Student Debt Proposal #4: Reducing tradeoff between retirement saving & student debt repayment

Reforms centered on increased use of Roth IRAs would better balance saving for retirement and student debt repayment than the Secure Act 2.0 reforms.

Introduction:   Tax and financial incentives are more generous for contributions to 401(k) plans than for the repayment of student debt.

  • Workers are allowed to to save untaxed dollars in a firm-sponsored retirement plan or an individual retirement account.
  • Firms can match employee contributions to the 401(k) plan. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 
  • Student borrowers can deduct up to $2,500 of interest on student loans.  
  • The student loan tax deduction pertains exclusively to interest while the entire 401(k) or IRA contribution is exempt from taxes.
  • There are no matching contributions for student loan repayment.

The decision to prioritize 401(k) contributions over student debt repayment does not always work out well as discussed in a previous post.  Potential consequences include:

  • Higher total loan payments associated with selection of longer loan maturities.
  • Higher borrowing costs stemming from higher debt levels and lower credit ratings.
  • Early disbursements of 401(k) funds leading to penalty and tax payments.
  • Increased likelihood of having debt obligations in retirement.

Student borrowers who quickly repay their loans would increase saving for retirement, realize lower borrowing costs, start the process of paying off their mortgage and would basically be much better off.  

There is general agreement that student debt significantly impedes saving for retirement by young households.  There is, however, no real consensus on how to fix this problem.

Proposed modifications to 401(K) plans in the SECURE Act 2.0, which would induce some student borrowers to begin saving through a 401(k) plan, don’t solve this problem. Expanded incentives for the use of Roth IRAs by student borrowers would be far more effective than expanded incentives for 401(k) contributions.

The Secure Act 2.0:

Wall Street favors and greatly benefits from incentives for 401(k) investing. The Secure Act 2.0 maintains the high priority attached to 401(k) saving and facilitates participation in 401(k) plans by student borrowers.  

The Secure Act 2.0 has the following features:

  • Requires automatic enrollment of employees in 401(k) plans
  • Requires all catchup contributions be designated as Roth contributions
  • Allows designation of matching contributions to a Roth account 
  • Delays mandatory distributions
  • Reduces waiting period for 401(K) contributions from 3 to 2 years for part-time workers.
  • Authorizes 401(k) matches for student borrowers even if they do not participate in a 401(k) plan.

The general purpose of the Secure Act 2.0 is to expand investments through 401(k) plans.

Many people who rely on high-cost 401(k) plans often end up paying a substantial portion of their savings to Wall Street. Go here for a discussion of the impact of 401(k) fees on retirement. 

The proposal only benefits student borrowers at firms with 401(k) plans, workers at firms with plans offering matching contributions, and workers eligible for the 401(k) plan.  

Many student borrowers will not benefit from this provision in Secure Act 2.0 including:

  • Self-employed workers and people employed by firms not offering a 401(k) plan.  Only 53 percent of small and mid-size firms offer a 401(k) plan.
  • People at firms with 401(k) plans that do not match employer contributions. Around 49 percent of all firms do not offer an employer match.
  • Employees who are ineligible for the firms-sponsored 401(k) plan.  Around 24 percent of firms require one year of service for entry to the firm-sponsored 401(k) plan.
  • Employees eschewing 401(k) plans due to  vesting requirements.

It is reasonable to anticipate that increased 401(k) contributions by young adults with student debt will fail to increase retirement wealth because, as evidenced by this CNBC article, around 60 percent of young adults end up raiding their retirement savings earlier in the career.

An Alternative Proposal, Incentives for Increased Use of Roth IRAs:

A more equitable and efficient way to balance the goal of saving for retirement with rapid repayment of student debt is through incentives to increase contributions to Roth IRAs instead of 401(k) plans

This could be accomplished by modifying the SECURE Act in the following fashion.

  • Mandate automatic contributions to Roth IRAs instead of automatic contributions to 401(k) plans 
  • Mandate automatic use of low-cost highly diversified IRAs unless person opts for a different investment strategy
  • Allow employers to match contributions to Roth IRAs or contributions to 401(k) plans
  • Allow employers to give employer matches to holders of Roth IRAs even if the student borrower does not contribute to the Roth IRA.
  • Prohibit distributions from investment income inside Roth IRAs prior to age 59 ½. 

