Allow me to clarify the title right off the bat…I generally don’t think you can save too much. But I do think you can save too much in your 401k plan and not enough in other tax-favored accounts, like your HSA or Roth IRA.
As Americans, we generally don’t receive enough financial coaching in our youth, adolescence, nor early adulthood. Yet in that absence, there are two false financial truths we hold to be self-evident: 1) You should save into your 401(k) plan for your future, and 2) You should save into a 529 college account for your child’s future.
I’m here to tell you that you’ve been misinformed…err…not informed…err…developed misconceptions on your own. In any matter, let me set the record straight here. I’ll be focusing on the first false ‘truth’ in this article, and I’ll hit those 529s next time.
First, let’s develop a brief understanding of how 401(k) plans became the default. In 1978, Section 401(k) was added to the Internal Revenue Code, allowing employees to avoid being taxed if they ‘deferred’ their income. A few years later, the IRS provided guidance allowing employees to defer their income via payroll deductions and have their company set aside that money for them into a 401(k) account. Companies realized they could offer a matching contribution and retirement benefit through a 401(k) plan to employees far cheaper and far risker than through pension plans. 401(k) plans spiked in popularity. The term “401(k)” has now become synonymous with “retirement plan”, much like “Kleenex” is to “tissue” or “Rollerblade” is to “in-line skate”. Seriously, did you even know the term “in-line-skate” existed? That synonymousness gave birth to the false self-evident truth that you should save into your 401(k) plan for your future (retirement).
The truth is that any savings strategy you have for your future should involve a combination of your 401(k), Health Savings Account (HSA), and Roth IRA. And it’s a lot less in your 401(k) than you think.
**End Spoiler Alert**
A Quick 401(k) Discussion
The key benefit to the 401(k) is that there is a tax-favored element to it. Specifically, when you save money into your 401(k), you don’t claim income on that savings in the year you earn it (for clarity, I’m talking about the “pre-tax” source in 401(k) plans, albeit you could also save on a Roth basis – but table that digression for now…), so you pay less in taxes that year. In addition, all investment earnings on your ‘deferred income’ in the 401(k) plan also grow tax-deferred. You won’t claim any income nor pay taxes until you take a withdrawal from the 401(k) plan.
A key disadvantage to saving into the 401(k) plan is that your money is tied up in the plan for a long time. You have less liquidity. In fact, that money is basically tied up until you turn age 59 ½. Generally, if you take money out of your 401(k) plan prior to age 59 ½, then not only are you going to claim it as income and pay your ordinary income taxes, but you’ll also pay an early withdrawal penalty of 10%! So roughly 30-50% of your withdrawal will vanish to taxes given the current tax brackets for most folks. Sure, you may be able to access some of that 401(k) money via a loan or hardship distribution instead, but those will usually require you to pay processing fees to the recordkeeper. Ain’t no free lunch here.
A Quick HSA Discussion
Health Savings Accounts are also tax-favored, and most people will recognize the ‘triple-tax-advantage’ term that describes their tax-favored-ness. Concisely, the ‘triple-tax-advantage’ means that the HSA is the most tax-favored account under the Internal Revenue Code in the great US of A. Utilizing an HSA is basically the only way that one can actually build tax-free wealth. Similar to deferring income into your 401(k), you won’t pay income taxes on any income deferred into your HSA in the year you earn it. And similar to the 401(k), all investment earnings in the HSA also grow tax-deferred. But a key difference is that when you take money out of the HSA you will not pay any taxes, assuming that withdrawal is used to pay or reimburse yourself for a prior qualified medical expense. That sounds like a big assumption and a potential limitation of Health Savings Accounts, but it’s really not.
Consider that some studies estimate that an age 65 couple retiring this year are likely to face approximately $300k of medical expenses from the day they retire to the day they die. Wow, that got morbid fast. Most of those expenses can be paid from tax-free withdrawals from your HSA. Plus, consider all the medical expenses you’ll have from now until you reach age 65…it’s a lot, especially if you have a kid every 20 months over your 30’s (personal zinger there). The punch line here is that the HSA is more tax-favored than a 401(k), and as such it should be used instead of a 401(k) to generate more tax-favored wealth for your future. Of course, another key limitation is that you must be covered by a High-Deductible Health Plan to even contribute to an HSA, but most people are these days.
A Quick Roth IRA Discussion
A Roth IRA is yet another tax-favored account, but slightly different than the two we covered already. In the year that you contribute to your Roth IRA, you still claim that money as income and pay taxes on it. But once invested within the Roth IRA, all earnings grow tax free. When you eventually take a distribution from your Roth IRA after the age of 59 ½, it all comes out tax-free. Yes, this Roth IRA thing also has that darn 59 ½ limitation just like the 401(k), lest you want to pay an early withdrawal penalty.
But here’s one of the most important advantages of the Roth IRA…so do not miss this. The early withdrawal limitation prior to age 59 ½ only applies to the investment earnings of your Roth IRA. You can withdraw any of your contribution basis from your Roth IRA penalty-free and tax-free at any time. This increases your liquidity, serving as both an emergency fund and also as a funding mechanism for large expenses prior to retirement – such as college expenses for your children or home renovations.
Before moving on, let me simply explain this ‘contribution basis’ concept. Let’s say you contribute $6,000 to your Roth IRA for 10 years straight, for a total of $60,000. At the end of 10 years with investment earnings, your Roth IRA is worth $120,000. Of that $120,000, $60,000 is considered contribution basis and available at your disposal. If you’ve got some Roth IRA contribution basis, then you likely don’t need to tap into early withdrawals, loans, or hardships from your 401(k) plan.
A Quick Summary for Completeness
Some Quick Advice
So, what’s the optimal savings allocation across the 401(k), HSA, and Roth IRA? It depends on your situation. Yup, you knew I had to say that, right? Alright fine, I hear you cursing at me in your head, and this entire article would simply be a waste if I didn’t provide some high-level guidance…right?
First, if your company provides a matching contribution in either the 401(k) or the HSA, then contribute to those accounts the minimum amount necessary to get the free matching dollars from your company. Free money is free money after all.
Second, fill that HSA bucket with as many Benjamins as you can. Tax-efficiency is tax-efficiency after all.
Third, if your income is only putting you into the 12% marginal bracket…then load up that Roth IRA. If your income is putting you into the 32% marginal bracket…then load up that Pre-tax 401(k). You probably could use a tax-deduction more than increased liquidity, and you probably have enough money to fill up your Roth IRA bucket every year anyway as well. If your income is putting you into the 22% or 24% marginal bracket, then you probably need to figure out if liquidity or tax-deductions are more important to you right now while considering your short-to-medium-term expense needs (like college or cars or vacations or homes).
Fourth, fill up the bucket that’s still available, whether the Roth IRA or the 401(k) depending on what you did on step number three. Candidly, most people will never get to this point in any year as it’s a significant amount of annual savings.
On the record, I would simply like to state that this is generally good advice and most people can follow the above four step process. I did caveat, however, that it depends on your situation and there are some really good reasons why one would want to deviate from the advice above.
At a minimum, hopefully you’ve realized the self-evident financial truth about 401(k)s is…well…it’s just not the whole truth.
Contributed by Brian Riefepeters, FSA, EA