Childcare & Employment Outcomes

  • Recent research likely understates the impact of children and lack of childcare on the economic recovery.
  • Many people with children may be underemployed and hours worked should be a key economic variable in a study of the impact of children on employment outcomes.
  • The impact of children and childcare on employment outcomes is concentrated on the part of the workforce that is of child-rearing age.  An analysis including people who are older and retiring will understate the impact of childcare on employment outcomes.
  • Additional research should consider multivariate models based on repeated cross sections and on longitudinal datasets.  The research should consider multiple existence of children definitions and educational attainment groups.

In a recent article, Jason Furman and coauthors argue that lack of childcare had only a small impact on the U.S. jobs recovery at the end of the COVID pandemic.    

Furman’s focus is on the change in the employed to population ratio for people with children under 13 and for people with no children over 13.  He finds a small decrease in labor force participation for women without a bachelor’s degree but no impact for any other group.

The research paper is narrowly focused on labor force participation and on a single definition of households with children.   Several additional tests are needed.

  • Many people without childcare are employed part time and would like to work additional hours.  It would be useful to examine how the pandemic impacted hours worked and underemployment for people with and without small children. My hypothesis is the existence of children of certain ages has a larger impact on underemployment than on labor force participation or unemployment.
  • The article does not document a pre-pandemic baseline on the impact of children and childcare on employment patterns.  It is likely that in normal times many people with children were already out of or marginally attached to the workforce.
  • Furman and coauthors consider only one classification of people with children — at least one child under 13.  Other existence of children variables including a child not yet in school, a school-age child, and multiple children in certain age groups should be considered.     
  • Furman and coauthors consider the impact of two education groups – no bachelor’s degree and bachelors or above on the impact of childcare on labor market outcomes.  It would be useful to consider three groups – less than bachelor’s degree, bachelor’s degree, and above bachelor’s degree.   I suspect this partition will show a significant impact of children on labor force outcomes for the large cohort of people ending their educational career with a bachelor’s degree.  Additional education beyond a four-year degree may reduce the impact of children on labor force outcomes.
  • The bivariate results presented by Furman and coauthors can be misleading because of omitted variables.   The bivariate framework does not allow for consideration of multiple child-existence variables or multiple education groups.  (See two comments above.). The bivariate framework also does not account for the impact of age on workforce outcomes and the interaction of an age and children on work outcomes.  
  • An analysis of the population in peak working years age 26 to 50 is likely to show a larger impact than an analysis of the entire population.  Older workers who are retiring may be out of the workforce regardless of whether they have children.  Furman’s finding that the impact of children on employment outcomes is small may be the result of the existence of a large number of older workers who are leaving the workforce.  The pertinent population for this question is workers of child-rearing age only.
  • The speed of the recovery and the impact of childcare on the labor market is likely to differ across industries.  Labor shortages have been most pronounced in restaurant and hospitality industry.  It would be useful to determine if the impact of childcare on employment and the labor market recovery is larger in some industries than other industries, especially since certain industries have a more pronounced labor shortage and are more highly dependent on female workers with young children.
  • The CPS can be used to track individuals over a period of time.  It would be highly useful to use longitudinal CPS data to compare month to month changes in labor market outcomes – fully employed, unemployed, underemployed, non-participant, from month to month.

Concluding Thoughts:  The analysis by Furman and coauthors likely substantially understates the impact of childcare on the economic recovery.  Much more analysis on this topic is needed.

Jason Furman, Kearney, M., and Powell, W. How much have childcare challenges slowed the US jobs market recovery.

Julia A. Rivera Drew, Flood, S, and Warren J.R. Making Full Use of the Longitudinal Design of the Current Population Survey:  Methods for Linking Records Across 16 Months


Conventional vs Roth Retirement Accounts

Some Tips on Saving and Distribution Strategies

  • Distributions from Roth retirement accounts are not subject to federal income tax, are often not subject to state income taxes and reduce the amount of Social Security benefits subject to tax.
  • People in low marginal tax brackets should choose to contribute to a Roth rather than a conventional plan and should covert conventional accounts to Roth accounts.
  • The conversion of conventional to Roth often requires workers roll over 401(k) plans to IRAs.
  • Non-deductible contributions to traditional IRAs can be converted to a Roth IRA without paying tax. 

Introduction:   Workers today have a choice between saving for retirement through a conventional or a Roth retirement. Both conventional and Roth retirement accounts allow investors to defer tax on gains from their account until funds are disbursed.   However, there are significant differences between the two types of retirement plans.

  • Contributions to most conventional retirement plans are made on a pre-tax basis and are not taxed during the year the contribution is made.  Contributions to Roth accounts are after-tax and fully taxed in the year the contribution is made.
  • Funds disbursed from the conventional account are fully taxed when disbursed. Funds disbursed from the Roth account are untaxed after age 59 ½.  
  • Funds distributed from a conventional retirement plan are part of adjusted gross income (AGI) and their inclusion in AGI can increase the portion of Social Security benefits subject to income tax.   Funds distributed from a Roth IRA are not included in AGI and do not result in an increase in Social Security benefits subject to income tax.
  • All funds disbursed from a conventional retirement account prior to age 59 ½ are subject both to income tax and a 10 percent penalty.   Withdrawals of contributions from a Roth account prior to age 59 ½ are not subject to penalty or tax because the funds were fully taxed at the time of the contribution.  Early withdrawals of investment income from the Roth account are subject to tax and penalty.

Most workers fund their retirement plan through a 401(k) or similar defined contribution plan at work.   Workers at firms that do not have access to a retirement plan through their employer may fund their retirement through an Individual Retirement Account (IRA).  Firms can offer either a conventional or Roth 401(K) plan and individuals can choose between a conventional or Roth IRA.  Some workers choose to invest in both their firm-sponsored retirement plan and an IRA. 

The conventional vs Roth choice for people who do not have access to an employer-sponsored plan depends primarily on potential tax and financial situations during working years compared to potential tax and financial situations in retirement.   

The conventional vs Roth choice for people with access to a firm-sponsored retirement plan is more complicated.    The choice depends on the characteristics (fees and employer match) of the firm-sponsored retirement plan and the availability of a Roth option.  In some cases, it makes sense for a worker to maximize the employer match available from the firm-sponsored retirement plan and invest additional funds through an IRA.

This memo provides several tips on how to save through retirement plans during working years and how to distribute funds from retirement plans during retirement.

Tips on the Conventional vs Roth Decision

Tip Number One – Tax avoidance during working years should not dictate the choice between conventional and Roth contributions. A smaller Roth contribution is comparable to a larger conventional contribution.  Whether a person with a smaller Roth balance is better or worse off than a person with a larger conventional balance depends on potential savings in retirement. 

Since contributions to conventional retirement accounts are pre-tax and contributions to Roth accounts are after-tax, people can afford to contribute more to conventional account than a Roth account.  

  • A person in the 10 percent tax bracket who contributes $4,000 to a conventional account would forego the same amount of current resources by contributing $3,600 to a Roth account and paying $400 in tax.
  • A person in the 32 percent tax bracket making a $4,000 contribution to a conventional retirement account would forego the same level of current resources by contributing $2,720 contribution to a Roth and paying $1,280 in tax.   

Naturally, a person who contributes pre-tax dollars into a conventional retirement account will have a larger balance than a person who contributes after-tax dollars to a Roth.  

Estimates of the differences in conventional retirement account balances were calculated assuming lifetime marginal tax rates of 10 percent and 32 percent.   The assumptions behind the estimates are equal after-tax conventional and Roth payments, a pre-tax conventional payment of $4,000, 30 years of work, 26 payments per year and a rate of return of 8 percent per year.  