A strong case can be made that many workers should maximize the use of Roth IRAs instead of traditional IRAs even under current law.

  • There are substantial tax savings in retirement from the use of Roth IRAs from two sources. First, the distribution for the Roth IRA is not taxed during retirement.  Second, the Roth distribution does not count towards the income limit leading to the taxation of Social Security benefits.  Households that rely primarily on Roth distributions in retirement often do not pay any tax on their Social Security benefits.
  • Distributions from Roth contributions prior to age 59 ½ are not subject to income tax or penalty.  This feature benefits young adults who tend to raid their account prior to retirement and pay taxes and penalty.
  • The Roth account does not allow 401(k) loans, a feature that causes people to distribute funds and even close the entire account prior to retirement. 

This proposal encourages student borrowers who are ready to save for retirement to choose a Roth IRA instead of a 401(k) plan.  The change will increase retirement saving for several reasons

  • Some firms without a firm-sponsored retirement plan may provide an employer match to an IRA because there should be no administrative costs imposed on the firm for this type of contribution
  • The automatic selection of a low-cost IRA will usually result in lower fees and higher returns compared to the default 401(k) option. 
  • The restriction on distributions from investment income until after age 59 ½ prevents people from distributing all retirement assets and closing the retirement plan prior to retirement. 
  • The IRA could receive matching funds from multiple employers.

Both the Secure Act 2.0 reforms and the alternative one presented here favor Roth accounts over traditional accounts.  The use of Roth accounts favors low-income student borrowers because their marginal tax rate and deduction for contributions to traditional 401(k) plans is low.  

The use of Roth accounts by low-income low-marginal-tax-rate workers facilitates diversion of some assets for debt repayment because the holder of the Roth requires less wealth to fund a sufficient retirement.  

Concluding Remarks:  Wall Street and financial advisors consistently advise their clients to prioritize 401(k) contributions over rapid repayment of student debt.  This approach is not leading to a secure financial life for many student borrowers who are paying more on student debt over their lifetime, incurring high borrowing costs on other loans, having trouble qualifying for a mortgage and raiding their 401(k) plan prior to retirement.   The use of Roth IRAs and rules allowing employers to match contributions into a Roth rather than contributions into a 401(k) will help student borrower better balance student debt repayment and retirement saving.

The more rapid repayment of student debt might also be facilitated by a partial discharge of student debt after around 60 on-time payments as describe in this post.

A list of student debt post presented here will be updated with new articles when available.

Financial Tip #12: Impact of mortgage debt on longevity risk

The existence of mortgage debt in retirement is shown to substantially increase the likelihood a person will totally deplete their retirement account and will have to rely exclusively on Social Security and Medicare for all expenses.

The Situation:  Consider a person who took out a 30-year mortgage, 15 years prior to retirement.   The initial balance on the mortgage was $600,000 and the interest rate on the mortgage was 3.6 percent.

The person retires with $1,000,000 in her 401(k) plan but the retiree also has an outstanding mortgage of $378,975 and an ongoing monthly mortgage payment of $2,728.  

The retiree plans to spend $40,000 per year $3,333 per month to cover non-housing consumption in retirement. 

  • The total annual disbursement from a 401(k) plan for a person with a mortgage is $72,735.
  • The total annual disbursement from a 401(k) plan for a person without a mortgage is $40,000.

Question One:  What are the outstanding balances of the retirement plan after 15 years for a person with a mortgage and a person without a mortgage if the rate of return on investments in the retirement plan is 6.0 percent per year?

Answer:  

  • The outstanding 401(k) balance after 15 years for the person with a mortgage is $691,380.
  • The outstanding 401(k) balance after 15 years for the person without a mortgage is $1,484,698.

Question Two:  What are the 401(k) outstanding balances after 15 years if the person started retirement with $900,000 in 401(k) assets.

Answer:  

  • The person with the mortgage has a 401(k) balance of $445,971 after 15 years.
  • The person without a mortgage has a 401(k) balance of $1,239,290 after 15 years. 

Implications for longevity risk:

The existence of a mortgage payment substantially increases the depletion rate of the 401(k) plan. The mortgage payment cannot be avoided during market fluctuations.  The existence of a mortgage during a market downturn at the beginning of retirement can have an especially adverse impact on retirement wealth.

