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 #8: Make contributions to a health savings account a high priority

Households with high-deductible health plans (HDHPs) need to contribute to their health savings account (HSA) even if lack of funds and limited income causes them to decrease savings for other goals.

Tip #8:  The growth of high-deductible health plans (HDHPs) has increased financial risk and created an incentive for many people to reduce expenditures on essential health services.   People with high-deductible health plans need to contribute to a health savings account (HSA) to offset these risks.  When funds and income are limited, the increase saving for health care will reduce savings in retirement accounts and general liquidity.

Background on Health Savings Accounts:  

  • An HSA is a tax-preferred saving vehicle for people who enroll in an HDHP.   The primary advantage of an HDHP is reduced premiums for the employer and the insured person.   The primary disadvantage is the insured must pay a large share of health expenses.
  • The minimum deductible on a HDHP in 2022 is $1,400 for individual coverage and $2,800 for family coverage.  The maximum allowable out-of-pocket limits in 2022 are $7,050 and $14,100.   It is permissible for the HDHP deductible to be as high as the out-of-pocket limit.   A typical HDHP policy requires the insured person pay a share of all health care expenses after the deductible is met and until the out-of-pocket limit is reached.   
  • HSAs, created as part of the Medicare, Prescription Drug Improvement Act of 2003 are now a major insurance option.   An HDHP is the only plan offered by around 40 percent of employers and is sometimes the most affordable option through employers or on state exchanges.
  • People with high-deductible health insurance coverage are often exposed to large medical bills, take on high levels of medical debt, and often choose to forego necessary medical treatments. The health consequences can be especially severe for people who forego prescription drugs for chronic conditions.  
  • People can reduce the adverse health and financial impacts associate with HDHPs by contributing to an HSA. However, this study by JAMA reveals that one in three people with an HDHP do not have an HSA and that 55 percent of people with HSAs failed to contribute to their account.  An article by SHRM cites work by EBRI which found more than half of people initiating contributions to HSAs do so by reducing contributions to 401(k) plans.
  • The IRS caps the amount of funds a person can contribute to a health savings account.  In 2022 the caps on health savings account contributions are $3,650 for self-only plans and $7,300 for family plans.
  • Contributions to HSAs result in significant tax advantages.   The contribution to the account is not taxed during the year the contribution is made.   The funds are never taxed if they are used for a qualified medical expense.   Funds used for non-medical purposes prior to age 65 are subject to a 10 percent penalty.   There is no tax penalty after age 65.  
  • After age 65, funds disbursed from a HSA are fully taxed but are not subject to penalty.  Funds placed in a traditional 401(k) plan are always fully taxed but are not subject to a penalty after age 59 ½.  Fund placed in a Roth account and investment returns from funds in a Roth are completely untaxed after age 59 ½.  In addition, withdrawals of contribution to a Roth are completely untaxed at any time.

Allocation of Resources between HSAs and other saving vehicles:

People with limited income and high debt have a difficult choice between saving for health-related expenses through a health savings account or saving for other priorities.  There is no one-size fit all approach to the appropriate savings strategy.  

  • Finance Tip #2, concluded that it was okay for a person entering the workforce with high student debt to forego contributions to a 401(K) plan to prepare for emergencies, maintain a solid credit rating and rapidly reduce their student debt. An HSA reduces taxes and allows for the use of funds for medical expenses.  Young adults who have high debt and are dependent on a HDHP should likely contribute to an HSA instead of a 401(k) fund.
  • People with access to a 401(k) plan that does not match employee contributions are likely better off with a combination of a Roth IRA (see finance tip #3) and an HSA.   The HSA gives some tax relief in the year of the contribution while the Roth IRA provides substantial tax savings during retirement. 
  • Workers at a firm that matches employee contributions to a 401(k) plan should maximize receipt of the employer match, as discussed in finance tip #5 and then contribute additional funds to a mix of a Roth IRA and an HSA.
  • The choice between contributing the last dollar to a Roth or the last dollar to an HSA is affected by several factors.    
  • The HSA is the only preferential savings plan that I am aware of that allows for a tax-free contribution and distribution. HSA distributions for qualified medical expenses are never taxed.  The Roth contribution is fully taxed but all distributions after age 59 ½ are tax free and the distribution from the Roth does not increase tax incurred on Social Security benefits.  Workers nearing age 59 ½ will often prioritize Roth contributions because the tax-free distributions could be used for any purpose. 
  • HSA funds can be used to fund retirement after age 65, however, funds not used for medical expenses are fully taxed.  It makes sense to spend HSA funds for health care and retirement funds for general consumption.

Concluding Remarks:  The process of saving for retirement is complicated.  Simply plowing everything into a 401(k) is not an optimal strategy.   As noted in Financial Tip 2 people drowning in debt should even forego matching contributions into a 401(k) plan until they can bring their debt down to a manageable level.  

The growth of HDHPs complicates the savings process.  The increased likelihood of incurring high health care expenses increases the need for an emergency fund. A health savings account, like a 401(k) contribution, provides both immediate tax savings and funds for medical emergency.   The analysis presented here and in previous supports the need for investors to use diverse savings vehicles.

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.

Excel Hint #4: Calculating the future value of a mortgage

A key advantage of choosing a 15-year mortgage over a 30-year mortgage is the more rapid decrease in the mortgage balance and increase in house equity. This post discusses the use of Excel to calculate the future value of different mortgages.

