The pandemic forced three million US baby boomers out of the workforce and into retirement. Did you also know that four out of ten people do not have a retirement plan in place? Ouch!
As reported in a Gallup poll: compared to 1990, when the average American retirement age was 60, it’s now 66. While the average lifespan is now 78.7 years, that’s around 12 more years to map out financially. So, if you’ve been worried about saving enough for retirement, leverage your 401(k).
Of course, there are multiple avenues to save, invest, and grow your nest egg, but let’s first offer a dose of reality. A recent survey shows the amount of Americans who have taken money out of a retirement plan early:
- 44% of ages 40 to 79
- 46% of people 40 to 49
- 53% for people 70 to 79
This is a growing trend, which we do not recommend if avoidable. Why? Because taking money out of a retirement plan early can activate financial penalties.
Humanity Wealth Advisors has empathy for those forced to dip into retirement funds early, which is why we offer retirement planning at Humanity Wealth!
This article serves as a guide to one strategy that may help you avoid pulling retirement funds out early. If you plan and leverage your 401(k) optimally, you shouldn’t have to.
401(k)s are the most common plan types offered to many American employees as part of their benefits package. With that said, it is critically important that you can take advantage and leverage this as you near retirement.
1. At A Bare Minimum, Always Contribute Up To Your Company Match
Most employers that offer their employees a 401(k) Plan will also provide a company match. This means that if you contribute, your company will also donate money to your account.
For example, a company may match 50 cents on the dollar up to 6% of your salary. This free money is only given if you also contribute. We highly recommend taking advantage of this at a bare minimum to optimize for your long-term retirement goals.
Do: Contribute up to your company match (at a bare minimum).
Don’t: Miss out on free money.
2. If Possible, Max Out Your Employee Elective Deferral Into Your 401(k)
The next level of prioritization aims to contribute the maximum amount you can contribute to a 401(k) as an employee. The IRS contribution limit for employee elective deferrals for 2022 is $20,500.
This means that you can defer $20,500 of your earnings from your employer and invest it in your 401(k), which is an excellent way to:
- Reduce taxable income (if choosing pre-tax 401(k))
- Get more money into the Roth Bucket (if choosing Roth 401(k))
- Ultimately put yourself on a fast track towards saving for retirement.
Do: Aim to contribute as much as you can each year, contributing a little more than the last. You will slowly see that you may be able to achieve the maximum contribution in no time. Stick to that amount until you retire.
Don’t: Avoid figuring out if it makes sense to contribute pre-tax, Roth, or a mix of both. It is okay to adjust these choices year-over-year or as your tax situation changes.
3. Take Advantage Of Catch-up Contributions (if over the age of 50)
In addition to the $20,500 contribution limit, there are IRS rules that allow employees over the age of 50 to contribute even more to their 401(k). For 2022, the IRS allows for a catch-up contribution of $6,500 if over 50. This means that an employee (50+) can elect to defer up to $27,000 of their income into their 401(k) for 2022.
Do: Take advantage of the catch-up contribution if you are age 50 or once you are 50.
Don’t: Forget to target the catch-up once you are eligible (over age 50).
4. Make Sure Asset Allocation Aligns With Your Time Horizon & Risk Preferences
Every 401(k) Plan will have a list of funds from which to choose. Not every 401(k) is created equal, but you have to work with what your company offers – no matter what.
Asset allocation has to do with the percentage breakdown of your portfolio, or in this case, your 401(k). The primary asset classes to consider are US equities, international equities, US fixed income, international fixed income, alternatives, and cash. While there are sub-asset classes to consider, we will focus on the major asset classes.
When reviewing the fund options, it is vital to ensure you have an understanding of the following areas that help investors land on a sensible asset allocation:
- Time horizon
- Risk preferences
When considering the time horizon, you would likely have more exposure to equities (or stocks) if you have a while to retire. In contrast, one year before retirement, you may have less equity exposure.