  • At the 10 percent tax rate, the wealth at retirement is $499,132 for the conventional account and $449,219 for the Roth account.
  • At the 32 percent tax rate, the wealth at retirement is still $499,132 for the conventional account but is now $339,410 for the Roth account.

The larger magnitude of wealth in the conventional account does NOT mean people are better off with Roth accounts than conventional accounts because Roth disbursements are not subject to tax after age 59 ½ and their exclusion from AGI reduces Social Security benefits subject to income tax.

Tip Number Two: People in low marginal tax rates should choose a Roth account over a conventional account.

Most people start their career at a low marginal tax rate and move to a higher bracket when their career advances.  Note that at low-marginal tax rates the difference in contributions between conventional and Roth plans is relatively small.  People should contribute to a Roth rather than a conventional plan when their marginal tax rate is low and should contribute to a conventional plan rather than a Roth when their marginal tax rate is high.

The choice between conventional and Roth contributions may involve a reduction in the amount contributed.  As noted above, a $4,000 contribution to a conventional retirement plan is equivalent to a $3,600 contribution to a Roth account for a person in the 10 percent tax bracket.   

Tip Number Three:   Workers need to consider relative advantages of firm-sponsored retirement plans and individual retirement accounts.   In some cases, the choice of an individual retirement account leads to an increase in Roth investments.

Most people routinely enroll in the firm’s retirement plan.  Some firms do not offer a Roth 401(k) plan.  Workers at firms that do not have access to a Roth 401(k) plan may be able to contribute to a Roth IRA.

The ability to contribute to a Roth IRA is phased out for people with income of $125,000 for individual filers and income of $197,000 for married joint return filers.  Higher income filers are often unable to invest through a Roth IRA and must instead rely on the firm-sponsored plan.

All people can contribute to a traditional IRA as well as their employer-sponsored retirement, however, the tax deduction associated with the contribution to traditional IRAs is phased out for people at work.  The non-deductible IRA can be converted to a Roth IRA through a process called a backdoor IRA, discussed further in Tip Number Six below. 

Workers at firms that offer a 401(k) plan but impose high fees or do not match employee contributions might be better off with an IRA than the firm-sponsored plan. The most common rule is for employers to match 50 percent of contributions up to 6 percent of income.  A person at a firm with this matching benefit could contribute 6 percent of income to a 401(k) plan and then save additional funds in a Roth IRA if the person’s income is below the phase out limit. 

Tip Number Four:   Conversion of conventional retirement accounts to Roth IRAs can substantially increase after-tax retirement savings.  Tax considerations determine the best time to implement the IRA conversion.  It is possible for a person in retirement with a zero or low marginal tax rate because of Roth IRA disbursements to convert additional funds to Roth IRAs at little or no cost.

Some people with assets in a conventional retirement plan may be able to convert the assets to a Roth retirement plan.  The ability to make this transfer varies based on several circumstances described below.

  • Some, but not all, firms with both conventional and Roth 401(k) plans will allow employees to convert their conventional 401(k) plan to a Roth 401(k) plan.   
  • Employees who leave a firm can roll over their 401(k) assets to an IRA.   This action is highly desirable if the firm 401(k) plan has high fees or if the investment opportunities at the firm’s retirement plan are highly limited.  The conventional IRA can then be converted to a Roth IRA.
  • Some firms allow employees over the age of 55 to make an in-service rollover from the firm’s retirement to an IRA.   The conventional IRA can then be converted to a Roth IRA.
  • A person with a conventional IRA can convert to a Roth IRA at any time.  There are, however, limits on disbursements from the newly converted Roth IRA for five years after the conversion.

The cost of the conversion is the additional tax from the increase in adjusted gross income.   The payment for the conversion should come from funds outside the retirement plan to avoid a 10 percent penalty.  Some analysts argue the payment of taxes from sources outside the retirement plan is preferrable to allow greater tax deferral inside the retirement plan.  However, some investments outside retirement plans, like Treasury I-Bonds and EE-Bonds, also defer tax.   

The most desirable time to make a conversion from a conventional to Roth account is when the taxpayer is in a low marginal tax bracket.   This will occur when a worker becomes unemployed, takes a sabbatical, returns to school, has low taxes due to some other life event, or has low taxes in retirement.   

A person in retirement who is paying low or zero taxes because she is disbursing Roth assets can covert additional conventional assets at an extremely low cost.  

Tip Number Five:   Disbursements from Roth IRAs can substantially lower the amount of Social Security benefits subject to income tax.  People who delay claiming Social Security benefits should delay disbursements from Roth accounts and use funds from conventional accounts until they claim Social Security benefits.

Conventional 401(k) disbursements are included in Adjusted Gross Income (AGI).  Disbursements from Roth accounts are not included in AGI.  The portion of Social Security benefits subject to federal income tax is based on a concept called combined income, which is reduced by disbursements from Roth IRAs which are not include.

The reduction in AGI and potential taxes can be considerable.

  • A person with a $25,000 Social Security benefit and a $30,000 distribution from a conventional retirement account would, based on my back of the envelope calculation, have an AGI of $44,850.  (The conventional retirement account plan distribution is fully taxed along with $19,850 of Social Security benefits. 50 percent of benefits between $30,000 and $34,000 plus 85 percent s of the remaining $21,000.) A person filing an individual return, with a $25,000 Social Security benefit and a $30,000 Roth disbursement would have an AGI of $0.  (The Roth distribution is not taxed and all Social Security benefits below $25,000 are untaxed.)

The person in this example paying $0 in tax because of Roth will claim the standard deduction of $12,400.   If the person has no additional income, she could convert an additional $12,400 from a conventional to a Roth account and still pay $0 in tax.

Larger Roth disbursement lower the taxpayer’s marginal tax rate and lower the cost of additional conversions from conventional to Roth accounts.  A married couple disbursing $80,000 from a Roth instead of a conventional account, with no additional income would likely be in the 0% tax bracket and be able to convert $24,800 from a conventional to a Roth account at zero cost.

The total savings from the use of Roth is the sum of the direct savings from distributions from the Roth account not being taxed, the lower marginal tax rate from the exclusion of Roth distributions from AGI and the reduction in tax on Social Security benefits from the exclusion of Roth distributions from AGI.   The benefits from the use of Roth tend to be larger when the person is claiming Social Security benefits because of this third component.

Hence, a general rule of thumb is, distribute conventional assets when you are not claiming Social Security benefits and distribute assets from the Roth account when you are claiming Social Security benefits.

Tip Number Six:  Funds in a Non-Traditional IRA that were not deducted from income in the year the contribution was made can be converted to a Roth account without paying additional tax.

All people even those with high income or access to a firm-sponsored retirement plan can contribute to a non-deductible IRA.  Funds in the non-deductible IRA can be converted to a Roth with the investor only paying tax on investment returns because the investor has already paid tax on the contribution to the non-deductible IRA.   

The process of contributing to a non-deductible IRA and immediately converting all funds to a Roth account is called a backdoor IRA.   It basically allows higher-income people who are not eligible to directly contribute to a Roth account to circumvent the income limits on Roth accounts.   This useful tutorial shows how to establish a backdoor IRA.

Tip Number Seven:  People withdrawing funds from retirement accounts prior to age 59 ½ are likely to be better off with a Roth than a conventional plan.

