Individuals interested in maximizing the savings they have to live off of in their retirement years should be very focused on boosting the dollars they save while in their working years. The 401(k) plan is one of the primary savings vehicles to help them live well in retirement. And with the prospect of higher taxes and the fact that more traditional retirement savings vehicles are going away completely or about to experience severe stress given the coming rapid rise in retirees, the 401(k) could end up making or breaking your retirement. The prospect for higher market returns going forward is another key consideration. (For related reading, see Pick 401(k) Assets Like A Pro.)
TUTORIAL: 401(k) And Qualified Plans
Taxes Going Up?
In late 2010, Congress extended the Bush tax cuts for another two years. However, it's difficult to see the cuts extended beyond that, consider the massive federal deficit. The cuts included a rate as low as 10% for lower income earners, as well as a lowering the highest tax rate from 39.6% to closer to 39.1%. It also lowered the long-term capital gains tax to 15% from 20% and placed a 15% rate on most dividends. Taxes on dividends used to be taxed at ordinary income rates, meaning as high as 39.6% prior to the tax cuts.
This and other pressures to increase taxes only increase the appeal of investing in a tax-deferred vehicle such as a 401(k). And since contributions are made with pre-tax dollars, it reduced taxable income and can therefore lower your tax rate, especially if you are at the cusp of bumping up into a higher tax bracket. While investments are in a 401(k), there are no capital gains taxes or taxes on income, be it from dividends on stocks or bond coupon payments.
Defined Contribution Plans
Over time, investing decisions have increasingly been placed on individuals, with the 401(k) retirement plan becoming one of the primary savings vehicles. This type of plan is known as defined contribution, which signifies that it is up to the employee to determine contribution levels and make the right asset allocation and investment decisions to save up for retirement. (To learn more, read Is Your Defined-Benefit Pension Plan Safe?)
The shift to these plans has taken place over the past several decades. Previously, defined benefit plans, where the employer saved on behalf of employees and paid them a pension based on years of service worked and how high they rose in the corporate ranks, were the primary savings vehicle. Years of belt tightening and the desire to offload the risk and responsibilities for providing income for retirees have decreased the popularity of defined benefit plans. And with an aging of America taking place, retirement obligations are set to skyrocket as Baby Boomers reach retirement age. 2011 marked the year in which the first vintage of roughly 76 million Baby Boomers reached the 65 retirement age.
An older U.S. demographic is also going to seriously stress the Social Security Administration that was created in 1935 to provide a government program to provide living funds for individuals after they stopped working. Back when Social Security was created, there was an estimated 17 workers for every retired person, meaning there was a huge difference between those paying into the system from those withdrawing. This ratio is projected to plummet to 2.1 by 2035, and could pose a serious hurdle for the government to make payments to all of the retired individuals in the country.
Potential fixes to the Social Security system include raising the retirement age, reducing benefits or otherwise restricting eligibility requirements. In other words, it serves as another reason to boost your own 401(k) contributions and take better control of your own retirement plans.
A final argument for boosting contribution rates is that market returns have been dismal. A number of studies have detailed that investment returns tend to improve after a difficult decade of performance. Professor Richard Sylla of New York University has studied stock market returns going back more than a century and has concluded that stocks have a solid chance of returning to posting 6.5% annual real returns, as they have historically. His indications are that the depths of the credit crisis and Great Recession in 2008 and 2009 marked a bottom, and that return prospects are much more favorable for the coming decade. (To learn more, read how to Achieving Better Returns In Your Portfolio.)
The Bottom Line
Given the shift away from traditional retirement living vehicle,s including defined benefit plans and Social Security, it will definitely pay to boost 401(k) plans and take more control over your own retirement needs. Pressure towards higher tax brackets as well as less favorable capital gains and dividend tax rates also enhance the appeal of tax-deferred savings vehicles. Finally, the potential for higher market returns, especially those of stocks, could be worth trying to take extra advantage of.
At worst, government and employer retirement vehicles won't exist in the coming decades. If that ends up being the case, individuals will have no choice but to live off of their own savings. This is unlikely, but having higher levels of personal savings can add a further cushion and improve your standard of living in retirement. It is also going to remain the primary savings vehicle for millions of Americans going forward. (Do you know when you're going to retire? It might not be as soon as you think. Read The New Retirement Age.)