Are you maxing out your employer retirement plan and find yourself asking, “now what?” If yes, keep reading because this one’s for you! And don’t worry if you aren’t because it’s actually quite uncommon. According to a Vanguard study, only 13% of their 5 million defined contribution plan participants (think 401(k) or 403(b) plans) currently maximize their employer provided retirement plans.
To clarify, maxing out your 401(k) or 403(b) contributions means that you are saving $19,500 to your plan (not including your employer match). If you are over 50 years old then the IRS allows you to contribute an additional $6,500 per year.
So how does this all apply to your situation? Well, the traditional school of thought is that we should save 20% of our total household income. Let’s use a hypothetical example and say you and your partner are both in your mid 30’s, working locally here in Rochester, MN at Mayo Clinic. Your household income is $250,000. Therefore, your household savings should be $50,000 ($250,000 household income x 20%). If you are both maxing out your 401(k)/403(b) plans then your total savings within these plans would be $39,000 ($19,500 employer plan savings x 2). This leaves your household with a shortfall in savings of $11,000 for the year (50,000 - $39,000; and let’s ignore employer contributions for simplicity sake). Again, congratulations for maxing out your employer retirement plans! But, where do you stash the rest of the $11,000 needed to get your savings to 20% of your income? Remember, if you aren’t saving it then you are most likely spending it… so let’s discuss some of your options.
EMERGENCY FUND
We advocate that our clients maintain an emergency fund consisting of 3-6 months of living expenses. As financial planners, we tend to lean toward the latter. What living expenses should be included in this calculation? Think necessary living costs that would need funding if you or your partner were to lose/stop employment - rent, mortgage, food, medication, transportation, insurance, and bills.
Your emergency fund should be held in a liquid account. What this means is that the cash is readily available should something happen. Examples of this type of liquidity include a checking, savings, or money market account. If you hold it in a longer term investment account you risk delayed receipt, tax implications, and penalties/fees.
TRADITIONAL OR ROTH IRA
Fund an IRA! There are income restrictions on contributing to a Roth IRA, but not a Traditional IRA. The only requirement to fund an IRA is that you or your spouse must have earned income. IRA contributions are limited to $6,000 per individual or $7,000 per individual older than 50. Income limitations exist on the ability to deduct contributions made to a Traditional IRA.
Roth IRAs are typically recommended for young professionals because it is assumed that your income will grow over time, so why not pay the tax now while you are in a lower tax bracket. When it’s time to start taking distributions from your Roth IRA, taxes have already been paid so the distribution is (likely) tax free. And remember, IRAs are designed for distributions in retirement, not for funding your next boat purchase!
Traditional IRAs allow you to defer taxes now (if your income level permits) and pay the tax upon your distribution years. Distributions from Traditional IRA funds are taxed at your ordinary income rate.
TAXABLE BROKERAGE ACCOUNT
I don’t care if you are just scraping by or not knowing where to put your dollars...open a taxable brokerage account! It’s too easy (and cheap!) to not have one of these. Not sure where to even start? Ask us. We are happy to point you in the right direction.
The main difference between taxable brokerage accounts and IRAs are the tax implications. When accessing funds from a taxable brokerage account you are responsible for paying capital gains tax (if you made money) on the difference between your cost basis and the value at the time of sale. For example, you purchased a stock for a total cost of $10,000 in 2015 and sold it in 2019 at a value of $30,000. That gain of $20,000 is taxed at your capital gains rate.
There are other tax implications that occur within a brokerage account. Those include realizing losses in an account, paying short term capital gains, or paying taxes on interest or dividends earned.
You can even open a taxable brokerage account and leave a portion (3-6 months of living expenses) in cash and invest the rest in stocks or bonds. This allows you to consolidate accounts rather than having a separate emergency fund account in one place and a taxable brokerage account somewhere else. Organization and simplicity is key when managing money!