Research indicates that distributions from 401(k) plans prior to retirement are widespread. One study by E-trade indicates that 60 percent of millennials have withdrawn funds from their 401(k) plan.   A study by the Boston Research Group found that 22 percent of people switching jobs routinely take funds out of their 401(k) plan and spend it.   My own recent research has indicated that people tapping 401(k) plans tend to have poor credit ratings and high levels of other consumer loans.  The use of Roth rather than conventional accounts may allow some people to avoid unanticipated taxes and penalties.

A person who is likely to withdraw funds prior to retirement will likely be better off having made contributions to a Roth account than a conventional account. Distributions from conventional accounts prior to retirement are fully taxed at ordinary income tax rates and are subject to a 10 percent penalty.   The initial contribution to a Roth account is not subject to tax or penalty.  

Tip Number Eight:  People who inherit a Roth IRA will be substantially better off than people who inherit a conventional IRA.

As explained in this CNBC article,  the 2019 Secure Act changed rules governing distributions from inherited IRAs and 401(k) plans.   The new rules require people, with the exception of spouses and minors, who inherit a 401(k) plan to take disbursements within a 10-year period. Funds not distributed by year 10 are subject to a 50 percent penalty.

Funds distributed from the Roth retirement account during the 10-year period are untaxed.  Funds distributed from a conventional account are taxed as ordinary income.   The additional tax for the person inheriting an IRA during peak working years can be considerable.

Tip Number Nine:  State tax considerations also impact investments in Roth IRAs.

The decision to use a Roth rather than a conventional retirement plan is more attractive in States with an income tax, especially if the state has a high marginal tax rate and states that tax Social Security benefits.

Thirteen states tax Social Security benefits.  Most states follow federal rules and do not tax Roth distributions and do not count Roth distributions towards the taxation of Social Security benefits.  However, it is permissible for states to differ from federal rules. 

The cost of the conversion from a conventional account to a Roth account is also impacted by state income taxes as discussed in this CNBC article.  People planning to move from a state with an income tax and a high marginal tax rate to a state with either no income tax or a low marginal tax rate should delay conversions until they move.   People moving in the opposite direction might convert prior to the move.

Concluding Remarks:   Financial planners often stress the need to accumulate large retirement plan balances.  Retirement plan balances are generally much larger for people who use conventional retirement accounts than Roth accounts.  However, people saving primarily through Roth accounts often pay very little tax during retirement and a person with a medium sized Roth account may be substantially better off than a person with a larger conventional account.


Some Comments on the 2021 Enhanced Child Tax Credit

Key features of the New Child Tax Credit:  The American Rescue Plan increases the child tax credit from $2,000 to $3,000 for dependent children age 5 to 17 and to $3,600 for children 5 and under.   

The extra $1,000 or $1,600 is phased out at AGI of $75,000 for single filers and $150,000 for married joint filers.  

Half of the tax credit will be paid in advance and half will be applied as a credit towards taxes paid on the 2021 tax return.   The Kiplinger report has a useful on-line tax calculator that provides an estimate of a taxpayer’s monthly stipend based on four variables – (1) filing status, (2) number of children age 5 or under, (3) number of children age 6 to 17, and (4) estimated AGI.   The AGI estimate is obtained from the 2020 tax return unless one is not available in which case AGI is obtained from the 2019 return.

The new child tax credit is only in existence for the 2021 tax year. The Biden Administration wants to make the tax credit permanent.

Some Comments on the New Child Tax Credit:

Comment One:   The rationale for the advanced monthly payment of the childcare tax credit is that the advanced payment will give taxpayers money in their pockets during the year.  Advanced payments are not needed to achieve this goal.   This goal could be achieved by allowing taxpayers who plan to claim the credit the right to reduce the amount of tax withheld from their paycheck.   Advanced payments for the tax credit covering health insurance premiums enacted in the ACA are needed because the person claiming the credit must pay insurance premiums and the credit is sent directly to the health insurance firm.  No such imperative exists for the child tax credit.

Comment Two:   The advanced monthly payments are based on an estimate of 2020 income or 2019 income if 2020 income was not available.  The taxpayer will receive advanced payments larger than she is entitled to if actual AGI exceeds estimated AGI, a situation that is likely given depressed income levels in 2020 and the current strong recovery.  Will many taxpayers owe the IRS money in this situation?  Why did Congress create an advanced tax credit that increases financial uncertainty when it would be less complex to simply have taxpayers adjust the amount of tax withheld.  Taxpayer estimates of the amount that should be withheld are almost certainly likely to be more reliable than estimates generated from past AGI.  Also, the amount withheld can be modified at any time in the tax year as income changes.

Comment Three:   The child tax credit will increase the number of taxpayers paying little or no tax.    The tax credit is refundable and does not alter the marginal tax rate applied to taxable income; hence, the tax credit does not appear to impact the difference in taxes paid from the choice between a conventional or Roth IRA.  However, the extra liquidity and lower tax obligation might make the choice of a Roth more attractive.  The potential tax savings from the use of Roth accounts in retirement are huge.  Consider a recent post on the advantages of Roth accounts.  Hope to share more on this topic soon.

Final Comments on the Biden Economic Approach:  I do believe the Biden team has their heart in the right place.   I would have prioritized permanent subsidies for health insurance premiums and additional subsidies for retirement savings over the expansion of the tax credit because such subsidies are more likely to remain in place over the long haul and these subsidies help fix other economic problems.

Many of the benefits enacted in the COVID relief bill including their child tax credit and some health care subsidies phase out quickly.    Phaseouts are sometimes necessary in order to meet budget blueprints and rules of the reconciliation process.   The case can be made that the reason for the short phaseout of some benefits in the COVID relief bill is political because Congress will have to vote on these popular benefits prior to elections.

The extra unemployment benefits in the COVID relief bill have been eliminated in many states.  In retrospect, funds allocated to programs like the enhanced unemployment benefit should have been allocated to a permanent enhanced childcare or health care tax subsidy.

Quick Tip: Invest in Roth Not Conventional Retirement Plans

  • Households paying little or no income tax in working years should select a Roth retirement account over a conventional one.  
  • The gain from the exemption on tax or deduction from a contribution to a conventional retirement account during working years is negligible for these taxpayers.
  • The potential reduction in tax during retirement from use of Roth is huge and from several sources.   The Roth distribution is not taxed.   Substantial Roth distributions lower marginal and average tax rates.   The Roth distribution reduces Social Security benefits subject to tax.  The Roth is not subject to a required minimum distribution, which improves tax planning.
  • The choice between Roth and conventional accounts can be a bit harder for higher income taxpayers.  These taxpayers may have access to Roth 401(k) plans at work that allocate contributions to a Roth account and employer matches to a conventional account.
  • The lack of tax on inherited Roth IRAs allows many beneficiaries to avoid large taxes during peak working years.
  • Roth accounts can be used as an emergency fund because contributions can be distributed without penalty or tax.

Over 40 percent of U.S. households pay zero or negative federal income tax.  A CNBC article finds this number will increase n 2021 due to the family tax credit.   Under the current tax code, there are also a lot of people in the 10 percent tax bracket.

People don’t like paying tax.   I certainly get that.  However, people who are already paying zero or negative tax due to tax credits should pursue other financial goals in addition to tax reduction.

Many of these people will be asked to choose between a traditional deductible retirement plan or a Roth retirement plan.    

People not covered with an employer-based retirement plan can usually choose between a Roth and conventional IRA, although, there is an income limit on eligibility for Roth IRAs.  Many firms now offer both conventional 401(k) plans and Roth 401(k) plans.

