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Take It to the Limit?

Kyle McIntosh

LIKE SOME OF YOU reading this, I get a thrill from seeing my 401(k) contributions start at zero in January and tick up to the annual limit. I’ve been fortunate to maximize my contributions for most of my 24 working years. Last year, my contributions topped out at the 2021 limit of $19,500. In 2022, I’m aiming to make the maximum contribution of $20,500. For those age 50 and older, you can contribute up to $27,000 in 2022.

Up to now, I’ve considered it a no-brainer to contribute the 401(k) max. While I’m not making any changes this year, I am starting to think differently as I inch closer to retirement. If you’re in a similar situation, here are three factors you may want to consider when deciding how much to contribute.

First, if you’re in a low-tax bracket or live in a low-tax state, the tax benefit of contributing pretax dollars to a 401(k) account could be minimal. If you think your tax rate will be higher in retirement, you could be better off investing through a standard brokerage account and paying tax on your earnings now. You could also opt for a Roth 401(k) if your employer offers that option. Factors that might drive your future tax rate higher include a retirement account that’ll generate significant income or plans to move to a higher-tax state.

A second factor to consider is how you’ll invest the funds. If you will be conservative when investing 401(k) contributions, the benefit of deferring tax on investment earnings will be minimal. It may be worth paying the small annual tax bill and having immediate access to your savings.

Finally, you should consider how long the funds will be in the 401(k) account. If you have many years—or even decades—before you’ll withdraw the funds, contributing to the 401(k) will be beneficial from a tax standpoint. But if the funds will sit in the 401(k) account for only a few years, the tax savings on your investment earnings will likely be modest.

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R T
R T
10 months ago

I wonder why retirement/401K experts seem to emphasize so strongly with young people to use pre-tax dollars.

Their calculations always show the pre-tax person investing more because they pay less in taxes up-front. They generically discuss expecting lower tax brackets in retirement.

I’ve never seen anything discussing RMD in these scenarios.

I think it might make more sense to contribute after-tax in your 20s/30s and switch to pre-tax when a little older and in a higher tax bracket.

What do you think?

Carl Book
Carl Book
10 months ago

I’m the perfect example of someone who overdid the retirement plan contributions. I kept looking at my plan balance and failed to consider what my tax rates would be when RMD’s started. As things stand now, my future rates will be higher than when I was working due to the size of the RMD’s. It was very poor planning on my part; or I should say “lack of planning.”

Harold Tynes
Harold Tynes
10 months ago
Reply to  Carl Book

Consider converting IRA’s to Roth’s. Today’s tax rates on the conversion may be lower than paying taxes on RMD’s in the future. Also, consider the impact of IRMAA on the conversion math.

John Wood
John Wood
10 months ago
Reply to  Carl Book

I’d offer you the bright side, Carl. Tax Rates are lower now than they were in the past, so if you’re looking at higher taxes on your RMD’s, you must have an enviable retirement balance. Also, don’t discount the economic benefit you earned off of your deferred taxes for all of those years. For most taxpayers, our primary reduction strategies are our 401k deferrals, the standard deduction, and perhaps some mortgage interest and charitable contributions. I wouldn’t feel bad about maximizing one of the few tax reduction strategies that were available to you each year.

Devesh Shah
Devesh Shah
10 months ago

I found the column and the comments very thoughtful. Thank you.

UofODuck
UofODuck
10 months ago

Another factor to consider is the balance between your pre-tax retirement and other resources. If you have a majority of your savings in pre-tax retirement accounts, you will eventually have to pay taxes on every dollar that you withdraw from your retirement savings.

Its not necessarily the end of the world to have to pay taxes on your withdrawals, but for large unplanned expenditures, it helps if you have after-tax funds available that you can dip into before looking to your retirement savings.

Harold Tynes
Harold Tynes
10 months ago

Many discussions in Humble Dollar about diversification. One type that has not been discussed often is tax diversification. The dimensions that I see include IRA/401k tax deferred, Roth tax prepaid, and capital gains/dividends/interest. The state treatment of these items is different with each state and may change. The federal treatment is known for today but may change in the future. Let’s assume you have enough saved to draw down your investments and fund your lifestyle. You will pay regular federal tax rates for the tax deferred, lower capital gains rates for taxable account gains and dividends. The Roth taxation is a certainty for the initial investment, but unknown for future benefit. When you can’t predict the future taxation would it be advantageous to have a mix of savings across all the tax dimensions?

Kyle Mcintosh
Kyle Mcintosh
10 months ago
Reply to  Harold Tynes

Great comments Harold. Since this was a shorter blog post, I didn’t get into too much detail. But I fully agree with you that tax rate diversification strategies are very important. The way that our government spends – and this is not a political comment as both parties blow cash like there is no tomorrow – there could be a day when tax rates are much higher. As such, having at least some retirement cash in a Roth is a great way to go. Among other strategies, if ever there’s a year when your earnings will be down in your income earning years, the silver lining could be that it’s a great time to convert some of a rollover IRA into a Roth.

IAD
IAD
10 months ago

I always find the discussion regarding lower tax rates in retirement interesting, especially if one is married. People fall into the “rates have to rise”, “rates will remain low” or “no one knows” category. The one thing we know for sure that if married, at one point one or the other will pass. From then on, the survivor now pays taxes at the single rate instead of the married rate, which is a considerably higher rate.

The year following my father’s death, my mother had the RMDs from not only her 401k and IRA, but also both from my father. Since they didn’t have Roth’s, all the RMDs, pensions, and my mother’s social security are considered income. While she would have been in the 24% tax bracket had my father still lived, she is now in the 35% tax bracket.

If one is married, there is no doubt your tax rate will go up in retirement. The only way around it is to die with your spouse or to immediately re-marry, both options I think are less than ideal.

Mark Schwartz
Mark Schwartz
10 months ago

One consideration is to move some of your 401k fund contributions into an IRA and buy RealEstate with it. The IRS allows your IRA to own rental RealEstate as long you follow specific rules. This can be and has been one of the diverse ways to maximize my retirement funds. I used Equity Trust out of Ohio to manage the renral Realestate IRA portfolio and im in Georgia and it has been very successful towards allowing me to retire at 62.

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