5 Steps To Retiring Rich (Step 1)
Rumors were swirling that lawmakers were going to change the rules surrounding 401(k) plan contributions as part of their tax overhaul … but it sounds like the idea has been completely scrapped for now.
That makes this a good time to talk about these plans in greater detail, along with other types of retirement accounts and how they fit into your overall financial picture.
It’s a very large topic so I want to cover it over the next several days.
Today, we’ll start with the basics on 401(k) plans — including my thoughts on the newer Roth variety.
For most regular working Americans, 401(k) plans represent THE way to save for retirement.
In fact, there are about 500,000 different employer-sponsored 401(k) plans in the United States right now, with more than 50 million active participants.
These accounts have been permitted by section 401(k) of the Internal Revenue Code since 1980, the result of legislation passed by Congress in 1978.
The idea is pretty simple: you can take out some of your money and put it into a special retirement account. In doing so, you don’t owe income taxes on it until you withdraw the money.
If you wait to take the money until you’re at least 59 1/2, you just pay taxes on what you withdraw (including investment gains).
If you take money out sooner, you owe taxes plus an additional 10% early withdrawal penalty.
Actually, that’s a bit oversimplified.
For example, it may be possible to take a certain amount of money out penalty free for certain financial hardships. Many plans have this feature but not all. (More details from the IRS here.)
Likewise, there is a little-known provision known as the “Rule of 55” that allows anyone 55 or older to avoid the early withdrawal penalty as long as they separated service in the year they turned that age or at any point thereafter.
Either way, since many people drop into lower tax brackets during their retirement years, the tax deferral is a nice feature. And as a side benefit, there’s more money in the account to invest over all the years in between.
Contribution matches are an additional benefit offered by many employers, many of whom are much happier to kick in a little money rather than have the much larger obligations they had with defined benefit pension plans.
If you currently have access to a 401(k) plan with some type of employer match, my recommendation is always contributing enough to get the maximum amount of “free” money.
The absolute maximum that any regular employee can contribute to a 401(k) is $18,000 for 2017 and $18,500 in 2018.
However, if you’re age 50 or older you can also take advantage of an additional “catch-up” contribution of $6,000.
Now, how much you should contribute depends on a number of factors.
Your personal budget is obviously one.
Your tax picture is another.
Plus, you need to consider your access to other types of accounts and how they fit into a larger plan.
As an example, you might want to put a certain amount of money into an IRA that offers more investment choices. Or you might want to use a Coverdell account. There are a number of possibilities and we’ll cover many of them in future articles.
For now, let’s just stick with the idea that the primary goal with a 401(k) is at least getting any money an employer is willing to chip in.
That’s a pretty straightforward rule, and it was really my last major word on the subject until a new type of 401(k) plan came onto the scene … the Roth 401(k).
Like a Roth IRA, the Roth 401(k) does NOT give you an upfront tax break. Instead, you contribute after-tax money but your money then grows tax free from there on out.
Standard financial planning would tell you that this favors younger workers since their money can snowball for longer periods of time. In theory, that makes the lack of future taxation much more valuable.
I say “in theory” because there is no guarantee that the government will actually honor that promise in the future.
In addition, unlike Roth IRAs, Roth 401(k)s force account owners to make required minimum distributions once they reach age 70 1/2.
So for me, the traditional 401(k) is still the better choice if you have it. The upfront tax deduction is known and immediately realized. I consider this one case where a bird in the hand is worth two in the bush.
Meanwhile, if you like the idea of having some money in a possibly-free-from-future-taxation account then simply put some into a Roth IRA as a supplemental and complementary approach.
To a richer life,
for The Rich Life Roadmap