The discussion presented here does not explicitly consider taxes.

  • All traditional 401(k) assets are fully taxed as ordinary income.   
  • The person with higher spending due to a mortgage will have also have higher taxes.
  • This person may increase spending to have adequate non-housing consumption.

More on these issues will follow.

Technical Note:  Discussion of Financial Calculations

The most straight forward way to obtain the 401(k) balance is to set up a spreadsheet where the loan payment is subtracted from the balance each month and the balance minus the loan payment earns a monthly return.   

A second approach involves the use of the FV function.  

The arguments of the FV function are

  • Rate 0.06/12 or 0.005.
  • NPER 12*15 or 180.
  • PMT 6061.21 for person with a mortgage and $3,333.33 for person without the mortgage.
  • PV -1,000,000. Negative because PV is cash in and must be the opposite sign of the PMT function.

The FV function is set up to analyze loans, so be careful with the sign of answer.

The logic of the spreadsheet approach is easier to follow.

Financial Tip #11: Roth Conversions Early in Retirement

People entering retirement with liquid assets outside of their retirement account should delay claiming Social Security benefits, delay disbursement from traditional retirement plans and convert traditional retirement assets to Roth assets. This strategy requires substantial liquid assets outside of a retirement account

previous post explored the potential gains from converting traditional retirement assets to Roth assets whenever taxable income was low.  This post explores a specific situation, the conversion of traditional retirement assets to Roth assets early in retirement prior to a person claiming Social Security benefits. 

Discussion:  

Many financial advisors recognize the benefits from delaying claims in Social Security benefits.

Social Security benefits are reduced by 30 percent for workers born 1960 or later who claim retirement benefits at age 62 instead of 67. In addition, each month delay in claiming retirement benefits after reaching the full retirement up to age 70 age, increases benefits by 2/3 of 1 percent.  Go here to the SSA site for a discussion of advantages of waiting until the full retirement age to claim Social Security benefits.  Go here for a discussion of the advantage to claiming Social Security at age 70.

The potential gains from delaying 401(k) disbursements and delaying claiming Social Security benefits while converting traditional retirement assets to Roth assets have not been fully publicized.   

The strategy of converting traditional retirement assets to Roth assets early in retirement can be profitably implemented if the household has substantial financial assets outside of a retirement account to fund current consumption.  In some cases, these liquid assets can be obtained by a household downsizing to a smaller home and using the house equity to fund consumption.  

The cost of converting traditional retirement assets is the additional tax paid on the increased income stemming from the conversion.  A household in retirement not claiming Social Security benefits and not disbursing 401(k) funds will have a low marginal tax rate and low conversion costs.  

The benefits of the conversion of the traditional assets to Roth assets are the reduction in tax during the year Roth assets are disbursed instead of traditional assets. The amount of Social Security benefits subject to federal and state income tax is linked to modified adjusted gross income.  Since Roth disbursements are not taxed and not included in modified adjusted gross income the disbursement from a Roth instead of traditional retirement plan can have a substantial impact on taxes.  

Go here for a discussion of the taxation of Social Security benefits.

Funds obtained from investment returns on the conversion of conventional assets to Roth assets cannot be disbursed without penalty or tax for five years starting January 1 of the year of the disbursement.   The five-year rule pertains to investment returns on all conversions, even those that occur after age 59 ½. 

An example of returns from converting traditional assets to Roth assets in retirement:

This example of the potential advantages of converting traditional retirement assets to Roth assets early in retirement was published in this Tax Notes article.

A married couple — filing a joint return with $10,000 in investment income — converting $34,550 in traditional assets to Roth assets would have taxable income of $19,750 and would pay $1,975 in tax.  The cost of conversion in this instance is $1,975, the difference in tax paid with the conversion and the tax paid without a conversion. 

The investment of $34,550 in a Roth account that earns a 6 percent annual return would be slightly more than $46,000 in five years. The one- year conversion would, in this instance, pay for the $39,000 distribution and would leave $7,000 for future distribution. 

A household distributing $50,000 from a traditional retirement account would pay around $7,072 in tax.  The household that distributes $39,000 from a Roth account and $11,000 from a traditional account would pay approximately $400 in tax.  

