You Might be Saving Too Much in your 401(k)

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).

**Spoiler Alert**

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

Dear Grad, Avoid These Mistakes

Dear soon-to-be college graduate (or parents of a soon-to-be college graduate),

You will soon enter a new era of salaried full-time employment with broad benefits from a great employer.  We’ve seen numerous offer letters and countless benefit packages.  This new era will bring you new financial opportunity, but it also brings a few financial traps to be aware of.  That’s why we’ve compiled this list of four common first-time-job financial mistakes, so that you can be confident in the financial decisions and benefit choices you make on day one of your new gig!

MISTAKE 1: LIVING ON 100% OF YOUR NEW PAYCHECK

You’ve got the offer letter. $60,000 salary. Nice! Quickly, you do the math: just over $1,150/week.  Bazinga! You can have a lot of fun with $1,150/week!  Sadly, that would be a mistake, because you won’t have anywhere near $1,150/week of disposable income. Instead, you’ll likely end up with about 20% of your pay as disposable income, which is more like $230/week.  A healthy way to think about your paycheck would be as follows:

You won’t even see the first 25% of you pay as it will be deducted for taxes and premiums, including federal and state taxes, FICA, and employer benefit premiums. This may come as a shock in the first paycheck you receive!

Now that you’re on your own, you’ll need 40% for essential living expenses such as housing, food, utilities, and maybe even some student loans and debt payoff.

And don’t forget to pay yourself by setting aside 15%. Some will be siphoned off before you see it into your 401(k) and HSA, and some you’ll put into an IRA afterwards. Your future self will thank you for getting into good savings habits early.

Let’s do the math, and that leaves you with 20% as disposable income. Ouch!

MISTAKE 2: RIDING ON YOUR PARENTS’ HEALTH INSURANCE UNTIL YOU’RE 26

You’ve been covered by your parents health insurance for years, and it seems easy to maintain the status quo. But Just because your parent’s health insurance allows them to cover you until you’re 26 doesn’t mean it’s a good idea.  It’s usually a pretty bad idea.  Often, it means higher premiums paid by your parents and lost opportunity to get free HSA money from your employer. You have to review in detail both the insurance your new employee offers as well as the insurance your parents’ employer offers.  Usually, premiums are higher for covered dependents (you would be a dependent on your parents’ insurance) than for the employee themselves. Your parents may be paying premiums that are 50-100% more than what you could pay for similar health coverage.  Plus, as a young and healthy individual, it would probably be a wise decision to enroll in a low premium high-deductible health plan offered by your employer, which often comes with a nice contribution to your Health Savings Account. Bazinga!

MISTAKE 3: SAVING TOO MUCH IN THE 401(K) PLAN

Save…yes.  But only in the 401(k)…no.  If you read the summary of mistake #1, you’ll recall that we suggest saving a total of 15%.  But generally, the most you want to save in the 401(k) right of the college is enough to receive the maximum company match. After that, you should be pumping the rest of that 15% in your Health Savings Account (annually up to $3,500 individually or $7,000 if married) and your Roth IRA (annually up to $6,000). Doing so will increase your Financial Agility, or your ability to react to changes in your financial situation in the future. What you need to know is that any money saved in the 401(k) is basically locked away until the age of 59 ½ unless you’re willing to pay early withdrawal penalties to the IRS. However, money saved into your HSA and Roth IRA may be accessed in the short term and even right away without penalty. The gist is that you’re going to use your Health Savings Account to actually accumulate or save money, pay for medical expenses out of pocket, and those unreimbursed medical expenses become future tax-free and penalty-free withdrawals. Relative to Roth IRAs, your contribution basis (the money you contribute, not the investment earnings portion of your Roth IRA account) is always available to you for withdrawal tax-free and penalty-free in the future. The availability of these funds from your HSA and Roth IRA on a tax-free and penalty-free basis provide you with Financial Agility.…all while you’re still getting tax free investment earnings for the future! Bazinga!

