How Much Should You Contribute to Your 401k or IRA?
Insights | by Sharon Winsmith
If you find yourself asking how much should you contribute to your 401k or IRA, this article will give you some new insights you may not have heard before.
TABLE OF CONTENTS
- 401ks and IRAs are Old News
- Tax Disadvantages of 401ks and IRAs
- Other Non-Tax Disadvantages of 401ks and IRAs
- The One Time You Should Contribute to a 401k
- How Should I Be Planning for Retirement?
- Should you do a Backdoor Roth-IRA Conversion in 2022?
- The Tax Impact of a Backdoor Roth-IRA Conversion
- How to Do a Backdoor Roth-IRA Conversion
- Tax Reporting for Backdoor Roth-IRA Conversions
I’m going to skip to the good part → The answer is $0.
401ks and traditional IRAs have long been the favorite mechanism for saving for retirement. For many years, people have operated under the false belief that it is always best to maximize contributions to your retirement plans. However, there are many issues with these plans and it is quite possible you are doing yourself a great disservice by maximizing the amount you contribute each year.
From both a tax perspective and investment perspective, there are a number of issues with traditional retirement plans such as 401ks and IRAs.
It is important while reading this article to keep in mind that we are covering traditional IRAs and 401ks. Many of the disadvantages mentioned below do not apply to Roth-IRAs or Roth-401ks.
The key point to emphasize is that there are other options that can accomplish the same objectives as 401ks and IRAs that are better from both a tax and investment perspective. Get in touch with us today for a tax strategy plan to determine what approach makes the most sense for you.
401ks and IRAs are Old News
The right way to think about taxes and investing is that you want to have a strategy in place where you pay tax on the seed and not the harvest. It is better to pay tax on the money you make today and invest it in a way where you will pay as little tax as possible in the future on the gains that money makes over time.
This is the opposite of what a 401k and IRA does.
That doesn’t mean you don’t want to do tax planning to reduce the taxes you pay on the money you earn now. We work with all our clients to implement current tax reduction strategies. However, 401ks and IRAs do not reduce taxes. They just defer the tax that you will ultimately have to pay once you access the cash inside your plan. This is not tax planning!
Tax Disadvantages of 401ks and IRAs
The general idea is that you avoid paying tax today on amounts contributed to your plan so that it can be invested on a tax-free basis and grow over time. Then, when you retire, you take distributions to fund your living expenses. This is all of course based on the premise that when you retire, you will be in a lower income tax bracket.
There are a number of issues with this line of thinking.
Tax rates are likely to increase
We cannot predict the future. It is impossible to guess what tax rates will be when you retire. However, with the current amount of debt and the state of social security in this country, it is probably a safe assumption that tax rates will increase over the next few years.
I have yet to meet a tax professional who thinks there is a good chance tax rates will go down in the future. Some tax practitioners, such as David McKnight, the author of The Power of Zero, have argued that tax rates will double in our lifetime. Given the likelihood rates will rise, it might be better to pay tax today rather than in the future when rates are higher.
You should not plan to be in a lower income tax bracket when you retire
If you are planning to have a level of income at retirement that will result in you being in a lower income tax bracket, you may want to re-examine your investment objectives.
The only reason someone would earn more income when they are in their 20s and 30s setting up a retirement account vs. when they are 65 or older would be because of poor investment choices and planning. While you may find yourself making slightly less money right after retirement as compared to right before, which may have been the height of your career, this should not hold true throughout the majority of your career.
A better approach might be to assess ways to structure your operations and investments today in a tax-efficient manner instead of planning to make less money when you retire. A good wealth building plan does not result in you making less money in the future than you are today.
Penalty for early withdrawals
As a general rule, you are not permitted to access the money contributed to a 401k or IRA until you reach retirement age. If you do take early withdrawals, you will be subject to a 10% penalty unless an exception applies. Therefore, you have a limited ability to access these funds should you ever need additional cash before retirement.
Not being able to access the cash inside the plan significantly inhibits your ability to implement some of the best tax planning strategies.
Ordinary income tax rates apply to capital gains
All income in a 401k or IRA is taxed at ordinary income rates, regardless of the type of income. This means that all cash contributed to the account and any gains from investments made in the account are all going to be subject to tax at the higher ordinary income rates.