The total tax savings from the conversion, assuming a 6 percent return on converted assets is around $7,700.

The rate of return on the conversion is estimated a 30.7 percent.

Concluding Remark:  People entering retirement can extend the longevity of their retirement savings by initially using non-retirement assets to fund consumption, by delaying claiming Social Security benefits and 401(K) disbursements, and by converting traditional retirement assets to Roth assets.

Financial Tip #10: Convert traditional 401(k) funds to a Roth when income is low

The cost of converting a traditional IRA to a Roth IRA, the additional tax paid on the amount of the conversion, is generally low in years where a person leaves the workforce. The potential tax savings in retirement is considerable.

Introduction:

Often people leaving the workforce raid their retirement plans to fund current consumption.  A departure from the workforce creates an opportunity for people to convert traditional retirement assets to Roth assets at low cost.  The low-cost conversion to Roth assets can substantially improve financial outcomes in retirement. Households are only able to make this low-cost conversion if they have a decent ratio of liquid assets to debts.

Analysis:

  • A previous post, financial tip #6, found that people leaving a firm with a high-cost 401(k) plan should roll over funds from the high-cost 401(K) to a low-cost IRA to increase wealth at retirement.   The rollover is often a prerequisite to converting traditional 401(k) assets to a Roth.
  • The tax code allows for the conversion of traditional IRAs to Roth IRAs. Distributions from a Roth account in retirement are not taxed and do not count towards the amount of Social Security subject to tax. The person converting previously untaxed funds in an IRA pays income tax on the converted funds in the year of a conversion.   The cost of converting traditional assets to Roth assets, the additional tax paid stemming from the conversion, is low when households have marginal tax rates.   
  • Marginal tax rates are lowest when a worker or a spouse leaves the workforce.  This can happen when a person returns to school, decides to care for a family member, becomes unemployed or retires.  
    • Conversion costs are $0 if AGI including the amount converted is less than the standard deduction ($12,950 for a single filer).
    • Conversion costs for single people filing an individual return are 10 percent of taxable income AGI minus the standard deduction for taxable income between $0s and $14,200.  Increases in taxable income up to $54,200 increase conversion costs by 12 percent, the marginal tax rate.
  • The potential gains from converting traditional retirement assets to Roth assets early in a career perhaps when returning to school are tremendous.   
  • A person leaving the workforce for school for a couple of years at around age 28 might convert $20,000 from a traditional IRA to a Roth at a cost of around $2,000.
  • The balance of the Roth account from this conversion after 30 years assuming a 6.0 percent return is $114,870. 
  • The direct tax savings from the conversion assuming a tax rate of 10 percent would be $11,487.  An indirect tax savings from the omission of tax on Social Security, assuming around $50,000 in Social Security payments spread over a couple of years, would be around another $5,000.  The conversion can be thought of as an investment of $2,000 leading to a return of around $16,000 in around 30 years.  The rate of return for an investment of $2,000 and a return of $16,000 in around 30 years is around 7.2%.
  • A person in a low tax bracket because she is young and single and returning to school and only working for the part of the year could be in a much higher tax bracket in retirement, especially if married and both spouses worked and claimed Social Security.  In many cases, the returns from converting a traditional IRA to a Roth will be much higher than the one reported by the simple example in the above bullet. A person living 100 percent on Roth distributions and Social Security could easily pay $0 in annual tax after accounting for the standard deduction.
  • A person returning to school full time with no reported earnings could convert an amount equal to the standard deduction to a Roth and pay no additional tax.  It would be irrational for a person with a 0 percent marginal tax rate to fail to make a conversion.
  • Workers leaving the workforce are often more concerned about meeting immediate needs than for planning for retirement.  However, conversion costs are small during a year a person leaves the workforce.
  • Workers leaving the workforce with debt or with 401(k) loans often distribute funds from their 401(k) plan, pay a penalty and tax, and are unable to rollover or convert funds to a Roth.
  • The five-year rule imposes tax and penalty on funds disbursed from a Roth IRA funded through a conversion from a traditional IRA within five years from January 1 of the year of the conversion.  A separate five-year waiting period is applied to each conversion.     The five-year rule applies for conversions after age 59 ½ even though all funds in Roth accounts funded by contributions can be withdrawn without penalty and tax at that age.  The purpose of the five-year rule for conversions and its implementation even after age 59 ½ is to prevent immediate access to funds in a traditional retirement account.  The five-year rule for conversions appears to apply to disbursements from both contributions and earnings for both pre-tax and after-tax IRAs. 

