: Another Strategy To Reduce RMDs
Those articles all dealt with how to reduce pending RMDs after your previous choice of investment accounts and allocation set in motion your strategy that would highly influence their size once you reached the age when those RMDs would start. This article examines what will most likely be your largest retirement account, your 401(k), before you get too far down that road to change course. The main choice is between paying taxes while you are employed versus paying them when you are retired. Which type of 401(k) you contribute to will have a great effect on the size of your future RMDs.
401(k): The basics
For most investors from the post-Boomer generations, defined-benefit pensions will be scarce. Some might have a few years under such a plan but they should expect a buyout offer to get them off the books. That, plus the uncertainty of Social Security, will make their 401(k) plan the center piece of their retirement strategy, even more so than for me: (My 401(k) – The Linchpin Of My Retirement Investing Plan).
- Before-Tax: By far the most popular version as the employee saves on their income taxes for every dollar contributed that year. RMDs are required currently under the same rules as Traditional IRAs.
- Roth: These operate the same as a Roth IRA. No tax savings going in; no taxes paid on the RMDs. Not all employers this choice.
- After-Tax: As the name suggests, contributions are made with no tax benefit in that year. RMDs are fractionally taxed based on the ratio of contributions to asset growth.
- 401 (k) only: Self-employed individuals or couples can set up their own plan using any or all the above options.
There might be others, but these are the ones I am aware of.
Naturally, the IRS is not going to let you stuff unlimited amounts into your 401(k) plan each year. The contribution limits for the 401(k) plan are inflation adjusted annually. For those looking to max out their 401(k)s in 2022, you can contribute $20,500-an increase of $1,000 over 2021. For workers over the age of 50, the catch-up 401(k) contribution is still $6,500 per year. For small business owners, the total contribution limit for a 401(k) is $61,000 in 2022. Depending on the terms of your employer’s 401(k) plan, catch-up contributions made to 401(k)s or other qualified retirement savings plans can be matched by employer contributions. Any matching funds from your employer do not count toward these limits.
However, there is another limit which applies to overall contributions; your employer match contributions are taken into account for this contribution limit. For tax year 2022, that limit stands at $61,000 or $67,500 when you include catch-up contributions for workers 50 or older. This limit can come into play with the After-Tax version of the 401(k), and that will be discussed in detail later.
This article from SHRM.org shows how all the contributions change from 2021.
Most employers will match a fraction of the employee’s contribution, up to a certain percent. Always contribute enough to get the full match! Amazingly, about 18% percent of eligible employees do not enroll at all, let alone enough to get the full match.
Most experts recommend an annual retirement savings goal of 10% to 15% of your pre-tax income. High earners generally want to hit the top of that range; low earners can typically be closer to the bottom since Social Security should replace more of their income. So if your employer matches 50% of the first 6%, that’s 9% toward that goal.
A growing trend is for the employer to only add their match if the employee is still working there at year-end or on their retirement; otherwise it’s lost. Also, company matching funds usually vest over time – typically either 25% or 33% a year, or all at once after three or four years. Once you’re fully vested, you can take the entire company match with you if you change employers.
Each plan will come with a set of investment choices or maybe a brokerage window that allows you to make own decisions. This is the biggest difference, in my opinion, for Defined Contributions plans, of which 401(k)s are and the old Defined-Benefit plans, like pensions. The value of your pension was based on a formula, usually Years worked * High 3-Yr compensation * factor, so the investment risk was on the company and your risk was the company’s ability to meet that obligation. With DC plans, the risk of having enough at retirement is all on you and varies by how much you saved and your ability to invest wisely. Many plans have Target-Fund options that change the asset mix based on the target retirement date of the individual fund.
After that possibly depressing bit of news, here is one of the great benefits of 401(k) plans. Once fully vested, 100% of it can go with you every time you change employers, which statistics say could happen five times over your career. Your new employer might allow you to rollover, tax-free, into their plan.
When I started work, I had to wait a year and then contact HR to sign up. Few employers now make you wait and about 62% of businesses with a 401(k) plan automatically enroll workers into the retirement plan, according to the Plan Sponsor Council of America. Some also automatically increase your contribution rate until you reach a designated level.