The fact that you pay tax on the gains at ordinary income rates also makes it difficult to do estate planning. We discuss the estate tax issues with 401ks and IRAs more below.
Also, a good investment strategy would set you up such that you pay little to no tax on the gains the money invested makes. This is what we mean when we say it is better to pay tax on the seed than on the harvest.
Estate tax implications
Retirement accounts are probably the worst vehicle for transferring wealth to your heirs. There are a number of adverse estate tax implications triggered with these accounts.
- Heirs are subject to full tax at ordinary income tax rates on their share of the account inherited. Rather than getting a step-up in basis in the assets inside the account, such as a step-up to the fair market value of stock on the date of death, your heirs will pay tax on 100% of the income in the account.
- As mentioned above, the entire value of the account, including investment gains, is subject to tax at ordinary income tax rates.
- The heirs are generally required to take mandatory distributions and pay tax over a short period of time.
- The total amount in all retirement accounts will apply against your estate tax exclusion.
- There is limited flexibility to do estate tax planning with these accounts without triggering the deferred tax.
Other Non-Tax Disadvantages of 401ks and IRAs
Lack of predictability
If I ask you how much your net worth is, do you remember to subtract out the tax that will be due on distributions from your retirement plans? The answer is invariably no. Everyone forgets to take into account that you still have to pay tax on that money.
The real answer is that you have no clue how much money is inside your 401k or IRA. This is because you have no clue how much is really your money vs. how much you have to pay to Uncle Sam.
There is no way to predict what tax rates will be or what tax bracket you will be in when you retire and start to take distributions from your plan. When the tax savings apply at the time money is contributed instead of when distributions are made, you are subject to uncertainty as to what amount in the plan is really your money and what amount belongs to the government.
Fees, fees, and more fees
These plans usually carry various different types of fees that drastically reduce the amount you are able to save and earn through compounding over time. Typical fees for managing a 401k can be 2%-3% or higher in some cases.
Unless you have a self-managed account, you will also be paying fees to financial advisors to manage the account. It’s no secret that I am not a fan of using financial advisors.
Lack of flexibility in investment options
The types of investments that can be made through a 401k or IRA are limited in most cases. Use of a Roth-IRA typically provides more flexibility to invest in assets other than stocks and bonds, such as real estate, which may not otherwise be possible through a 401k plan.
401ks and traditional IRAs have required mandatory distributions once you reach a certain age. Therefore, regardless of whether you need the money, you are required to take a distribution from your account and pay the associated tax. Other retirement planning tools such as Roth-IRAs do not have mandatory distribution requirements.
We have cutting edge strategies for reducing taxes for our clients. However, there is very little planning that can be done to reduce the taxes due on required minimum distributions.
A common problem I see is high net worth individuals accumulating so much money in their retirement plans that they end up in the highest tax bracket as a result of the annual required minimum distributions. You may be surprised at how much the value of your 401k or IRA can grow after several years of compounding. There is little to no flexibility to do any planning to reduce the tax you will pay in those situations, at least not if you don’t want to contribute all of the cash to charity.
The One Time You Should Contribute to a 401k
Notwithstanding the many disadvantages discussed above, you should still consider contributing to a 401k if your employer provides matching. Employer matching is free money and it would be hard to justify not taking advantage of free money in this case.
How Should I Be Planning for Retirement?
A Roth-IRA is the opposite of a 401k or IRA. You pay tax on the money you contribute to a Roth-IRA now and any future gains that money makes are exempt from tax.
Using Roth-IRAs is usually a better idea than using traditional 401ks or IRAs. However, the ability to contribute to a Roth-IRA is subject to limitations based on the level of income you make. Therefore, if you are a high earner, you may not be able to make annual contributions to a Roth-IRA account.
If you are subject to income limitations and cannot contribute to a Roth-IRA, it may be possible to do a backdoor Roth-IRA which would allow you to rollover funds in a traditional IRA to a Roth-IRA. Read more below about backdoor Roth-IRA conversions.
In some cases it may be possible to use a Roth-401k instead of a traditional 401k.
Other Retirement Saving Strategies
If you are subject to limitations and cannot otherwise contribute to a Roth-IRA or Roth-401k, the good news is that there are other mechanisms available that can accomplish the same objectives. There are other strategies that can achieve the same tax benefits if structured properly. We cover these strategies in detail in our tax strategy plans.