Concluding Remarks:   The cost of converting a traditional IRA to a Roth IRA, the additional tax paid on the amount of the conversion, is generally low in years where a person leaves the workforce.  The potential tax savings in retirement is considerable.

Several additional posts on IRA conversions are planned.  One post considers issues related to conversions of non-deductible IRAs in a procedure called a backdoor IRA.  A second post considers the advantages of converting pre-tax IRAs during retirement.

Financial Tip #9: Payoff the entire mortgage prior to retirement

Avoid taking mortgage debt into retirement to substantially reduce the likelihood of outliving your retirement savings.

Tip #9: People with mortgage debt in retirement must often take large taxable distributions from their 401(k) plan regardless of the level of the stock market.  The elimination of all debt prior to retirement substantially reduces the likelihood a person will outlive their retirement savings.

General Discussion:  Many financial advisors believe it is appropriate for their clients to keep some debt in retirement.   They will advise their clients to take out a 30-year loan instead of a 15-year loan to increase contributions to a 401(k) plan and to take full advantage of the deductibility of mortgage interest. They also argue that people nearing retirement should make additional catch-up contributions to their 401(k) plan instead of increasing payments on their mortgage.

The decision to keep debt in retirement is a recipe for financial disaster, especially if the household is reliant on fully taxed distributions from a 401(k) plan and partially taxed Social Security benefits.  

Issue One: The person with debt will more rapidly deplete their 401(k) plan and will pay higher taxes in retirement.

Discussion:  A person taking out a 30-year $500,000 mortgage, 15 years prior to retirement has annual mortgage expenses of $26,609.  The person that used a 15-year mortgage enters retirement debt free.  See the example presented in Financial Tip #4 Guidelines for the choice between a 15-year and 30-year mortgage.  

The person with the mortgage debt must either reduce non-mortgage expenditures or distribute additional funds from their retirement account to maintain the same consumption as the person that paid off her entire mortgage prior to retirement. 

Large tax-deductible mortgages reduce payment of federal and state income taxes in working years but increase payment of federal state and income taxes in retirement.

  • Retirees without business expenses generally have lower itemized deductions than people in their prime earnings years, hence, the advantages from itemizing in retirement are often small.
  • An increase in the distribution of 401(k) funds to cover the mortgage is fully taxed as ordinary income. 
  • An increase in 401(k) distributions increases the amount of Social Security subject to income tax as discussed on this page offered by the Social Security Administration.  

Issue Two:  The person without debt is better able to maintain current consumption levels and preserve wealth during market downturns.

Discussion:   Typically, a person attempts to maintain a certain level of consumption perhaps 60 percent of pre-retirement income throughout retirement.  A person with a mortgage or a monthly rental payment is less able to reduce expenditures when the value of stocks in their 401(k) falls because the mortgage payment or the rent are not optional. 

Any reduction in disbursements from 401(K) plans, which are reduced in value due to a collapse in stock prices, would have to occur from a reduction in non-housing consumption.   

The largest financial exposures occur when the market falls by a substantial amount in the early years of retirement when the entire savings from working years is exposed to the market.  The market downturn in stocks in 2008 was somewhat offset by an increase in bond values.   This time around both stocks and traditional bonds appear to be in a bubble.   People may want to consider Series I or inflation bonds as discussed in  financial tip #7.

Still, the best way to prepare for a market downturn is to eliminate all debt prior to retirement. 

Concluding Remarks:  During working years, many households take on a large amount of mortgage debt to reduce current year tax obligations. Failure to eliminate all mortgage debt prior to retirement often leads to rapid depletion of 401(k) assets, higher income tax burdens in retirement and increased exposure to financial volatility.  

Financial Tip #7: Invest in Series I Savings Bonds whenever possible

Middle income households should purchase some Series I Bonds from the Treasury annually.

Tip #7: Series I Savings Bonds should be included in every investor’s portfolio.  This asset purchased directly from the U.S. Treasury without fees is an effective hedge against inflation and higher interest rates.

