How to Maximize Your 401k Contribution Limits
Finding a job that pays you well, or getting your business to be profitable are huge achievements, but making enough money to cover today’s bills and save consistently is far from the end-all-be-all in financial life planning. Many people with a comfortable income level begin wondering if they can afford to take a pay cut and pursue a career that brings them more joy, or perhaps take a step back from work at some point. Increased financial security opens many new doors and increases the flexibility of our choices, but like anything else in financial planning, these new options and decisions are complex and require trade-offs. At Mana, we help clients plan for their best future, which doesn’t always mean taking the raise! Having a thoughtful 401k strategy is one way to both increase your options as well as feel more secure when choosing a new path or transitioning into retirement. 401k success is critical to long-term planning and life changes at every stage. In this week’s blog, we want to present readers with a strategy that lets you actually maximize your 401k plan while you’re making those big bucks.
While most employees and entrepreneurs are aware they have a 401k and are actively contributing to it, many do not read the fine print in the legal docs. We documented some commonly missed or unrealized 401k details that could help you be more creative and productive in how you use it.
The 401k is a tax deferred investment vehicle. Though 401ks have only been around for about 50 years, they have taken over as the primary savings vehicle for retirement. The most common and straightforward way to save for retirement is to contribute pre-tax dollars to your 401k plan and (hopefully) receive a company match. If you use this strategy in 2020, you will receive a tax deduction for the dollars you contributed to your 401k. Your investments, consisting of the contributions both you and your employer made, will grow year over year without any tax consequences. When you eventually withdraw funds in retirement, you will pay taxes on the distributions from your 401k. These dollars are referred to as tax deferred, because you get a benefit on taxes this year and defer the tax consequences until retirement.
Before we strategize, is maxing out your 401k enough?
Many individuals are aware that the maximum they can contribute to a 401k this year is $19,500. If you’re over 50, you can contribute an additional $6,500, called the ‘catch-up contribution’. The term ‘maxing out your 401k’ = is somewhat deceptive, because the maximum contribution is actually $57,000, not $19,500. And just because you are maxing your employee contribution doesn’t necessarily mean that the savings will be sufficient to maintain your current lifestyle in retirement.
Realistically, if you’re spending more than $100,000/year, a $19,500 per year contribution is probably not enough.
Fortunately, there are a few ways to go beyond maxing your employee contribution. Every company 401k plan is different, but let’s illustrate a common scenario where your company will match 100% of your contribution up to $10,000. In this example, if you are under the age of 50 and contribute the maximum of $19,500, your employer contributes $10,000. So, your total contribution is $29,500. Now, what else can we do to get to $57,000? Three words: after tax contributions.
After tax contributions are different from Roth contributions. These are contributions that you are making with after tax dollars to your Traditional 401k. In a way, they are a hybrid between the Traditional 401k and Roth 401k. Because you are contributing dollars after tax, you will never owe taxes on these contributions (because well, you’ve already paid taxes on that money). However, you are making contributions to a Traditional 401k, which grows tax-free, but is taxed when you withdraw income in retirement.
The benefit? You will defer paying taxes on the growth of more dollars until retirement. But remember, ultimately you’re still going to have to pay tax on all of that growth. If you’re in the highest tax bracket, this could be a good strategy, assuming that your income, even with the additional retirement funds, will be lower in retirement. If you’re currently in a lower tax bracket, you might be able to save the difference of what your tax bracket is today vs. what it will be in the future.
Maximizing your 401k strategy:
After tax contributions can be super useful if your 401k plan offers in-plan Roth conversions. In this case, we take our strategy a step further. Once you’ve contributed after-tax dollars, you can convert the after-tax dollars into your employer’s Roth 401k. Then, they are treated like any other dollars in the Roth 401k, and they will grow tax free from now until retirement. Best of all, when you withdraw these funds in retirement, there are no tax consequences! Top employers are offering this strategy as part of their retirement program, including an automatic conversion from Traditional 401k to Roth 401k of after-tax dollars. The automation is very beneficial, because it avoids any tax consequences from converting after tax dollars that have already grown. Remember, any earnings on after-tax dollars are subject to taxation if they are housed in the Traditional 401k.
This strategy comes with the additional benefit of tax diversification. As a high income earner, it’s most tax efficient to max out your pre-tax employee contribution first, and then receive the full employer match. It will provide you with a tax benefit in the current year, give you free money from your employer, and allow you to grow your retirement savings without much effort. Once you’ve reached the employee max threshold and employer match threshold, then consider executing some version of the strategy illustrated above.
Why do we like this strategy? Tax diversification.
Assuming you contributed evenly to your retirement accounts with pre-tax and post-tax dollars and they grew at the same rate, in retirement you’ll have 50% of your investments in pre-tax dollars and 50% of your investments in post-tax dollars. If you decide to withdraw 50/50 from your pre-tax and post-tax in retirement, you’ll be taxed as though you only earned half the amount of income you received, because the Roth money will not be taxed. Additionally, if there are major changes to the tax code, you can feel good about not putting all of your eggs into one tax basket.
Dedicating your funds to your 401k plan is a great way to optimize your current tax situation and build your retirement savings. But keep in mind that the amount you need saved in retirement depends on how much you spend on an annual basis. You might get some ideas about this value in our previous post, Retirement’s Magic Numbers. If you find out that you only need to save an additional $6k/year to meet your retirement needs, working with a financial advisor to execute a backdoor Roth might be a preferential strategy. We wrote about this in our blog, You Might Be Rich, But You Can Still Roth. Roth IRAs have an added benefit that you actually can easily withdraw funds pre-retirement if you end up needing them. If you’re considering retiring early, you might also consider funding a taxable brokerage instead, because of the flexibility it provides. We wrote about how best to use a taxable brokerage and invest tax-efficiently in our blog, How To Not Let Taxes Drag You Down.
And finally, if all of this seems overwhelming - because yes, there are tons of different retirement strategies - please feel free to reach out. At Mana, we love building and optimizing financial life plans that help clients achieve their best future.
Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.