Risk preferences are your general propensity to take risks. Can you withstand some market volatility and uncertainty? Some investors can stick to the long-term plan, while others may want to move to cash if markets are choppy.
Ultimately, asset allocation will dictate your long-term returns the most within your portfolio. Making sure that your 401(k) allocation aligns with your time horizon and risk preferences can help you reach your retirement goals.
Do: Look at lower-cost funds for comparison and make sure to have a balanced, diversified approach to your asset allocation.
Don’t: Avoid your 401(k) altogether just because your fund options are limited.
5. Consider After-Tax Contributions & The Mega Backdoor Roth Conversion Strategy
Previously, we talked about employee elective deferrals within a 401(k). In addition, your company can also match and put additional money into your 401(k).
There’s another way to get more funds into your 401(k). Depending on your plan, it will be different, but this option is often called “After-Tax Contributions.”
In summary, a 401(k) Plan is called a Defined Contribution Plan with an annual contribution limit for 2022 of $61,000 (or $67,500 if over 50). This limit can be comprised of the following:
- Employee Elective Deferral (maximum amount: $20,500 or $27,000 if over 50)
- Employer Match
- After-Tax Contribution
For example, if your employer matched $18,000 and you (as the employee) deferred the max of $20,500, you would also be able to contribute $22,500 into the “After-Tax” bucket to get to the full defined contribution plan limit of $61,500.
Of course, cash flow has to make sense, but this can be a great way to put more money into tax-advantaged retirement plan accounts.
Mega Backdoor Roth
After-tax 401(k) contributions can convert into the Roth category within your plan. This helps get more money into the Roth tax-free bucket, optimizing tax diversification in retirement. This can typically include some tax consequences on the converted amount.
Do: Consider after-tax contributions into a 401(k) if you have access to income cash flow and are already maxing out everywhere else.
Don’t: Tie up all of your money into tax-advantaged accounts if you have early retirement goals or if there are other short-term or medium-term goals where money needs to be saved (or invested).
6. If You Own Company Stock Within Your 401(k), Be Aware Of NUA
If you hold company stock within your 401(k), it is critically important to be aware of NUA (Net Unrealized Appreciation). This is the difference in value between what you bought the company stock and its market value when it is distributed from a retirement plan (like a 401(k)).
The biggest takeaway is that the IRS gives preferential tax treatment to employees with company stock within their 401(k).
In short, if you are to keep the company stock within your 401(k) and eventually retire, then sell the shares of the company stock at some point, the NUA is taxed at a long-term capital gains rate (as opposed to ordinary income tax rates).
Do: Make sure to access all of your options when rolling over your 401(k) into a Rollover IRA if you have company stock held within the 401(k). You could forfeit the tax advantages of NUA treatment.
Don’t: Only hold employer stock within your 401(k). That leads to individual company stock risk and is not a well-diversified 401(k).
7. What To Know About 401(k) Loans
Some 401(k) Plans have a loan feature. However, the most crucial advice is to make sure that you can pay back the loan. The maximum amount you can take out is generally 50% of your vested account balance, or $50,000, whichever is less.
Do: If taking a short-term 401(k) loan, make sure to pay it back fast and on schedule.
Don’t: Leave a job with an unpaid 401(k) loan.
How Humanity Wealth Advisors Can Help
Offering some of the most affordable financial planning in the Bay Area, we can help by assessing your unique portfolio as a fee-only financial planner and with a fiduciary focus. We provide financial guidance no matter where you stand.
Serve multi-millionaires to financial planning newbies; we stand firm on the importance of retirement planning – so don’t wait to build a holistic, personalized financial plan.
Schedule your no-obligation appointment to get started! You deserve to prepare for retirement with confidence.
Asset allocation does not ensure a profit or protect against a loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
Humanity Wealth Advisors and LPL Financial do not provide legal advice or tax services. Please consult your legal advisor or tax advisor regarding your specific situation.