Characteristics and rules governing Series I bonds:   The Series I bond, an accrual bond issued by the U.S. Treasury tied to inflation, is described here.  

Key Features of Series I Bonds:

  • Backed by the full faith of the U.S. Treasury
  • Cannot be redeemed until one year after issue.
  • Redemptions prior to five years from issue date forfeiture of one quarter of interest.
  • The composite interest rate changes every six months,
  • The interest rate is based on two components – a fixed rate and the inflation rate.   
  • The composite rate is guaranteed to not fall below zero.
  • The interest is taxed when the bond is redeemed.
  • Bond matures and stops paying interest after 30 years.
  • The Treasury limits annual purchases of the bonds to $15,000 per person with a limit of $10,000 on electronic purchases and $5,000 on paper purchases.  The paper Series I bonds can only be purchased through refunds from the IRS.

Reasons for Purchasing Series I Bonds:

  • Series I Bonds, unlike traditional bonds and bond ETFs, do not fall in value.
  • In the current low-interest rate high valuation environment, traditional bonds and stock prices are almost certain to decline in value.  
  • A retired person with I-Bonds outside of a 401(k) plan can respond to a market downturn by using proceeds from the redemption of I-bonds to fund current consumption rather than disburse funds from a 401(k) plan, which could be temporarily down in value.
  • The Series I Bond is a riskless asset.  Investors with this asset can reduce holdings of traditional bonds and cash and increase investments in equities.

Difference Between Series I Bonds and TIPS:

Treasury Inflation Protection Securities (TIPS also allow investors to protect returns when inflation and interest rates rise.

Key differences between TIPS and a Series I bond as explained here:

  • The TIPS value can fall in an era of deflation.  The Series I bond never falls in value.
  • The tax on interest from TIPS is paid annually and not deferred to redemption
  • TIPS bonds can be sold without forfeiture of any interest at any time.  The redemption of a Series I bond is not allowed until after a year from the purchase date and sales prior to five years from the purchase date involve a forfeiture of a 3 months of interest.  
  • All TIPS can be counted as a liquid asset.   Only Series I older than 5 years from issue should be considered liquid.
  • Up to $5.0 million in TIPS can be purchased in a single auction.  The annual limit on the purchase of Series I Bonds is $15,000.

Thoughts on Series I interest rates:

  • The current fixed interest rate on a Series I Bond is 0 percent.  The current composite fixed + inflation component on bonds purchased prior to May 2022 is 7.12%.  A delay in the purchase of a Series I bond until the second half of the year could result in a permanently higher fixed rate.  However, investors would lose an annualized return of 7.12% accruing in May. 
  • Bonds purchased years ago in a high interest rate environment have a higher current composite rate because the fixed component is higher.  People are currently aware of I-Bonds because of the elevated inflation rate.  The purchase of I-bonds also makes sense when inflation is low and interest rates are high because the investor will obtain both a higher fixed rate and increases in interest when inflation returns.

Concluding Thoughts:  Investors should purchase a Series I bond every year.  Investors who maximize receipt of the employer matching contributions to a 401(k) plan can then divert additional investments to a Roth IRA or a Series I Bond.  People without a 401(k) plan that allows matching contributions should contribute to a Roth, invest Roth contributions in equities, and divert some funds to the purchase of Series I bonds.

Financial Tip #6: Rollover 401(k) assets to IRAs

Employees changing jobs with funds in a high-cost 401(k) need to consider rolling funds into a low-cost IRA.

Tip #6: An employee leaving a firm can substantially increase retirement wealth by moving

401(k) funds to an IRA.   Be careful though!  Protections against creditors are stronger for 401(k) plans than for IRAs in many states.

Examples of potential gain from rolling over assets in a high-cost 401(K) to a low-cost IRA

Example One:  A worker leaving her firm at age 50 can keep $500,000 in 401(k) funds in the firm-sponsored retirement plan that charges an annual fee of 1.3% or can move the funds to a low-cost IRA that charges an annual fee of 0.3%.   The return on assets prior to fees in both the 401(k) plan and the IRA is 6.0 percent per year.  

What is the value of the account at age if assets remain in the high-cost 401(k) and if assets are rolled over into the low-cost IRA?

  • Account value of high-fee 401(k) plan is $995,796.
  • Account value of low-cost IRA is $1,148,404.
  • Gain from rollover is $152,609.

