Rethinking Your Retirement Savings

Employees are often advised to contribute the maximum amount to their 401k for tax savings and compounding potential. However, for high earners this may not always be the best choice.  Surprised? Hear us out.

In a traditional 401k, individuals can contribute a portion of their pre-tax income, up to $22,500 for 2023, which grows tax-deferred until withdrawn. Each dollar contributed results in an equivalent decrease in taxable income, and a lower current tax liability. Employers may also contribute to the 401k plan, either by matching employee contributions or Safe-Harbor contributions.

Free money from your employer?  Current tax savings?  Tax free growth?  That all sounds great. However, there can be a “dark side” to the story.  Once you reach the age of 73 (or 75 from 2023 forward) the IRS mandates Required Minimum Distributions (RMDs) from your traditional 401k each year. RMDs are calculated based on your account balance and life expectancy, and distributions are subject to ordinary income tax. The same type of tax avoided by the initial contributions.  Failure to take the RMD results in a hefty penalty of 50% on the amount not withdrawn.

The conventional rule of thumb suggests that individuals will be in a lower tax bracket during retirement compared to their working years. However, this is not always true, as the combination of RMDs, social security, pensions and investment income can lead to significant taxable income in retirement.  In some cases, tax rates may be even higher in RMD years, putting into question the benefit of deferred income taxes.    

HIGHER TAXES IN RETIREMENT…PROVE IT

Consider the case of Michael Scott, a 30-year-old employee earning $200,000 annually. From age 30 onwards, he consistently maxes out his 401k contributions while receiving a 3% employer match. Based on his income in 2023 and after his 401k contributions, Michael is in the 22% tax bracket. Assuming his portfolio grows at a rate of 5% with an inflation rate of 2.5%, his first year RMD at age 75 would be $219,352. If we add in $150,000 in social security income (of which $127,588 is taxable), his taxable retirement income would be $346,940. Based on today’s tax brackets, this would place Michael in the 28% tax bracket.

Income in retirement can have an impact on your Medicare premiums as well.  Premiums for both Part B and D are impacted by your Modified Adjusted Gross Income. Michael for instance will have an increased Medicare part B premium of $264 per month, and an increased premium on Medicare part D of $51 per month. This results in an annual total premium increase of $3780 per year.

In the given example, the tax brackets used are from 2023. However, since Michael’s first RMD won’t occur until 2068, it is reasonable to assume that tax brackets may increase in the future based on government spending trends over the past 15 years. This implies that Michael could potentially face even higher taxes in the future when he is required to take his RMD.

Besides the potential for higher tax brackets, maxing out a 401k for many years may have other financial implications. By prioritizing your 401k contributions, you may be neglecting other important financial goals, such as paying off high-interest debt, saving for emergencies, or investing in taxable brokerage accounts for increased flexibility.

THE TAX DEFERED GROWTH MISCONCEPTION

Inevitably, the IRS is going to get its share of tax dollars.  In a traditional 401k, taxes are typically paid decades after contributions are made. Many people believe that making more contributions today will result in more money in the future, assuming equal investment returns for post-tax investments. This implies that investing $1 of pre-tax money is better than investing $.75 of post-tax money because the money grows and compounds from a larger base.

However, this belief is incorrect. The only significant factors from an after-tax perspective are the income tax rates during contribution and withdrawal. Having a higher tax rate later in life can actually reduce your wealth, despite the compounding growth in your traditional 401k. There are some exceptions to this rule, which we discuss below. But the key takeaway is that it’s the tax rates at both ends that truly matter.

ESTATE PLANNING IMPLICATIONS

An often-overlooked disadvantage of 401k and IRA accounts is their impact on estate planning. Under the Secure Act, inherited IRAs are now subject to the 10-year rule requiring non-spousal beneficiaries to withdraw the inherited funds within 10 years of the original owner’s death. These withdrawals are subject to ordinary income tax based on the beneficiary’s tax bracket.

