401(k) Basics
Something very crucial but often overlooked, today we are going to talk about your 401(k) (or 403(b), TSP, etc.) Now I understand that when we hear someone talking about their 401(k), we are almost always bored to sleep, but stay with me for just a few minutes.
First, let’s talk about how your plan is set up. In 2021, you almost certainly have an option to elect a Roth option, and if you can, you should, especially if you are high earner. Some of you probably have heard of a Roth, but I’m sure many of you haven’t. The first thing you should do if you haven’t heard about a Roth is firing your financial professional, and then elect a Roth.
Essentially, the only difference between a Roth and a Traditional Deferral 401(k) is how you are taxed. As you already know, a traditional plan is contributed with pre-tax money. You contribute, and pay taxes at retirement, when you withdraw the money. A Roth however, you contribute with money that has already been taxed. You may be thinking, why would I want to pay tax now, when I don’t have to until later, when my tax bracket will almost certainly be lower? Here’s why: with a traditional deferral, you are taxed on every penny in the plan when you withdraw it. This includes your contribution, your employer’s contribution, as well as any gain you may have experienced, which will in all likelihood be substantial, if you contribute properly. For a Roth, you are only taxed at the time of contribution, not at withdrawal, meaning you aren’t taxed on any of the gain.
For instance, with a traditional plan, let’s say just for simple numbers sake, you contribute $100,000 tax free over your career. At retirement, you withdraw the money at a rate of 20% on $200,000, after gains in the market. We know this equates to $40,000 paid in taxes.
With a Roth, let’s assume you contribute the same $100,000, paying taxes at 30% at the time of contribution. In retirement, you again have $200,000, and pull it out tax free, meaning you saved $10,000 on taxes, since you paid 30% on your $100,000 contribution ($30,000), and got to withdraw all the gains tax free.
Another added factor that people often don’t think of is the tax rate. I’m not sure if we are all watching the same government spend our money with stimulus bills, but the tax rate is only going up. I think it is wise to get it out of the way now, because the 20% we spoke about earlier, may in fact be 30% by the time some of us retire.
As for the employer contribution, it is unaffected. You can still get your match; however, it will be contributed to traditionally, with pre-tax money. Think of it like having two buckets: one with money already taxed, withdrawn tax free (Roth); one pre-tax, contributed by your employer, which will be taxed at withdrawal (employer match).
Now that we’ve talked about the structure, let’s talk about allocation. Unless you are within 15 years of retirement, it is my belief that you should hold 100% equities, and here’s why: Over the last 100 years, the average rate of return for stocks in the US has been roughly 10%. Meanwhile, bonds have returned about 4%. I know we have all been told that bonds mitigate risk, and that’s true. But only over the life of the bond. A 10-year bond will only provide risk mitigation for those 10 years, not the following years. The majority of plan sponsored bond options are about 13 years, meaning they only provide diversification and mitigation of risk for that 13-year stretch. If you aren’t within 15 years for retirement, you are sacrificing almost double the return, for mitigation of risk during a time period you can’t withdraw money, without paying penalty. For this reason, it makes more sense to get the return until you are within a diversifiable window, which is roughly age 50, assuming you retire at 65.
There will be multiple market corrections in our lifetimes, whether you are a young professional or nearing retirement. Keep this in mind when you make any investment decisions.
-Colin Feller, President