The traditional deductible IRA reduces income tax during the year the contribution is made while the Roth IRA reduces tax in retirement.

The tax reduction for many working-age people who contribute to a conventional retirement account is small, maybe even negligible.

People with negative income tax due to a refundable credit will get a slightly larger refund if they contribute to a conventional retirement plan.  People in the ten percent tax bracket could get a savings of 10 percent of the 401(k) contribution, likely a small number.

The existence of a Roth IRA during retirement will substantially reduce tax obligations in retirement through multiple channels.   

  • The distribution itself is not subject to tax.
  • A large Roth distribution could substantially reduce marginal and average tax rates relative to a large distribution from a conventional retirement account.
  • The distribution from a Roth rather than a conventional account often leads to a reduction and maybe even elimination of the taxation of Social Security benefits because Social Security benefits are only taxed above certain AGI thresholds.
  • People with Roth accounts are not required to take a required minim distribution (RMD) after age 72.   The lack of a RMD requirement extends retirement income and improves tax planning.

Working-age people can reduce their tax obligations many ways.  They can take the family tax credit if they have children, they can contribute to a health savings account, or they can buy a house and deduct mortgage interest.  Many of these measures are generally not used or not available for older households.    For example, people over age 65 are covered by Medicare and generally do not contribute to a health savings account.  Most people over 65 have paid off their mortgage and no longer deduct mortgage interest or other housing expenses.  Few people over 65 have minor dependent children and can claim the child tax credit.

The decision to take a Roth instead of a conventional account can be a bit harder if you are in the top tax bracket.  Many of these households will work at a firm that offers both Roth and conventional 401(k) plan.   These taxpayers can send their contribution to the Roth account.  Employer matching funds are placed into a conventional plan.

There are other advantages with Roth IRAs.

Roth IRAs can be used as an emergency fund.   The IRS allows contributions from Roth IRAs to be withdrawn without penalty or tax because they are fully taxed at the time of the contribution.  People should not rely on a Roth as the primary source of funds for an emergency. There is also a limited window to repay funds taken from a Roth prior to retirement.    This benefit from the use of Roth accounts is extremely important because as indicated by my paper many people taking distributions from conventional accounts prior to retirement are struggling.

The use of Roth accounts allows recipients of an inherited IRA or 401(k) to avoid a large tax bill.  Under current tax law, all IRA funds must be distributed over a 10-year period.  Conventional retirement accounts, inherited by someone other than a spouse, are taxed as ordinary income.  Roth accounts are untaxed.  A person that inherits a conventional retirement account during peak earning years could have larger than anticipated tax bills.

The main message here is don’t let immediate tax avoidance dominate your investment, savings and even tax planning goals.  Think long not short term.  The narrower message here is use Roth not conventional retirement plans.

How to minimize the impact of 401(k) fees

  • Retirement plan fees vary substantially across firms.
  • Annual fees appear trivial but small differences in the annual fee have a substantial impact on retirement wealth.
  • A median-wage worker at a firm with a high-cost retirement plan can pay more than $100,000 in retirement plan fees over her lifetime.
  • Workers can reduce lifetime retirement fees by moving to a job at firm with a low-fee plan, moving retirement funds to a low-cost IRA when changing jobs, greater use of IRAs, and greater use of investments outside retirement plans.

Background on impact of high retirement plan fees:  A report by the Center for American Progressrevealed that 401(k) fees are a substantial expense and drain on retirement income for many workers.  On average, annual 401(k) fees are 1.0 percent of assets.   

There is substantial dispersion in the annual fee percentage across firms.   A 2011 survey cited in the report found the average annual 401(k) fee for firms with fewer than 100 participants was 1.32%.   The report found that a well-managed retirement account could have a fee as low as 0.25%. 

The report calculates lifetime 401(k) fees for workers at three different annual fee rates – 0.25%, 1.0%, and 1.3%.   The scenarios assumed the worker contributes 5% of salary and receives a 5% employer match. The findings indicate that relatively small annual differences in fees as a percent of asset leads to large differences in lifetime fees paid by workers to the sponsor of their retirement plan.

  • Lifetime 401(k) fees for a median-wage worker starting her career are $42,000 at a 0.25% annual fee, 138,000 at a 1.0% annual fee, and $166,000 for a worker at 1.30% annual fee.  

The report also contained lifetime fee calculations for a higher wage worker.  Results were proportionate to income.

Higher retirement fees were associated with a higher likelihood of ending up with insufficient retirement income.

  • An increase in retirement plan fees from 0.5% of assets to 1.0% of assets will reduce the likelihood a worker will have sufficient retirement income from 69% to 57%.

The reported annual fee as a percent of retirement plan assets appears to be small, almost trivial.   However, the fee is applied each year.    The annual fee becomes large for older workers with larger amounts accumulated in the account.   

High retirement fees are an especially important issue when interest rates are low.  When the fee percentage is larger than the bond interest rate, the de-facto interest rate is negative. This is currently the case with a two-year Treasury rate stands at 0.16% below the level of even a low-cost retirement fund.

The Center for American Progress argues that a key solution to problems created by high retirement plan fees is better information about the fees.  Workers are not explicitly billed for retirement fees.  The retirement plan fee is an indirect charge deducted from investment returns.   Workers would be much more cognizant of retirement fees if they were directly charged the service.

Investment managers charging high fees claim their fees are justified because their fund realizes higher returns.  The finance literature indicates that passive funds with low returns tend to outperform active funds with higher fees.  Moreover, Warren Buffet, arguably the best active stock picker of all time, argues sticking with the S&P 500 will lead to better returns than active management.

Workers would be better served if they were automatically placed in low-cost funds unless they opted out.  The current default retirement plan is the plan chosen by the worker’s employer.   However, workers at firms that choose a high-cost retirement plan with inadequate options can and should take several steps to reduce fees and work towards a secure retirement.

Mitigation of the adverse financial impact on high retirement fees:

A worker who is aware that a retirement plan at her current or prospective job imposes high fees can take several steps to reduce fees.   These steps include, moving to a job with a better retirement plan, rolling over funds from the high-cost plan to a low-cost IRA when changing jobs, greater use of individual retirement accounts, and increased savings outside of retirement plans.

Moving to a firm with a better retirement plan:  A person with multiple job offers should consider the quality of the retirement plan when weighing different offers.  Factors determining the quality of a firm’s retirement plan include – whether the firm matches employer contributions, the level of the match, whether the firm offers a Roth 401(k) option and as shown above the level of fees.

Change jobs and rolling over retirement funds:  The existence of high retirement fees should motivate a person with assets in a retirement plan to look for a new gig.  Preferably the new job would have a retirement plan with a lower-cost plan; however, even if it does not the worker can take her funds out of the high-cost plan and place them in a low-cost IRA.   

Consider, a 45-year-old worker with $300,000 in a retirement plan charging a 1.3 percent annual fee.   The person is paying $3,900 in retirement fees in her current year.  She could quit her job and move the retirement funds to a low-cost IRA with a fee at perhaps 0.5 percent.   The current-year annual fee would be $1,500.

The annual leakage from high fees grows over time in tandem with the growth of assets.  One of the worse mistakes a person can make preparing for retirement is to leave assets in a high-cost plan once you move to a new position or retiring.

Investment related fees at reputable firms like Vanguard, Fidelity and Schwab have fallen in recent years and with a little research you can roll funds into a low-cost IRA when you leave your current position.    The impact on your retirement wealth is considerable and I see no advantages in keeping funds with a high-cost retirement funds after you move to a new position.

