Since their inception in the late 1970s, 401K plans have over-taken the traditional pension plan to become the cornerstone of most Americans’ retirement savings plans. In that time period, they have helped Americans save more than $4.7 trillion for retirement.[i]
However, in reality, many Americans can’t rely solely on their workplace 401K to generate decades of retirement income. The annual contribution limits on any single retirement savings vehicle are simply just too low to accommodate the anticipated retirement needs of high-income earners.
Nevertheless, the benefits of the 401K plan—including tax-deferral, the employer match, and higher contribution limits—make this vehicle an invaluable savings tool to form the foundation of your savings strategy.
So how can high-earning executives make the most of their 401K?
- Maximize Your Participation Beyond Your Employer Match:
For most working Americans, maxing out the annual 401K contribution is considered a retirement planning best practice. As you consider the appropriate role for your 401k in your retirement planning, here are the three most fundamental items to consider:
|Your Savings Needs
||Your Tax Bracket
|How much do you need to save each year to meet your goals?
||When would you most benefit from the tax savings?
||How will bequeathed funds affect your heirs’ tax liability?
|2020 contribution limits for 401K plans are $19,500 for those under 50 and $26,000 for those over 50 due to the $6,500 catch-up allowance. Compare these with the $6,000 limit (plus $1,000 catch-up allowance for those over 50) on Roth and Traditional IRAs respectively and it’s easy to see that IRA’s alone are not sufficient in allowing executives to save and build wealth for their future.
||Examine the tax impact of pre-tax contributions vs. after-tax contributions. Pre-tax contributions to a 401K are allowed to grow tax-deferred, which means the tax break is offered up front and taxes are assessed upon withdrawal. In general, someone who expects their tax rate in retirement to be as high or higher than while they are working might want to think seriously about Roth contributions, since Roth contributions offer no upfront tax deduction but do provide tax-free withdrawals in retirement. However, employees in very high tax brackets while working might benefit more from the 401k’s tax-deductible contributions today.
|If you think you will be lucky enough to leave large amounts of your retirement plan to your heirs, making after-tax Roth contributions could save them on taxes and help preserve their inheritance. But if your children are likely to be in lower tax brackets than you, pre-tax contributions to a 401k or traditional IRA might be more effective.
- Select the Right Investment Options:
Once you enroll in a 401K plan, you’ll have to decide which investment options within that plan most benefit you. When making this decision, the two most important factors to evaluate are your personal risk tolerance and expected long-term returns.
The key is to know how much risk you can tolerate at any given time and evaluate that against how much growth you need to meet your objectives. Create a balance which serves to optimize those results without taking so much risk that you won’t be able to ride out the market’s inevitable ups and downs.
Pro Tip: Be wary of target date funds. These vehicles aren’t as transparent as advertised. Holding them could overexpose you to market risk or underexpose you to desired performance.
Risk is present at all times in investing, even if not always palpably reflected in a thriving portfolio. The closer you get to your retirement date, when you no longer have 20 or 30 years to recover from a market correction, the more important managing this risk will be.
No matter what stage of life you are in, don’t let favorable markets dull your awareness of the importance of diversification. Diversification is how we hedge against the unpredictable, yet inevitable, exposure our investments have to market ups and downs.
Ready to start maximizing your 401K to build wealth for the future?
Atlanta Financial is here to help. A key component of our work is designing retirement planning strategies that help maximize savings while minimizing taxes.
Through our ExecFIT™ process, we start by helping you organize and gain clarity around your financial life. A key component of our work is designing retirement planning strategies that help maximize savings while minimizing taxes. We then work together to build a solid plan to get you where you want to be.
[i] https://www.americanbenefitscouncil.org/pub/e613e1b6-f57b-1368-c1fb-966598903769 [3/6/2020]