Example Two: A worker changing jobs at age 30 can keep $20,000 in the firm 401(k) or move the funds to a low-cost IRA.  The annual fee for the 401(k) is 1.3 %, the annual fee for the IRA is 0.3%. The underlying returns prior to fees for both assets in the 401(k) and assets in the IRA is 8.0%.  

What is the value of the account at age 60 if the person keeps assets in the high-cost 401(k) or moves funds to a low-cost IRA?

  • Account value of high-cost 401(k) plan is $139,947.
  • Account value of low-cost IRA is $185,140.
  • Gain from rollover is $45,194.

Note: The impact of financial fees on the future value of the account can be calculated with the FV function in Excel.  The arguments of the FV function are the rate of return after fees, holding period in years, and the initial balance in the 401(k) plan.   

 Additional Comments:

  • Most roll overs from 401(k) plans to IRAs occur when a worker leaves a firm for another employer.  Some firms allow for some in-service rollovers.  
  • Some workers, in need of cash routinely, disburse funds from their 401(k) plan.  The disbursement of funds from a traditional 401(k) plan prior to age 59 ½ can lead to penalties or tax.   A roll over of funds from a 401(k) plan does not lead to additional tax or any financial penalties.
  • One motive for moving funds from a 401(k) plan to an IRA is the desire to place funds in a Roth account when a firm only offers a traditional retirement plan.   The act of rolling over funds from a 401(k) to an IRA and the act of converting the new conventional IRA to a Roth IRA are separate and do not have to occur together.  Conversion costs are lowest when a worker has low marginal tax rate.  Several future posts will examine the costs and benefits on converting traditional retirement accounts to Roth accounts.
  • The federal bankruptcy code protects both 401(k) plans and IRAs. However, 401(k) plans offer stronger protection against creditors than IRAs outside of bankruptcy.  Whether IRAs are protected from creditors is determined by state law.  ERISA, a national law, provides protection against creditors for 401(k) plans.  This difference can persuade some people to keep funds in a 401(k) plan, rather than covert funds to an IRA.  Go here for a state-by-state analysis of protections against creditors for owners of IRAs.
  • The calculations, presented above, of greater wealth from the rollover assumes identical pre-tax returns for the high-cost 401(k) plan and the low-cost IRA.  Most financial experts believe that low-cost passively managed funds tend to outperform high-cost funds.  Interestingly, Warren Buffet, probably the best active investor of all times suggests passive investing in low-cost funds is generally the better approach.
  • Factors other than transaction costs can impact the decision to rollover 401(k) funds or stay.   Some 401(k) plans allow investors to purchase an annuity at retirement.  The existence of automatic enrollment from a 401(k) plan to an annuity could induce some workers to keep funds in a 401(k) rather than roll over funds into an IRA.

Financial Tip #5: Maximize the 401(k) match and then contribute to IRAs

Maximize the employer matching contribution then save additional funds in an IRA!

Tip #5:  A worker at a firm with a 401(k) plan that has high fees should maximize receipt of the employer match and divert additional funds to a low-cost IRA.

Analysis:

The Situation:

  • Worker has access to a 401(k) plan that matches contributions equal to 5.0% of salary.
  • The 401(k) plan has an annual fee equal to 1.3% of assets.
  • Vanguard and Fidelity offer a deductible IRA with an annual fee of 0.3% of assets.

The Choice:

  • Choice One: Contribute 10 percent of income to a 401(K) 
  • Choice Two: Contribute 5% percent of income to a 401(K) and 5.0% of income to an IRA.

Additional Assumptions:

  • The person earns $75,000 per year for 35 years.
  • The return on investments prior to fees is 6.0% per year.
  • Contributions are bi-weekly

The Outcome:

  • Choice One:  Wealth at Retirement $998,933 all in a 401(K).
  • Choice Two: Wealth at Retirement $1,083,089, with both 401(K) and IRA.
  • Additional wealth from diverting funds to an IRA is $83,876.

Concluding Remarks:   Many financial advisors ignore fees and recommend maximizing contributions to a 401(k) plan.  A better solution is to maximize the employer match and divert additional savings to a low-cost IRA.

