The most popular retirement plan for employees was invented by accident. The 401(k) was added to the IRS tax code in 1978 to address uncertainty about the tax status of profit-sharing plans. As it turned out, the 401(k) provision could be extended to cover retirement plans not initially envisioned by the law’s authors. For example, the plan could be extended to cover money deducted from a paycheck, regardless of whether the business turned a profit.
By the early 1990s, corporate America was moving away from its pension responsibilities, as a tax-sheltered retirement system based on employee contributions became the norm. Companies believed they could exit the pension business, thereby giving employees the responsibility for their retirement.
As you can see, 401(k) plans have only been the primary source of retirement funding for business owners and self-employed professionals for a relatively short period of time. Until then, traditional defined-benefit plans, especially profit-sharing, were their primary retirement vehicles. Though unintended, the 1978 rules did usher in an attractive tax-deductible path. But is having a 401(k) plan enough to successfully fund a retirement? Or should employees and business owners be taking additional steps to make certain their retirement planning strategies are complete? If so, what are the additional steps?
Is Your Retirement Savings on Track?
The first step is to calculate the amount you need to save each year to adequately fund your retirement. Sadly, most owners and employees have not performed this important calculation and are simply contributing to their plan at some predetermined level with little or no connection to their long-term needs. This creates a misalignment between how much is being saved and the investor’s ultimate retirement goals. (For related reading, see: Retirement Planning: How Much Will I Need?)
Today the 401(k) plan has largely replaced company pensions and other types of defined-benefit plans. Generally speaking, a defined-benefit plan guarantees a given amount of monthly retirement income, whereas a defined contribution plan, such as a 401(k), allow individuals to choose their own retirement investments with no guaranteed minimum or maximum benefits.
Because of their guarantees, defined-benefit plans are reviewed annually by actuaries to ensure the plan’s assets (i.e. current investments and future employer contributions) are keeping pace with its liabilities (i.e. promised future retirement payments). This is to make certain the plan is fully funded and has the assets to deliver the promised benefits.
Participants of a 401(k) should apply the same steps to determine whether or not their current investments and rate of savings are enough to match their retirement needs. Each year the 401(k) assets and the amount the participant is saving should be reviewed to ensure they are on track to achieve their retirement goals. An actuary is not needed to do perform this calculation, someone familiar with the math is.
Should You Change Strategies?
To become fully funded, owners may need to customize the 401(k) plan. Today over half of all business owners and self-employed professionals are behind in saving for retirement, and a large majority (69%) do not have a specific savings goal in mind. Carefully reviewing their current status (see above) will help owners set a savings goal. But what if their current plan does not allow them to save as much as needed? (For related reading, see: How Can an Entrepreneur Save for Retirement?)
Let’s say, for example, the owner fell behind in his or her retirement savings and needs to save $53,000 in 2016 to be 100% on track to meet the spending needs of retirement. Naturally, the owner would prefer to make a tax-deferred contribution, however the current 401(k) plan design only allows a deductible savings limit of $25,000. By having the profit-sharing plan amended, the deductible contribution in 2016 would increase to $53,000. In this case, changing the plan allowed the owner to fully fund the 401(k) in a tax efficient manner.
Having worked with business owners and self-employed professionals for over 20 years, I am convinced that they need to fully take charge of their retirement. Accountants don’t necessarily concern themselves with whether enough is being saved. Plan administrators may not be aware of the specific objectives. Insurance agents have a bias toward certain types of products. Even investment advisors who are paid a commission may offer “suitable” options that are not fully connected to the owner’s goals.
Just as owners have taken control over their working life, they should take the reins of their retirement planning. First, by setting up their own defined contribution plan, such as a 401(k). Then, by having the plan reviewed each year to make certain it is fully funded. And finally, to adjust the plan as needed so the annual funding needs can be met.
(For more from this author, see: The Hidden Costs of Too Many Retirement Accounts.)
DISCLAIMER: This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. Past performance of all investments do not guarantee future results.