Use of IRAs to replace or complement firm retirement plan savings: The person who accepts a job at a firm with a high-fee retirement plan must decide whether to contribute to the retirement plan, contribute to an individual retirement plan instead of the IRA or contribute to both the firm retirement plan and an IRA.

There are some limitations with IRAs.  Contribution limits are lower for IRAs than for 401(k) plans.  The contribution limit for IRAs in 2020 is $6,000 for people under 50 and $7,000 for people 50 and over.  The contribution limit for 401(k) plans in 2020 is $19,500 for people under 50 and $26,000 for people 50 and over.   

Tax rules link eligibility for Roth IRAs to household income.  Tax rules also link the tax deductibility of traditional IRAs to both household income and whether a person and/or spouse contributes to a 401(k).  These rules limit but do not eliminate advantages associated with a strategy of complementing investments in a firm-sponsored retirement plan with investments in a lower-cost IRA.

A person at a firm with a high-cost retirement plan might choose to contribute to the plan if the firm matches employer contributions.   The employee could take full advantage of the matching contribution and divert any additional savings to accounts outside the retirement plan. The employer match will lead to a generous return in the year the contribution is made, however, the annual fee will erode the fund over time.  The use of the IRA for contributions over the match can result in increased retirement wealth if the IRA has lower fees.   

The employee contributing to both the firm 401(k) plan and an IRA may have to place funds in a non-deductible IRA rather than a Roth or deductible IRA depending on her household income.  This allows for deferral of tax.  The worker may be able to convert the conventional IRA to a Roth IRA in a future year but this is a topic for another day.

Once the worker leaves the firm, the entire retirement fund should be rolled over to a low-cost IRA.  Brokerage firms may allow you to combine funds in the two accounts.

A person with at a firm with a high-cost retirement plan that does not match employer contributions should consider and should probably choose a low-cost IRA instead of the firm’s high-cost retirement plan.   This strategy limits contributions and retirement income for some workers because as noted contribution limits are substantially higher for firm-sponsored 401(k) plans than for independent IRAs.  However, the difference between IRA and 401(k) contribution limits may not matter for most workers because many companies, in. a response to IRA non-discrimination rules, limit contributions to a 401(k) plan to a percent of income.

Use of Low or No-Fee Bond Purchases Directly from the U.S. Treasury:  The current market environment is challenging.  The valuations of popular stocks like Microsoft and Apple are at historic highs.  Interest rates are low and for some maturities below the annual 401(k) fee. The actual investment return on many bonds in 401(k) accounts after accounting for the annual fees is negative.

Investors improve outcomes by purchasing I and EE Bonds directly from the Treasury.  The purchases can be done inside or outside of retirement accounts.

There are several advantages associated with the greater use of I-Bonds and E-Bonds directly from the U.S. Treasury.

  • There are no fees on bonds purchased through Treasury Direct and no fees on the purchase of I and EE bonds as stated in these FAQs.  
  • Tax is deferred on I and EE bonds until the instrument is sold.   
  • The tax on matured bonds is limited to deferred interest or capital gains while all funds distributed from conventional retirement accounts are fully taxed as ordinary income.  
  • Individual bonds can be redeemed at maturity at their par value while the value of the bond fund is determined by the prevailing interest rate.

Advantages of use of bonds as part of an overall retirement strategy and advantages associated with the purchase of bonds from Treasury Direct deserve and will get future analysis.

The point stressed here is that investments in bonds at Treasury Direct can reduce lifetime retirement fees.

Concluding Remarks:   Virtually all financial planners emphasize the importance of taking full advantage of retirement plans.  The advice starts as soon as a person enters the workforce even if the person has substantial student debt and a strategy of rapid repayment of student loans would substantially reduce costs, financial risk and stress for the new worker.  The financial planners often don’t worry nearly enough about paying off the mortgage prior to retirement.

Financial planners often don’t mention or stress the importance of high fees, which as discussed here have a large impact on retirement wealth and the likelihood a worker will have a secure retirement.   

The message presented in this post is that workers need to be aware of the retirement plan fees and the overall quality of the plan and come up with an alternative solution if the firm’s plan is inadequate.

Paying off the Mortgage Prior to Retirement

Financial Tip:   Pay off all debt, including the mortgage, prior to retirement.   This requires planning, the use of 15-year mortgages on the last purchased home, and prioritization of debt payments over additional contributions to 401(k) plans.

Discussion:   According to CNBC, experts differ on whether you should retire mortgage debt in retirement.  My view is that the retirement of debt in retirement is too little too late.  Mortgage debt has to be eliminated prior to retirement to reduce taxes and the risk of outliving your resources.

The goal of mortgage elimination prior to retirement is most important for people with most or all of their wealth inside a conventional retirement account because funds disbursed from 401(k) plans are taxed as ordinary income.  People with a mortgage and all funds in a 401(k) plan must disburse funds to cover the mortgage payment and tax on the disbursement.  Moreover, the increase in reported income from the larger 401(k) disbursements will subject a greater portion of Social Security income to tax.  (A portion of Social Security income is subject to federal income tax for single individuals for income starting at $25,000 and for married individuals for income at $34,000.)

The elimination of all mortgage debt prior to retirement requires some financial planning.  The goal could be achieved by the selection of a shorter-term mortgage for the final home purchase, refinancing from a long-term to short term mortgage, or by making additional payments towards the mortgage when nearing the end of your career.   A person over the age of 50 should, at a minimum, prioritize additional mortgage payments over catch-up contributions to 401(k) plans in order to meet this goal.   The worker might even consider further reductions in 401(k) contributions to eliminate the mortgage.

Action must be taken to eliminate the mortgage prior to retirement. A person already in retirement with a substantial mortgage and with most funds inside a 401(k) account does not have many good choices.

Consider, the case where a retired person has all of her wealth in a 401(k) plan.  She took out a 30-year $450,000 mortgage 25 year before retirement and has five more years of mortgage payments before the mortgage is retired.  The interest rate on the loan is 4.0%. Her mortgage payment, principal and interest, add up to $2,148.  (This was obtained from the PMT function in Excel.)   The annual payment on her mortgage is $25,780.   The outstanding balance on her mortgage is $116,654. (This was obtained from the FV function in Excel.)  

She could continue to live in her house and make her monthly mortgage payments.

She would have to withdraw funds from her 401(k) plan to cover her mortgage expense and other living expenses including her federal and state tax bills.  The larger disbursement to cover the mortgage increases her tax bill because the entire distribution from the mortgage is taxed as ordinary income.   She likely has Social Security benefits to cover some of her other living expenses.  However, the higher income from the larger 401(k) distribution to cover the mortgage increases the likelihood a portion of the Social Security benefit is subject to federal income tax.

It makes sense for people to reduce spending and 401(k) disbursements during market downturns to prevent rapid use of 401(k) funds. The person with a mortgage must withdraw funds from her 401(k) plan to meet the mortgage obligation regardless of the performance of the market.  The existence of the mortgage limits the ability of this person to reduce distributions in response to a market downturn.

The person could pay the entire outstanding mortgage balance of $116,654 in one year.  This would put her in a high marginal tax rate and would subject 85 percent of her Social Security benefits to tax in the year the large distribution was made.   

The person could sell her house, pay her entire mortgage and move.  Most elderly want to age in place.  

The viability of the downsizing option depends on the price the person could get on her current house, the amount of equity in her house and the cost of alternative housing, which depends on the price of the new house or the rent.   Hopefully, the new house would be purchased with cash not a new mortgage.