Financial Tip #3: Maximize use of after-tax Roth IRAs

Tip number 3:  Most households use traditional retirement accounts instead of Roth accounts.  The Tax Policy Center reports around 23% of taxpayers have a traditional IRA compared to around 12% of taxpayers with a Roth IRA.  According to CNBC, in 2016 around 70 percent of firms offered a Roth 401(k), but only 18% of workers used the Roth 401(k) option.  

More people should choose a Roth retirement plan over a traditional one.  People should use Roth accounts in the following circumstances.

  • Workers at firms not offering a retirement plan with a marginal tax rate less than 25% should use a Roth IRA instead of a deductible IRA.
  • Workers at firms offering both a traditional and Roth 401(k) should choose the Roth 401(k) if their marginal tax rate is less than 25%.
  • Workers with marginal tax rates less than 25% at firms with 401(k) plans without employee matching contributions should select a Roth IRA or Roth 401(k) over a traditional 401(k) plan.
  • Workers who maximize receipt of employer matching contributions should place additional contributions in a Roth IRA.
  • Spouses of workers with family AGI below the contribution limit for Roth contributions should contribute to a Roth IRA, if eligible.

Comments:

  • Gains from 401(k) contributions are relatively small when employers don’t provide a matching contribution and a worker’s marginal tax rate is low.  
  • Workers with Roth accounts are less likely to withdraw and spend all funds prior to retirement than workers with traditional accounts because they can access the amount contributed without penalty or tax prior to age 59 ½. 
  • The tax saving from Roth disbursements in retirement are high both because disbursements after age 59 ½ are not taxed and the Roth disbursement does not increase the amount of Social Security subject to tax.
  • Workers at a firm that do not match employee contributions, around 49 percent of employers, should contribute to a Roth IRA instead of a 401(k) plan unless the worker has a high marginal tax rate.
  • One effective contribution strategy is to take full advantage of the employer match and contribute all additional funds to a Roth IRA. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 
  • Most new employees at firms with a vesting requirement, a rule delaying full ownership of 401(k) matches, should contribute to a Roth IRA instead of a 401(k) plan.
  • Stay-home spouses of workers with income should choose a Roth IRA over a traditional one if they are eligible. In 2021, a single filer with MAGI less than $140,000 and a married joint return filer with MAGI less than $206,000 cannot contribute to a Roth IRA.  Workers with income above these contribution limits should contribute to a Roth IRA.  Other workers should use a backdoor IRA.

Readers should remember to open their Roth IRA early in life as explained in financial tip number one.

Financial Tip #1: Open and fund a Roth IRA early in your career

Tip #1: Open and fund a Roth IRA and invest funds in a low-cost ETF when you get your first job in high school or college.

  • People who open a Roth IRA early in life have a long investment horizon.   The longer investment horizon allows individuals to invest in equities and accumulate substantial wealth.
  • A person who invests $1,000 in a Roth at age 17 will have $25,729 at age 65 if the average rate of return was 7.0% per year.   The total wealth at age 65 would be $62,585 when rate of return is 9.0% per year.  This Nerd Wallet article suggests the average rate of return on stocks is around 10 percent per year.
  • Firms like Fidelity, Schwab and Vanguard offer exchange traded funds with low fees and no minimum balance. A fund like VOO from Vanguard which covers the entire S&P 500 at low cost could easily earn 7% over long investment horizons.
  • The wealth estimates presented above assume the person does not tap funds in the Roth IRA prior to age 65.   This is not always possible.   The owner of the Roth IRA is allowed to disburse the after-tax contribution without penalty or tax at any time.   The Roth contributions can be used without penalty or tax for emergencies or to repay debt. The investment returns from inside a Roth are subject to penalty and tax if disbursed prior to age 59 ½.
  • All funds disbursed from traditional 401(k) plans and deductible IRAs are subject to penalty or tax if disbursed prior to age 59 ½. A young person embarking on her first job with a lifetime of obligations ahead of her should select the Roth over the traditional retirement plan, especially if there is no employer match, which is generally the case on a first job.

Concluding Thoughts:  Many employers automatically enroll new employees in a traditional 401(k) plan even though the worker would do much better in a Roth IRA.  Too many workers contributing to a traditional 401(k) plan, disburse funds prior to retirement and incur penalty and tax.  My view, expressed here and in several future posts, is that the Roth IRA should become the default option.