Arguably, the most important financial decisions you will make revolve around your retirement accounts. Sure, buying a home is a big decision, but if you make the wrong retirement decisions now, having enough money to live on during your later years is nearly impossible.
That’s why you have to understand how your retirement accounts work and how to maximize their effectiveness. You don’t have to be an expert, but you should aim to understand enough about your financial future to know where to direct your money.
The Lack of Retirement Savings
Study after study decries Americans' lack of or limited retirement savings. If you’re like the majority of people, you need to save aggressively.
“With millions of Americans behind in their retirement savings, it is important not only to save, but to save more each year,” says Greg McBride, Bankrate.com chief financial analyst, and a CFA.
For many retirement savers, their 401(k) is their main retirement savings vehicle. In 2018, you can contribute up to $18,500 to your 401(k) plan. To do that, you will have to contribute $1,541.66 per month. If you’re 50 or older, you can contribute $6,000 more—up to $24,000 in 2018. That's a monthly contribution of $2,000.
Contributing that much may not be possible, but if it is, it might be a good idea.
It Lowers Your Tax Bill
“Participants who make tax-deferred contributions to their 401(k) are allowed to write them off of their income come tax time," says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors."
"You will eventually pay taxes once you withdraw funds in retirement," Hebner adds. "But it may be advantageous to make tax-deferred contributions, especially if you expect to find yourself in a lower tax bracket in retirement."
If you contribute the full $18,500 and fall into the 24% tax bracket for 2018 (annual income between $82,501 and $157,500), that's $4,440 you won't owe to Uncle Sam. If you’re 50 or older and making catch-up contributions, you could save as much as $5,760. It’s hard to say no to savings like that.
There’s Probably a Match
Not all financial planners believe you should max out your 401(k) savings—some believe it isn't a good idea. But most do agree that you should contribute up to your employer match. You’re probably getting about 50 cents on the dollar for a maximum of 6% of your salary if you fall into the average.
That’s the equivalent of your employer giving you a check for around $1,800 for a worker making $60,000 per year. And don’t forget that over time, that $1,800 will grow. That makes your employer’s contribution worth a lot more than $1,800. Don’t turn down free money.
You Don’t Have to Be an Investing Pro
Once you contribute up to your employee match, you have choices to make. Many 401(k)s have mediocre investment options. You’re probably forced to choose among a limited number of mutual funds with higher fees and lower performance.
You may read articles or receive well-meaning advice to “evaluate the available funds in your plan” or “speak to a financial advisor” – good recommendations if you actually know how to do it or whom to consult.
But no matter how bad the available choices in your 401(k) are, they’re all better than doing nothing at all. If you barely understand anything having to do with investing and finance, and you aren’t going to pay for a financial advisor, maxing out your 401(k) is the best choice. Not because it’s necessarily the best way to save, but because it’s better than doing nothing at all.
Most 401(k)s have at least a few low-cost index funds as their offerings. If you’re young, put a lot of your money into a stock index fund. As you get closer to retirement, shift the majority of it to a bond fund. Some people say to allocate by your age. If you’re 30, keep 30% of your retirement funds in a bond fund. If you’re 60, make it 60%. If you don’t want to mess with allocation, consider a target-date fund.
“Target date funds in a 401(k) can be a very good investment. They provide investment diversification without having to choose each individual investment. They also trend towards being more conservative closer to the selected date. The combination of these benefits can make this a one-stop-shop for 401(k) participants,” says David S. Hunter, CFP®, president of Horizons Wealth Management, Inc., in Asheville, N.C.
Maxed Out 401(k): Here's What to Do Next
Now, if you’ve contributed the maximum to your 401(k) but still want to save additional money for retirement, here are some options to consider beyond your 401(k).
Everyone is eligible to contribute up to $5,500 to an IRA (as long as their earned income is at least that much) in 2018. Those 50 or over can add another $1,000. Certain IRA options do have income restrictions, however. Deducting a traditional IRA contribution is subject to income ceilings if you are working and covered by a retirement plan at work.
In this case, for single taxpayers, the deduction phase-out starts at modified adjusted gross income (MAGI) of $63,000 and goes away completely with a MAGI of greater than $73,000 for 2018. For those who are married and filing jointly, the phase-out starts at $101,000 and goes away for a MAGI above $121,000. (Read about IRA contribution limits in 2018.)
Contributing to a Roth IRA also entails income limitations and phase-outs. For single taxpayers for 2018, the income phase-out starts at a MAGI of $120,000 and goes away for income in excess of $135,000. For married taxpayers filing jointly, the phase-out begins at a MAGI of $189,000 and ends completely above a MAGI of $199,000.
For those who do not qualify all or in part to make their traditional IRA contribution on a pre-tax basis, they can still make a non-deductible IRA contribution up to the contribution limits. Their investments will still grow on a tax-deferred basis. Upon withdrawal, they will need to have kept track of their non-deductible contributions.
Health savings accounts, or HSAs, are available to those with a high-deductible health insurance plan whether via their employer or one purchased independently. Contributions are made on a pre-tax basis and, if used for qualified medical expenses, withdrawals from the account are tax-free. Additionally, money does not have to be withdrawn at the end of each year, so it can function like another retirement plan. This is a great way to save for health care costs in retirement. The contribution limits for 2018 are $3,450 for an individual and $6,900 for a family. The catch-up contribution for those who are 55 at any time during the year is an additional $1,000. (Read more about the pros and cons of health savings accounts.)
Taxable investments are a viable way to accumulate retirement savings. While dividends and capital gains are subject to taxes, long-term capital gains (for investments held at least a year) are taxed at preferential rates. If you have maxed out your 401(k), be cognizant of asset location, i.e., which investments are held in taxable versus tax-deferred accounts.
Annuities often get a bad rap and, frankly, many annuity contracts deserve it. However, a variable annuity can provide another vehicle to allow after-tax contributions to grow on a tax-deferred basis. Variable annuities generally have sub-accounts which are similar to mutual funds. Down the road, the contract holder can annuitize the contract or redeem it in total or in part. The gains are taxed as ordinary income, and far too many contracts have onerous fees and surrender charges, so if you are considering a variable annuity, do your homework before writing a check.
401(k) Planning: The Bottom Line
If you have the talent, time to learn and are a little adventurous, you could remodel your home for a fraction of the price of having a pro do it for you. But if you’re like most, you don’t have the time to learn. The same holds true with retirement planning. There are potentially more profitable ways to invest your retirement funds – IRAs and traditional brokerage accounts, among them.
But for the sake of your future, putting your money to work somewhere is better than nothing. With a minimum amount of knowledge and research, you can learn about index funds. They come with low fees and they’re easier to understand than many other mutual fund types. And if you are a diligent saver who has maxed out your 401(k) contributions, there are other avenues for your retirement savings that can be considered.
(Read more about the best strategies to maximize your 401(k).)