A person with a large amount of liquid assets outside of her retirement account could more easily pay off her mortgage.  The tax from the sale of assets outside a retirement account are substantially lower than taxes on funds distributed from conventional 401(k) plans because only the capital gain portion of the disbursement is taxed and under current law capital gains are taxed at a preferential rate. 

The problems described here could have been avoided by use of a Roth retirement account rather than a conventional retirement account.   A post on the potential advantages of Roth retirement accounts will be available shortly.

Financial Priorities for New Entrants to the Workforce

  • Students entering the workforce tend to have high expenses and relatively modest income.
  • Young adults need to prioritize the establishment of a good credit rating, the creation of an emergency fund, and investments in their job search.  
  • Contributions to 401(k) plans can wait.
  • A strategy of rapid reduction of student debt immediately upon entering the workforce will substantially improve credit scores and borrowing costs and reduce lifetime student loan repayments, by tens of thousands of dollars.   
  • Student borrowers with low-cost federal loans and higher cost private loans should prioritize repayment of the high-cost loan. It may be possible to refinance the federal debt once the private loan is eliminated, further reducing lifetime student loan payments.
  • The rapid repayment of student loan debt can lead to increased contributions to retirement plans once some or all student debt is eliminated.

Many financial planners and firms with solid reputations urge new entrants to the workforce to start their career by aggressively contributing to their 401(k) plan and saving for retirement.  Fidelity, a leading investment firm, recommends young adults have a 401(k) balance equal to their annual salary by the time they are 30.  

My view is that this objective is unrealistic for the vast majority of young adults entering the workforce with limited liquidity and substantial debt.  

My financial advice to young adults entering the workforce can be summarized in three tips – (1) maintain a solid credit rating, (2) create an emergency fund, and (3) rapidly reduce student debt to a manageable level.   The achievement of these goals often requires that student borrowers entering the workforce either entirely forego contributions to their 401(k) plan during their first few years in the workforce or at least substantially reduce contributions for some time.  

The importance of an emergency fund and a solid credit rating:

The first few years after a person completes school and starts a career are often financially challenging.  People leaving school often starts their job search with limited funds in the bank.  Starting salaries are often lower than expected and relatively few students immediately get their dream job. The process of searching for a good job is expensive and time consuming.  The successful job candidate often has some moving expenses.

Student debt repayment obligations generally start 9 months after full-time student status ends.  Moreover, the proportion of students with subsidized federal loans has fallen. The increased use of unsubsidized federal loans and private student loans has increased interest costs on student debt early in the borrower’s career. 

Contributions to a 401(k) plan should be an extremely low priority for a person starting a career with a low starting salary, in full search mode for a better job, without substantial savings and with immediate student debt obligations.

The financial planner will tell the financially strapped person with no funds to take the employer match on 401(k) contributions because it is “free money.”  Employer matches to 401(k) contributions are not free money if the diversion of money from current needs results in late payments and a deterioration of the person’s credit rating

The highest, perhaps only, financial priority of the new entrant into the workforce is to build a financial buffer in order to maintain a solid credit rating.

The failure to maintain a good credit rating will lead to extremely high costs for borrowers.

A search was conducted for likely interest rates for good and poor credit risks for four different types of loans – (1) credit card loans, (2) car loans, (3) a private student loan, and (4) a mortgage.  Assumptions were made on the likely maturity and initial balance of each loan and these assumptions were used to generate estimates of the monthly cost of bad credit.

The interest rate assumption was obtained from WalletHub, the car loan assumption was obtained from Nerd Wallet, the private student loan assumption was obtained from Investopedia, and the mortgage rate assumption was obtained from this CNBC article. The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.

The cost of bad credit depended on both the interest rate differential and the likely loan amount.  The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.

The analysis assumed the borrower only paid interest on credit card debt.   Assumed maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.

Based on these assumptions, I found the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.

The figures presented here show bad credit ratings can lead to substantial costs with costs depending on both interest differential and loan amounts.  The interest differential stemming from credit ratings is highest for credit card loans and private student loans.  

The payment differential associated with credit ratings is often highest for mortgage debt because mortgage loans are large. In today’s housing market with soaring home prices and tighter lending standards it is very difficult to purchase a home without good credit.

The cost of bad credit is not limited to one or even a few loans.   Most people take out multiple consumer loans or mortgages in their lifetime.  The lifetime cost of bad credit will be substantial for households that do not improve their credit rating. 

Poor credit ratings have other adverse impacts in addition to higher loan costs.   The Insurance Information Institute points out the insurance companies use credit ratings to set insurance premiums because actuarial studies have shown that credit scores are good predictors of the tendency for people to make insurance claims.  The credit rating agency Experian points out that employers can and sometimes do base hiring decisions on an applicant’s credit history.   Landlords use credit ratings to determine eligibility for an apartment.

The Importance of Rapid Student Debt Reductions Early in a Career:

Students leaving school with substantial federal and private student debt should rapidly repay the private student loan even if the rapid repayment of the private loan causes them to forego contributions to their 401(k) plan.

The rapid reduction after joining the workforce will drastically reduce lifetime student debt borrowing costs.   Rapid debt reduction may make it possible for the student borrower to refinance remaining debt at a lower interest.

Finance companies often attempt to persuade student borrowers to refinance their federal student loans to lower-interest rate private loans.   This article provides recommendations from CNBC on the best companies for refinancing student debt. 

Often student borrowers cannot refinance to a substantially lower interest rate immediately upon graduation because their work and credit history is short, and their initial salary is low.  A student borrower could improve their credit report by foregoing 401(k) contributions for a year or two and then refinance the remaining student loan at a lower interest rate.

There are advantages and disadvantages associated with refinancing federal loans to private loans.  The primary advantage is a lower interest rate, perhaps as low as 3.0%.  You must be careful when refinancing a fixed rate student loan to a variable rate loan because the student loan interest rate can rise substantially if Treasury rates rise.   In addition, the decision to refinance with a private student loan makes the borrower ineligible for forbearances in case of economic hardship and makes the borrower ineligible for income driven loan programs 

The potential financial gains from a strategy of rapidly reducing student debt upon entering the workforce are examined for two student borrowers – one with a large federal undergraduate loan and the other with a mix of federal undergraduate and graduate loans and a private loan.

Student Borrower Number One:   The first student borrow is starting her career with a $50,000 per year job and undergraduate student loans totally $30,000 with an interest rate of 5.05% around the 2019 average student debt level for undergraduates.   

A person in this situation will typically take out a 20-year student loan.   Her payments on the loan will $198.82 per month.  Her total payment over 20 years will be $47,716.   

The person could more rapidly repay her student loan if she foregoes contribution to her 401(k) plan.   Assume she currently pays 10 percent of her income to her 401(k) plan.  If she foregoes this contribution her annual income tax will increase by $600.  However, she could increase payments on her 401(k) plan by $4,400 per year to a total monthly payment of $565.48. 

Under this assumption the student borrower would totally repay her $30,000 student loan on the 61stpayment.   Her total student loan repayment costs would be $33,837, a savings of $13,879.

The strategy of rapidly repaying the student loan causes the student borrower to fall behind on her accumulation of 401(k) wealth.  However, her student loan is totally paid off after 61 months and she could now make larger 401(k) contributions than the person who immediately initiated 401(k) contributions after leaving school.

The student borrower in this example could forego 401(k) contributions and make monthly payments of $565.48 for two years and then attempt to refinance the loan at a lower interest rate for a 10-year period.

The outstanding balance after two years of payments would be $18,932.