COLLEGE SAVINGS
Do you have kids? And you’re still reading this blog? Wow, congratulations! What an accomplishment to maximize your employer retirement plan contributions, pay for child expenses, have additional savings, and still have time to read this. There is no better time than now to start planning for their future. According to US News, the average public in-state tuition is $10,116, the average public out-of-state tuition is $22,577, and the average private tuition is $36,801. Some of us are still paying our own student loans back, so how can we possibly think about saving for our children’s education? College costs are inflating on average by 8% per year. Think about what the price tag will look like in 18 years. I’ll save you the trouble of doing math...the average private tuition cost would be as much as $147,057 per year!
My intention here isn’t to scare you, but to simply get you to start thinking of the next generation’s expenses that you could fund today. If you want to read further into this topic, read Natalie’s blog on saving for your childrens' future.
AFTER TAX 401(k) OR 403(b) CONTRIBUTIONS
So you’ve contributed the $19,500 maximum amount to your 401(k) or 403(b) (aka - defined contribution plans). What if I told you that you could potentially save above and beyond the $19,500 maximum via after-tax contributions? IRS states that in 2020 the maximum savings allowed in this type of account is actually 100% of total compensation or $57,000 ($63,500 if over 50)! Confusing? Let’s break it down.
Your Contributions (tax-deferred, Roth, or both)
+Employee deferral: $19,500 ($26,000 including “catch-up”)
+After-tax contributions
Your Employer Contributions
+Employer matching contribution
+Employer profit sharing contribution
= Total Contributions
(cannot exceed $57,000 ($63,500 if 50+) -OR- 100% of total compensation, whichever is less)
Hypothetical Example:
Individual age: 35
Annual income: $180,000
Employer match: 5%
Profit Sharing contribution: 2%
Your Contributions (tax-deferred, Roth, or both)
+Employee deferral: $19,500 ($26,000 including “catch-up”)
+After-tax contributions: $0
Your Employer Contributions
+Employer matching contributions: $9,000
+Employer profit sharing contribution: $3,600
= Total Contributions: $32,100
This individual could potentially add another $24,900 into their retirement account! Their total contributions above equal $32,100. Therefore, if the maximum 2020 contribution equals $57,000, and they’re only at $32,100, they could tuck away another $24,900 for their future ($57,000-$32,100 = $24,900). Why is this so great? After-tax contributions are treated separately from your pre-tax employee deferrals, employer contributions, and profit sharing contributions. Your after-tax contributions are not taxed upon withdrawal (because as the name implies, you already paid taxes on these contributions). The earnings from these contributions are taxed at ordinary income upon withdrawal.
It gets even better. You may be able to convert your after-tax contributions to a Roth IRA account (tax and penalty free!). The earnings are different. It’s likely best for those dollars to remain in a tax deferred account like your pre-tax 401(k) or Traditional IRA. Disclaimer: everyone’s situation and plan is different. We recommend consulting with us and a tax professional to know what’s best for you!
The after-tax feature with employer retirement plans can be extremely advantageous. However, we see time and time again individuals not taking advantage of this! **Here is the big caveat...the after-tax contribution feature is plan specific. Therefore, it’s up to your employer to include it or not. If your employer doesn’t offer this feature we always recommend advocating for it!**
FIND ADVENTURE
The intention of this blog is to provide additional clarity on your savings options beyond your employer retirement account. I wouldn’t be reflecting our values and approach to financial planning if I told you to save, save, save and not enjoy your life. The reality is that if you are maximizing your employer contributions and achieving your savings goals, then you deserve to spend your money on what is important to your household. You work hard for your money, so we recommend enjoying some of it now rather than waiting until your later years. I’m not saying quit your jobs and retire at 35, but what I am saying is that life is too short to not fully experience it.
My favorite exercise to run through with clients is for each partner to share what he, she, or they would want to do with only 5-10 years left to live. Then we ask what would you be saddened by if you were given one day left to live. What were you not able to accomplish? You’d be amazed at the answers we hear! Our point in asking these questions is to encourage achieving some of these desires now, not later.
You should be extremely proud of yourself for maxing out your employer retirement accounts. These additional savings vehicles are a glimpse into what we have recommended to our clients. We all have unique situations that are vastly different, so we always recommend scheduling a complimentary consultation with us if you are interested in learning what we would recommend for you.
- Dan
Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.