Should You Do a Backdoor Roth-IRA Conversion in 2022?
You can do a backdoor Roth-IRA regardless of how much money you make, at least under current law. Therefore, a common tool the wealthy use is to contribute money into a 401k or IRA and then do a backdoor Roth-IRA or a series of backdoor Roth-IRAs.
If you are considering doing a backdoor Roth-IRA, this may be your last chance. There have been recent proposals to eliminate the ability to do a backdoor Roth-IRA or limit the situations where they are allowed. For example, some earlier versions of The Build Back Better Act contained provisions to eliminate the ability to do backdoor Roth-IRAs in the future.
A good time to do the backdoor Roth-IRA conversion is also when the market is down. This is because the value of your account is subject to tax in full. Therefore, if you can do the conversion on a day when the account value drops (such as from a downturn in the stock market), you can lower the tax bill that you have to pay.
The Tax Impact of a Backdoor Roth-IRA Conversion
There are a few key points to understand before you do a backdoor Roth-IRA.
- You will pay tax on the entire amount of money you rollover into the Roth-IRA
The money you contributed to your 401k or IRA was on a pre-tax basis. That means you haven’t paid tax on those earnings yet. Because Roth-IRA contributions are made on an after-tax basis, you are required to pay tax on the full amount that you are converting.
That means you might have a pretty big tax bill in the year you do the backdoor Roth-IRA.
- You cannot use money inside the 401k or IRA to pay the tax due on the conversion
When you do the Roth-IRA conversion, you must rollover the full amount inside your 401k or IRA into your Roth-IRA. If you don’t rollover the full amount, you will be subject to a 10% penalty on the amount withdrawn. This means you can’t take a distribution to pay the tax due on the conversion.
Make sure you have enough cash on hand to pay the tax due in the year you do the rollover or else you will have to pay a pretty big penalty.
How to Do a Backdoor Roth-IRA Conversion
You can do a backdoor Roth-IRA with a current Roth-IRA you already have set up or you can set up a new Roth-IRA to do the conversion. You can also do multiple backdoor Roth-IRAs over your lifetime. See the steps below for how to do a basic backdoor Roth-IRA conversion yourself.
Optional Pre-Step: Set up and/or make a contribution to a 401k or IRA. [Skip if you already have sufficient funds inside an existing 401k or IRA]
Step 1: Set up your new Roth-IRA through an online brokerage company such as Etrade. [Skip if you already have a self-directed Roth-IRA]
Step 2: Make a distribution from your 401k or IRA directly to your Roth-IRA. The transfer can usually be done electronically online. However, in some cases you may need to get a paper check issued to you in your name from your 401k or IRA company and then deposit that check into your Roth-IRA account. You should immediately deposit the check once you receive it or else you could face stiff penalties on the full amount in your retirement plans.
Step 3: Close your old 401k or IRA unless you want to keep open the option to do more backdoor Roth-IRAs in the future.
Step 4: Pay the estimated tax due on the rollover. You will want to make an estimated tax payment for the tax that will be due in the quarter during which you do the backdoor Roth-IRA conversion.
Step 5: Repeat the process if desired. You can do multiple backdoor Roth-IRAs if you have multiple different retirement accounts. You can also do more backdoor Roth-IRAs in future years.
If you have a plan through your employer, such as a company-sponsored 401k, you probably want to contact your plan administrator or HR department before doing the conversion. There can be restrictions on when employees can do backdoor Roth-IRAs from their 401ks in some cases.
Tax Reporting for Backdoor Roth-IRA Conversions
The Form 1099-R should have an amount in Box 1: Gross Distribution. This amount should equal the total amount you rolled over from your old 401k or IRA into our Roth-IRA.
There may or may not be an amount in Box 2a: Taxable Amount. If this box is blank, Box 2b: Taxable Amount Not Determined will likely be checked. In any event, the entire amount in Box 1 is taxable and should be reported on both Line 4a and Line 4b of your Form 1040: U.S. Individual Income Tax Return.
Please note that Winsmith Tax is not a financial advisory firm and is not authorized to provide financial investment advice. We encourage you to do your own independent research before making any investments or changes to your retirement plans.