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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.
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?
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.”
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.
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.