The person after reducing the loan balance that quickly might be able to refinance at a 3.0% interest rate.  The total student debt payments from this strategy, rapid repayment for two years followed by a 10-year loan at 3.0%, is $35,509 or $12,207 less than under a 20-year term.

The rapid reduction of student debt will lower the probability the person experiences debt payment problems and will substantially reduce expenditures on student debt.   

The results are even more dramatic for a student borrow that has a combination of federal debt and high-rate private loans.

Student Borrower Number Two:   The second borrower has three student loans, a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00%.    Intuitively, it makes sense for this student borrower to prioritize rapid repayment of the higher interest rate private loan.  In most instances, the strategy of rapidly repaying the private student loan necessitates the borrower forgoing contributions to a 401(k) plan early in her career.

The student borrower who chooses to set the standard 20-year maturity on all three student loans has a monthly payment of $775 for 20 years leading to total student loan payments of $200,633 over 20 years.

The student borrower who chooses to set the standard 20-year maturity for the federal undergraduate and the federal graduate loan and set a 5-year term for the private loan will initially have monthly student loan payments of $1,065.   

The monthly payment will fall to $534 after the private student loan is totally repaid, which is lower than the $775 payment that exists if the person kept to a 20-year term on all loans.  This means the person who chose the rapid private student loan repayment strategy could after 5 years make larger 401(k) contributions for the next 15 years than the person who chose a 20-year private loan term.

The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years is $146,271, which is a total lifetime savings of $54,362. 

This student borrower is in a good position to refinance her federal student debt to a private lower interest rate loan after repaying her private loan.  The cost savings estimates presented here may understate potential benefits from a strategy of rapidly reducing private student debt.

Concluding Thoughts:  The student borrower entering the workforce is often under intense pressure from financial advisors to immediately contribute part of their salary to a retirement account.  This approach can lead to financial disaster.   

The young adult with a modest salary and high student debt payments who prioritizes saving for retirement can fall behind on her bills, which can lead to poor credit ratings.   The deterioration in credit ratings will lead to high borrowing costs and other problems including difficulties renting an apartment, loss of job offers and higher insurance costs.  

Eventually, many people who choose to aggressively save for retirement will raid their 401(k) and maybe even sometimes pay taxes and penalties.  Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan   

The wiser course of action for young adults entering the workforce saddled with student debt is to rapidly repay student loans, especially but not exclusively high-cost private loans.  This approach will secure a solid credit rating and will reduce lifetime student loan payments by tens of thousands of dollars.

This post is part of a series comparing the traditional financial plan, stressing 401(k) investments and house purchases with 30-year mortgages to an alternative financial plan, which prioritized debt reduction, use of Roth accounts and use of 15-year mortgages.   The first post provided an overview of the alternative financial plan.  The next post, available in a week or so, will look at some problems with conventional retirement accounts starting with high fees on some plans.

Outline of an Alternative Financial Plan for the New Generation

  • Traditional financial strategies, which prioritize accumulation of wealth in a conventional retirement plan, as soon as people enter the workforce are not working for many households.
  • The alternative financial strategy outlined here involving — aggressive elimination of student debt, greater use of 15-year mortgages, the use of Roth retirement accounts instead of conventional accounts, and additional investments outside of retirement accounts — will reduce financial stress and lead to a more secure retirement than the traditional financial plan.

Many households are struggling with historic levels of debt.

Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009.  Around half of bachelor’s degree recipients in 1992-1993 borrowed to finance their education, compared to around 65 percent today.

Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely takeout 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds. 

Statistics presented in a recent Business Economics article show that people who tap 401(k) plans prior to retirement were more likely to have taken out consumer loans, were more likely to have a poor credit rating and were more likely to be underwater on their mortgage than people who did not tap their 410(k) plans prior to retirement.   

A CNBC portrayal of the financial status of millennials nearing the age of 40 found many members of the age cohort highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.

2019 Congressional Research Service Report found that the percent of elderly with debt rose from 38% in 1989 to 61% in 2021.   The Urban Institute reported that the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019.  A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.

The standard financial plan, proposed by most financial advisors, emphasizing large contributions to traditional 401(k) plans instead of aggressive reduction of consumer and mortgage debt often fails to provide a secure financial outcome.  Future outcomes will be worse, barring a change in strategy in financial strategy, because people are starting their careers with higher debt burdens.

The aggressive pursuit of long-term investments in stocks and bonds instead of rapid reduction in debt is especially problematic in the current market environment where stock valuations are stretched, and interest rates are at historic lows.   The purchase of expensive securities inevitably leads to subpar returns when valuations return to more normal levels.

The alternative financial strategy proposed here differs from the traditional financial strategy in four important respects.   

First, the alternative approach prioritizes the establishment of a solid credit rating, the creation of an emergency fund and the rapid reduction of student debt for individuals leaving school and entering the workforce.  The achievement of these goals usually requires new entrants to the workforce delay or reduce 401(k) contributions for a number of years when starting their careers.

Second, the alternative financial strategy places a high priority on the growth of house equity and the elimination of all mortgage debt prior to retirement. 

Many households with less than stellar credit purchase a home with a subprime mortgage.  Subprime mortgages tend to have high interest rates, adjustable rates with short adjustment periods, a balloon payment, and restrictions on prepayments.  The alternative financial strategy opposes the purchase of a home with an unfavorable interest rate or subprime features.

Most households currently use a 30-year fixed rate mortgage.   The alternative financial strategy recommends the use of 15-year mortgages, either through the original home purchase or through a refinancing, to reduce lifetime mortgage payments and to accelerate growth in house equity.  

Many financial advisors currently recommend additional catch-up payments to 401(k) plans for workers nearing retirement even when the worker will retain a mortgage in retirement.   The alternative financial strategy prioritizes mortgage payoffs over additional 401(k) contributions.

Third, the alternative financial strategy utilizes Roth retirement accounts instead of conventional retirement accounts. 

The decision to use Roth rather than conventional retirement accounts can increase tax burdens in working years; however, there are multiple other ways for working-age households to reduce current tax obligations.  In particular, contributions to health saving accounts linked to high-deductible health plans reduce current-year tax obligations, reduce insurance premiums and like retirement accounts increase income during retirement.

The use of Roth rather than conventional retirement accounts directly reduces tax obligations in retirement, reduces the marginal tax rate for people with other sources of income and indirectly reduces tax on Social Security benefits for some households.

The use of Roth rather than conventional retirement accounts reduces the amount of money a person must park in stocks inside a retirement account because the investor no longer needs to save for taxes on disbursements.  The lower taxes from use of Roth accounts reduces financial exposure to market downturns.   

Retirement account fees will be lower on Roth accounts because the total annual fee is a percent of total invested assets, which is lower because tax on Roth accounts is paid prior to contributions.   

The use of Roth rather than conventional retirement accounts will substantially reduce tax on inherited IRAs.   This savings is larger today because of recent changes in tax rules governing inherited IRAs.

Fourth, the alternative financial strategy makes greater use of investments outside of retirement accounts including investments in stocks and investments in inflation linked bonds. 

Retirement accounts are an effective way to defer taxes until retirement.  However, the existence of assets outside a retirement account reduces tax obligations during retirement years.  

Disbursements from conventional retirement accounts are taxed as ordinary income while taxes on capital gains and dividends are currently taxed at preferential rates.   (The tax preferences for capital gains and dividends may be reduced by the Biden tax plan.) 

The availability of funds outside a retirement account are especially important when retirement accounts have high annual fees and interest rates are low.  The effective interest on some bonds held in retirement accounts is negative when the retirement account has a high annual fee. 

