I was recently asked by a dad if his daughter should save into her 401(k) plus open an IRA.
While they are both tax-deferred savings accounts, their savings opportunities differ significantly. Many people aren’t aware of the savings opportunity that a 401(k) or 403(b) plan allows. Often, they believe that they can only save up to 100% of the match their employer offers. For example, if the employer matches 100% of the first 3% of their salary, they believe that is maxing their plan. That is what this dad thought.
The statutory savings limit for a 401(k) plan in 2019 is $19,000. If you are over 50 years old, you can add another $6000 for a total of $25,000. That means, that even if your employer does not match you can save $19,000 or $25,000 in 2019. If your employer offers a Roth 401(k) plan you could also save that amount in that account. That is welcome news if your income phases you out or exclude you from making a Roth IRA contribution. The contribution phases out for single taxpayers between $122,000 and $137,000; married filing jointly $193,000 to $203,000. The 401(k) savings limit of $19,000 is more than triple the IRA and Roth IRA savings limit of $6000 in tax year 2019. The over 50 catch up savings advantage of the 401(k) is six times that of the IRA! If you feel behind on savings and have a 401(k), the higher 401(k) savings opportunity should be welcome news.
Let’s return to the dad and his daughter. I asked dad if his daughter intended to save more than $19,000. He said no. Unless her 401(k) plan did not have a Roth feature and she was making less than the phaseout of the Roth 401(k), she may want to still make a Roth IRA contribution after she had tapped out her company match. With the Roth, you make your contribution with after tax dollars. That should feel like paying for rent, utilities and groceries from your checking account.
If your company offers a 401(k) with or without a Roth savings feature, getting tax advantaged retirement savings doesn’t require the inconvenience of setting up another account. In addition, if you open a small IRA account you may find yourself with limited investment options. Moreover, many mutual funds have minimum amounts required for you to invest in them. For example, you may be required to invest $25,000 in order to invest in a specific fund. The amounts may be even higher.
There are advantages to participating along with many others pulling your assets together in an employer-sponsored retirement plan. One of them being lower costs. When you buy items in bulk you generally can buy them cheaper than buying the same item in smaller quantities. You can see this on display if you Google and use FINRA mutual fund analyzer. FINRA is an acronym for the Financial Industry Regulatory Authority. You will find that there are different share classes for the same investment. You may find that the same investment in the retirement plan has a different sales charge if purchased in an IRA. It is not uncommon to see sales loads for the same mutual fund, having a sales charge of 5 ¾% to 0% if it is an institutional class. To learn more, I recommend, going to the mutual fund analyzer and typing in the name of a mutual fund. You will see the various share classes that you can come in. You will note that the higher the sales load the lower the investment return.
How much should you save versus how much can you save? I believe that answer is derived from doing a retirement needs assessment. That is not what came up in the conversation with the dad. Most people seem to see savings and investments is two separate issues rather than see how they come together to pay for retirement. There are a couple of approaches to retirement needs assessments: replacing a certain percentage of pre-retirement income or one based on a desired retirement lifestyle. The income replacement approach is similar to the approach of a pension. Let’s say that you want to replace 80% of your $100,000 income for a retirement in 40 years. In 40 years, $80,000 will have inflated to say $320,000 given a historical inflation rate of around 3%.
In the lifestyle approach, you must determine what lifestyle you want and what will it cost. Once again don’t forget to inflate the number. Either way, it’s important to determine how much money you are trying to replace when considering how much money you’re saving. Determining how much you need to save must also include what rates of return are you getting on your money. While no rate is guaranteed, if you make 1% on your savings or 10% on your savings you are going to get different balances at the start of your retirement.
What if you save the same amount and vary your return? If you save $1000 and get a 3% return you have $1030. If you save a $1000 again, compounding gets you to $2090.90. If you save a $1000 and get an 8% return you have a $1080. If you save $1000 again, compounding at 8% gets you to $2246.4. If you need a balance at retirement of $500,000 and want to get there at the same time if you have a lower tolerance for risk, then you will have to save even more to make up for the difference in compounding rate. If you have a lower tolerance for saving and would rather take on more market risk, then and what rate of return would you need in order to catch up? You may find yourself needing to hit the lottery in order to close the distance. This is not to suggest that you take on more market risk or to save more, but to be aware that the savings rate and the rate of return work in tandem over time.
Let’s imagine that your calculations show need to save 10%. If you make $60,000, you can save that amount in an IRA. If you have access to a 401(k), they can save that without a company match. If you have a 3% company match, they have found money choices, such as:
- Save 3% in your 401(k) and use the 3% savings for other goals, like education,
- Increase your emergency fund or
- Bump your retirement savings.
If you are a higher income employee, such as one making $190,000, then you need a 401(k) in order to save $19,000 (10% of income) in tax-deferred retirement savings. It your 401(k) provides a 3% match then number climbs higher. Unfortunately, there are some complicating factors that may prohibit you from doing so. Those factors are beyond the scope of this article.
Are you saving enough? Determine whether you want to target and income replacement or determine a specific lifestyle that you want to live. While the income replacement ratio is much faster it may not lead you to the retirement reality you want to achieve. The sooner you choose your approach and calculate it, the sooner you’ll know if you are saving enough.
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