MISTAKE 4: ENROLLING IN UNNECESSARY VOLUNTARY BENEFITS

If your employer offers a nice suite of voluntary benefits, it can be tempting to go on a little shopping spree.  After all, they’d only offer those benefits if they were a good deal – right?  Not necessarily.  Look, you don’t need pet insurance, or critical illness or accident insurance, and you probably don’t need to buy an extra two days of vacation.  If you need life insurance due to debt or dependents, you’re likely better off applying for a term policy and being medically underwritten on your own versus buying one year of life insurance coverage through the company.  Instead of siphoning off your income into these voluntary benefits, you should be setting up a little emergency fund (including your Roth contributions and unreimbursed medical expenses from your HSA) so that you’re able to self-insure those small-ish unexpected expenses as they arise.  Save more into your HSA or increase your Roth IRA contributions to increase your Financial Agility. Bazinga!

So there you have it: four common first-time-job financial mistakes that you can easily avoid to give your working career a lift.  Just keep in mind that this article is written in generalities, and every situation, every employer, every job offer, and every benefits package is different. 

While we’ve captured common mistakes in common situations, you really should find a financially savvy advisor that will work with you in your situation.  Find an advisor that will review your benefits package with you and provide enrollment guidance.  Find an advisor that will give you a plan on how to allocate your income across living expenses, debt, and savings.  Find an advisor that will help you understand all the savings vehicles (401(k), IRA, HSA, etc) available and how and why to allocate dollars to them.  Find an advisor that’s willing to work with you for a small fee, even though you likely don’t have investable assets yet.  There may not be many advisors that fit that pattern, but we may have a reference or two if you need one. 😊

529s? Nah.

Do you really want to fund a 529?

Answer: probably not.  Don’t get me wrong, I’m with you on your intentions.  And your logic is spot on if it’s anything like that of a new (or experienced) parent, which probably goes something like this: “We have children.  We want the best for our children.  The best includes our children going to college.  We want our children to be able to afford going to college.  Let’s open a 529 account and start saving, because a 529 account is for college.”

That thought process is great.  And it seems quite logical.  But I believe there is one minor flaw.  It assumes that a 529 account is the best tax advantaged account to accumulate funds to pay for that college education.  The reality is that 97%* of us probably should never even consider a 529 account.

To explain why, let’s first remember that a 529 is advantageous for saving for college because it allows us to avoid paying taxes on the investment earnings in the 529 account.  It’s a tax advantaged account.  But what if there was a way to avoid paying taxes on investment earnings while having flexibility to use your money…for things like a home purchase, a large unexpected expense, or even college tuition when the time comes?  

There actually is a way, and it doesn’t involve 529 accounts.  Having your money set up in this ‘way’ is what we define as Financial Agility: optimizing returns, taxes, and flexibility so that you’re in the best position to financially react when the future comes your way.

Instead of funding a 529 account, we would suggest first funding your Health Savings Account and Roth IRAs. Both of these accounts are tax advantaged like the 529, but they will provide you with some additional financial agility.  We’ve discussed Health Savings accounts in our Thought Leadership series, so we won’t go into detail here.  The gist is that you’re going to use your Health Savings Account to actually save money, pay for medical expenses out of pocket, and those unreimbursed medical expenses become future tax-free and penalty-free withdrawals – all while your money is still enjoying tax free returns in the account.  Relative to Roth IRAs, your contribution basis (the money you contribute, not the investment earnings portion of your Roth IRA account) is always available to you for withdrawal tax-free and penalty-free in the future.  The availability of these funds from your HSA and Roth IRA on a tax-free and penalty-free basis provide you with flexibility.  They can be used in the near-term future for college expenses if you need it for that purpose.  Not only that, these funds can really be used as a source of near-term emergency funding for any need: home down payment, broken furnace, etc.  Of course, the hope is that you don’t need these funds in the near term and you can use them to help achieve your financial independence in the future; but the point is that you’ll have these financial resources and financial agility to react at that future point when it comes.

So unless you’re already contributing the maximum amount to your HSA and Roth IRAs, which is $19,000 in 2019 ($7,000 HSA family maximum, $6,000 for your IRA, and $6,000 for your spouse’s IRA), then it probably doesn’t make much sense to set up a 529 account.

* No official study was performed to validate the “97% of us” figure. 97% is a hyperbolized figure, kind of like a wet finger in the air, although the magnitude is likely accurate.