Using our earlier example, let’s say Michael Scott designates his child Jim as the beneficiary of his

401k. At age 75, Michael passes away and Jim inherits Michaels 401k now worth $5,446,504. Jim is 40 years old and is in his peak earning years, he will also be required to distribute the entire $5.4 million he inherited over the next 10 years. This additional income of about $540,000 per year pushes him into the highest tax bracket, resulting in a 38% tax on the inheritance. While Jim’s inheritance is still significant is has almost been cut in half because of taxes.

IS THERE A BETTER OPTION?

It’s important to note that saving to a traditional 401k can still be the right decision for certain situations. However, there may be better alternatives if one expects a high income in retirement.   

Roth 401ks– Employers often provide the option of Roth 401k contributions, enabling employees to contribute post-tax dollars. While Roth contributions reduce take-home pay more than pre-tax contributions, they offer significant advantages. Roth 401k funds grow tax-deferred and are exempt from RMDs. Inherited Roth assets are not taxable to heirs, though they must still follow the 10-year rule. If you can afford the lower take home pay and slightly higher tax bill from contributing after-tax dollars to your Roth IRA, they offer a highly tax-efficient approach to retirement savings.

The Hedge– We don’t have a crystal ball on future tax rates or RMD rules. To prevent the risk of under or over-saving in your 401k, a prudent approach is to divide your contributions equally between pre-tax and post-tax dollars. This strategy creates two retirement savings buckets with distinct tax advantages which will allow for easier income distributions throughout retirement.

Taxable Savings– Clients often prioritize saving in their 401k over contributing to a taxable account. We always recommend taking advantage of any matching offered by your company, but after that saving in a taxable account also has many advantages.

• Flexibility: Unlike a 401k or IRA, funds in a taxable account are not subject to early withdrawal penalties or contribution limits. You can access your money at any time without restrictions.
• Tax-efficient withdrawals: In a taxable account, you have more control over the timing and tax implications of your withdrawals. You can strategically sell investments to minimize capital gains taxes or take advantage of tax-loss harvesting to offset gains.
• No required minimum distributions: Unlike traditional IRAs, taxable accounts do not have RMDs. You are not obligated to withdraw a certain amount each year, allowing your investments to potentially grow tax-efficiently for a longer period.
• Potential for stepped-up cost basis: Inherited taxable accounts receive a stepped-up cost basis, which can reduce or eliminate capital gains taxes for your beneficiaries.

THE CAVEATS:

1. The Low Income, Post Retirement Window: If you have been successful financially and plan to retire “early”, the savings provided by a traditional 401k can be tax efficiently monetized before social security, pensions, and RMDs get triggered. This occurs in the sweet spot between 59.5 and whenever you start collecting social security.  This window provides opportunities to pull that income forward through Roth Conversions or taxable distributions, while they are early in retirement and in relatively low tax brackets.  This of course assumes tax brackets remain stagnant (which of course they won’t!)

• The Nerdy Tax Efficient Saver: There is a catch!  By contributing to a 401k, you have a lower tax liability, therefore you have more dollars saved at the end of the year. If you invested those into the stock market over the same multi decade as the 401k, you would end up with more overall after-tax dollars in your pocket.  In no small part because you will be paying capital gains, and not ordinary income taxes on those savings.  The same tax assumption applies here. 

THERE IS NO ONE SIZE FITS ALL SOLUTION

Flexibility is key when it comes to planning and saving. What may be suitable one year may not be the next, considering factors such as age, income, and career stability. It is essential to reassess your personal situation annually to determine the most efficient savings approach that aligns with your retirement and financial goals.

Maxing out your 401(k) for retirement savings may limit your options for managing your taxable income in retirement. Having a diversified portfolio that includes taxable accounts, Roth IRAs, or other investment vehicles can provide greater flexibility to control your income streams and potentially reduce your tax liability during retirement.

Most importantly, saving through any available means is the key to a successful financial plan.   It is crucial to assess your personal circumstances and determine the most suitable approach for you and your family.

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}