The current version of the SECURE Act 2.0 would require employers to automatically enroll eligible workers in 401(k) or 403(b) plans starting at 3% of their salary. This amount would then automatically increase by 1% each year until the employee contributes 10% of their earnings. Certain small businesses and non-profits would be exempt.
How each of the choices affects RMDs
Everything else being equal, this choice results in the largest RMDs. For younger employees, the choice is lower (most likely) taxes now versus more in taxes maybe decades later, even if your marginal tax bracket doesn’t move. The reason is all that growth is also growing decades without a visit from the IRS! You can start to reduce those RMDs be using one of the reduction strategies outlined in the article links above.
If done right, there are no RMDs, otherwise they start at the designated age but are not taxable. By rolling your Roth 401(k) into a Roth IRA before reaching your RMD age, they are avoided. The trade-off of the Roth versus the Before-Tax option is you do not get any tax savings at the time of the contribution. One risk is a law change that would make any growth taxable.
At first glance, why would anyone use this option as it has the bad parts of both of the others and little of the good? Here each RMD is partially taxable based on the split between contributions and asset growth. The answer is this option gets you around the Before-Tax/Roth contribution limit, so it would only appeal to employees hitting that maximum. For employees of a large company the most a person + company matching can be is $61,000 or $67,500 if over 55. So if your contribution is at the $20,500/$27,000 limit, you have room to give lots more.
The above illustrates the concepts as they would have applied using 2021 limits.
There is a caveat though. Your company might not be allowed to let you go all the way as there are lots of rules around 401(k) plans to be sure they aren’t designed to benefit the upper level employees or management. These are related to Highly Compensated Employees, or HCEs. For 2022, HCEs compensation is defined as $135,000 or more. HCEs can contribute no more than 2% more of their salary to their 401(k) than the average non-highly compensated employee contribution. Total HCE contributions also can’t be more than double the total contributions of non-HCEs. Both test means the upper contribution limit for HCEs varies by company. When I retired, it was 12% of a HCE’s compensation. Thus the more lower paid employees put in, the more HCEs can, thus auto-enrollment should benefit HCEs.
This article from Nerdwallet covers benefits and strategies for After-Tax accounts.
My reasons for allocating my 401(k) contributions
When first offered, there was no Roth option so getting the instant tax break drove the decision. Later, again before the Roth option availability, I started also using the After-Tax option as I hit the Before-Tax limits, the HSA limit, and Roth limit for both accounts. After-Tax was the last shelter available. My company didn’t offer the Roth option until years after its approval. When I estimated my pending 401(k) RMD, I realized the size would push us up a tax bracket, so once they did, I switched from Before-Tax to Roth. At that point, I also scaled back my After-Tax contributions. As my wife approached 63, I adjusted the Before-Tax/Roth mix to keep our MAGI below what I estimated the lowest IRMMA income breakpoint might be.
Besides deciding which type of 401(k) to contribute to, there are strategy questions to make. One is the account order to contribute to. The one I have recommended is:
- 401(k): Up to the level needed to earn all the match offered.
- HSA: Either estimates of what you can claim in medical expenses or preferably the maximum permitted. Although this should be treated as a retirement account, funds can be withdrawn tax-free for medical expenses.
- Taxable accounts: How much depends on assets available to meet known and unexpected needs without tapping retirement accounts.
- Roth IRA: For older investors, their income might prevent using a Traditional IRA. Also, their tax bracket is less likely move much in retirement, whereas younger investors most likely are in tax brackets that limit any tax benefit received at the time.
- 401(k): Additional contributions beyond matching levels. I rank IRAs above this as you have more control over choice of assets and maybe lower fees.
How you live in retirement is in your hands, probably more so since before the wide spread offering of pensions. Few, if anyone, can live comfortably on what Social Security provides unless they have lived modestly all their life. Forgoing some spending now for a better retirement can be tough but the sooner you start, the less you need to put aside, as the following chart shows.
For those uncomfortable making their own investments or allocation decisions, most plans and IRA providers offer limited advice and funds that make those for you.