There are no fees associated with the purchase bonds directly from the U.S. Treasury.  These bonds have relatively low market risk.  The purchase of Treasury bonds with specific maturity dates is an effective way to hedge against market down turns impacting consumption during retirement.

The traditional approach to retirement often centers on the question – How much money should be placed in a 401(k) plan in order for you to retire?   There are even calculators that create estimates of the amount people need to place in a 401(k) to retire with adequate income.

The actual amount of wealth you need to place in your retirement account is indeterminate.  The amount you need to save depends on several factors including whether the retirement account is Roth or conventional, retirement account fees, amount of debt, whether you plan to downsize, the quality of your health insurance and the tax status of assets outside your retirement account.

The alternative financial strategy outlined in this introductory memo recognizes that financial security cannot be summarized by the dollar value of a 401(k) plan.  A person with large net worth dominated by large equity holdings in a conventional 401(k) plan is faced with large future tax obligations and is perpetually exposed to a market downturn, especially if she has a monthly mortgage bill to meet.  The person could be better off with a lower 401(k) balance if she had paid off her mortgage, put money in a Roth rather than a conventional retirement account, and purchased some inflation-indexed bonds.  

Several features of the alternative plan presented here will reduce the amount that you must contribute to a retirement plan and the amount you pay over your lifetime in retirement plan fees.  Fees charge by retirement accounts are not a trivial matter.  This report by the Center for American Progress reveals a median-wage worker might pay $138,000 in retirement fees over her lifetime.

The traditional goal of financial planners is the construction of a portfolio that will allow retirees to initially distribute 4 percent of the 401(k) balance and maintain that distribution level though out retirement.   The 4 percent rule often fails to provide a sustainable level of consumption in retirement with the largest failures occurring when portfolios are closely tied to the market and the market takes a downturn early in retirement. 

Some financial advisors advocate a more flexible distribution rule that mandates reductions in distributions during market downturns.  It seems as though a strategy calling for sharp reductions in distributions during retirement is an admission that the financial strategy planning for retirement was a failure.  An alternative financial strategy which includes alternative investment including, I-Bonds, E-Bonds and perhaps annuities, will lead to more stable consumption patterns in retirement.  The alternative financial strategy would include a more stable and sustainable rule determining monthly distributions of funds.

The upcoming blog posts presented here and a larger formal paper will describe the potential benefits of the alternative financial strategy in greater detail.  A detailed discussion on how to best rapidly reduce student debt and the potential advantages of the debt elimination strategy will be available at this blog soon.

Roth vs Conventional Retirement Accounts: Impact of the Biden Tax Plan

The CNBC article makes the case the Biden tax plan will make Roth accounts more desirable than conventional accounts.  The article understates the benefits from choosing Roth over conventional accounts, which pre-date the Biden administration.

The article states that Roth accounts are generally more desirable than conventional accounts if you expect your marginal tax rate to be lower in retirement than during working years.

Actually, the decision between Roth and conventional accounts largely determines your tax bracket in retirement.   Roth distributions are not part of your taxable income.   People with other income, an annuity, interest, dividend or capital gain income, and wage income for a part-time job or from a spouse can keep their income and tax bracket down if they have funds in a Roth account rather than a conventional account.   The advantage of Roth over conventional accounts during retirement is not just that distributions from the Roth are untaxed but also that distributions from Roth reduce the taxpayers marginal and average tax rates.

The article points out that distributions from Roth rather than conventional accounts will reduce the amount of Social Security that is taxable income for taxpayers with income above a particular threshold.   This is also huge because the exclusion of both the Roth distribution and the Social Security benefit from taxable income both reduces tax and taxable income and moves the taxpayer into a lower tax bracket, thereby, reducing marginal and average tax rates.

The exclusion of contributions to conventional accounts from current-year taxable income is a key benefit of conventional retirement accounts.   However, there are many other ways to reduce taxable income and tax during working years, including, contributions to health savings accounts, newly enacted child tax credits, and deductions on mortgage interest and other housing deductions.

Many people with scarce funds and medical expenses should choose contributing to a health savings account over contributing to a 401(k) if they have a high-deductible health plan.  Health savings accounts and conventional retirement accounts are highly substitutable because both reduce current year taxable income and excess funds in health savings accounts can be used for non-health purposes in retirement.   People who lower their marginal tax rate by contributing to health savings accounts or through other means should place whatever funds they have remaining in a Roth rather than a conventional retirement account, especially if their tax reduction strategy was successful.

A lot of working-age people pay no or very little income tax.  But for some reason, financial advisors really like to push the tax advantages in working years associated with contributions to conventional retirement accounts.   This decision can be extremely costly in retirement years.  Household with a disproportionate amount of wealth in a retirement account, who also have mortgage debt, must distribute funds to pay the debt and funds to pay tax on the distribution to pay the debt.

The article mentions the new tax provision discussed here that requires many people with inherited IRAs to make distributions within 10 years.   This tax change was enacted in 2019 prior to the Biden presidency.  Heirs of a conventional account will pay tax, at the ordinary income tax rate, on these distributions.   This could be quite painful if distributions are forced during peak-income years.  Heirs of Roth accounts will not pay tax on these distributions.   Do your heir a favor and convert your traditional accounts to Roth account before you die.

The CNBC article states that lower estate tax thresholds proposed by Biden will cause Roth conversion.   Perhaps.  But there are already a lot of reasons to convert and even if the Biden administration succeeds in getting a sizeable expansion in the base subject to the estate tax most wealth in households impacted by the estate tax will not be associated with retirement accounts.

Roth accounts are for most people the better choice.  Not a close call.  This has been the case for quite some time.   The horse is out of the barn.

Complicated rules for inherited retirement accounts

The 2019 Secure Act changed rules governing distributions from inherited IRAs and 401(k) plans.  The new rules prevent some beneficiaries from stretching withdrawals across their lifetime.    This CNBC article does a good job explaining the rules.

The new rules require many people who inherit a 401(k) plan to take disbursements within a 10-year period. However, there are some exceptions for minors and spouses.   

The clock for disbursements over a 10-year period starts at 18 for minors inheriting a Roth IRA.  However, prior to becoming 18 the minor must make a required minimum distribution RMD based on life expectancy.  The RMD for minors should be really small because minors have a large future expected life.  This rule might make sense if the IRA or 401(k) is huge but is it rational for people who inherited a small account?

The distributions from Roth accounts are tax free while the distributions from conventional accounts are taxed as ordinary income.   I guess the Treasury will gain some tax revenue from accelerated Roth distributions if the funds are invested in assets with taxable interest, dividends or capital gains.

The distributions over the 10-year window can occur in any year.  Since Roth accounts are not taxed it may make sense to distribute the funds in year 10.  Conventional accounts are taxed; hence, taxpayers may want to spread distributions across years.

Funds not distributed by year 10 are subject to a 50% tax.  Ouch!

Spouses who inherit an IRA do not have to take distributions until age 72.

The time frame for distributions for people who inherit an account through probate is 5 years not 10.  Hence, it is important to name a beneficiary on your 401(k) or IRA.

Many people who inherit IRAs or 401(k) plans have modest income.  This bill requires distributions even when the person might be better off saving for retirement.    Many people inheriting a small IRA or 401(k) are not wealthy.

The bill was passed during the Trump Administration.     Trump Administration and Republican tax policy was in general very generous to high-income people but not averse to using complicated rules to get a bit more tax from some people who may be middle income.