Situation:   A person is considering two options for a $500,000 loan.   The first option is a 30-year term at an interest rate of 3.4%.   The second option is a 15-year term at an interest rate at 2.9%.  

  • How can Excel be used to calculate the mortgage balance at 7 years for the two options?  
  • What are the mortgage balances for the two options after seven years?

The Calculation:  The future value of the mortgages above are calculated in Excel with a two-step procedure. 

Step One: 

Calculate monthly payment from the PMT function.

The arguments of the PMT function are – the monthly interest rate, the maturity of the loan in months, and the initial loan balance.

  • The 30-year monthly payment is PMT(0.034/12,360,500,000) or $2,217.41.
  • The 15-year monthly payment is PMT(0.029/12,180,500,000) or $3,428.91.

These monthly payment values are input for the second step.

Step Two:  

Calculate the outstanding loan balance from the FV function.

The arguments of the FV function are — the monthly interest rate, the number of months the mortgage is held, the monthly mortgage payment, and the initial value of the mortgage.

  • The outstanding mortgage balance at 7 years for the 30-year loan is FV(0.034/12,84,2217.41,500,000) or $424,180.
  • The outstanding mortgage balance at 7 years for the 15-year mortgage is FV(0.029/12,84,3428.91,500000) or $293,466.

Concluding thoughts:  The more rapid build-up of equity from the use of a 15-year mortgage can allow a person to sell a home and pay off the mortgage even if housing prices fall.  The calculations presented here were used in finance tip #4, a discussion of the advantages and disadvantages of 15-year and 30-year FRM.   

Financial Tip #4: Guidelines for the choice between a 15-year and 30-year mortgage

People with substantial liquidity and secure income should choose a 15-year mortgage over a 30-year mortgage.

Tip #4: The selection of a 15-year mortgage reduces lifetime interest payments, leads to a rapid increase in house equity, and reduces the likelihood a person retires with debt. However, many homebuyers cannot qualify for or afford a 15-year loan. 

A Numerical Example: 

We compare outcomes from a $180,000 15-year and 30-year fixed rate mortgage.  The analysis assumes interest rates of 2.9% for the 15-year loan and 3.4% for the 30-year loan, a typical spread for the two maturities.

  • The monthly interest payments are $1,234 for the 15-year loan and $798 for the 30-year loan.
  • The total interest payments over the life of the loan are $42,193 for the 15-year loan and $107,376 for the 30-year loan.  
  • The total lifetime loan payments are $222,120 for the 15-year loan and $287,280 for the 30-year loan.
  • The remaining mortgage balances after 15 years are $0 for the 15-year loan and $112,435 for the 30-year loan.

Problems with the use of a 15-year mortgage:

  • Many potential home buyers cannot qualify for a 15-year mortgage. Whether an applicant can qualify for a 15-year mortgage depends on—household income, the size of the mortgage and magnitude of other debts.  Lenders restrict monthly mortgage payments to around 30 percent of income and total monthly loan payments to around 40 percent of income.  The applicant for a $180,000 mortgage considered above would require an annual salary of $49,360 for a 15-year loan and $31,920 for a 30-year loan, based solely on the limit on permissible mortgage debt. 
  • A household with a secure job and large levels of liquid assets is better positioned to take out a 15-year mortgage than a household with a less secure position and a lower level of liquid assets.  The choice of a 15-year mortgage necessitates more funds for an emergency; however, financial experts are largely silent about the amount of additional liquidity that is needed for recipients of a shorter-term loan.  One potential rule of thumb is for borrowers to keep liquid funds equal to 12 monthly mortgage payments.  Note as discussed in Finance Tip 3, contributions to Roth IRAs can be withdrawn at any time without penalty or tax, hence, owners of Roth IRAs may require less cash savings for emergencies than owners of traditional retirement plans.
  • The higher monthly payment associated with the use of a 15-year mortgage may cause the household to reduce contributions to retirement plans to meet daily living expenses.   However, retirement plan contributions could increase once the mortgage is paid off.  A decrease in contributions to traditional retirement plans can increase federal and state income taxes.
  • The use of a 15-year mortgage could reduce the amount of interest that is deducted from income against both federal and state income tax.  The potential impact of the choice of a mortgage on taxes is small in the early years of the mortgage when most of the monthly payment is interest and high in the final years when the mortgage payment goes mostly toward payment of principal.
  • Substantial home equity can be seized by creditors even in a bankruptcy situation in most states. People with aggressive creditors or people facing litigation may want to maintain a large mortgage to repel claims by creditors.

Advantages of 15-year mortgages

  • The use of a 15-year mortgage allows for a rapid accumulation of housing equity, which can be used as a down payment for a future house purchase. The higher accumulation of equity from the use of a 15-year mortgage increases the likelihood that a person will be able to pay off the old mortgage and put a large down payment on a new home even if house prices fall in value.
  • Consider the outstanding mortgage balance on a $500,000 mortgage at a 30-year term at 3.4% or a 15-year term at 2.9%.   The outstanding mortgage balances after 7 years are $424,180 for the 30-year term and $293,466 for the 15-year term.  The outstanding mortgage balances after 3 years are $469,697 for the 30-year loan and $415,548 for the 15-year loan.   The use of a 15-year loan can lead to substantial build up in house equity even over short holding periods when housing prices don’t rise.
  • A decrease in resources spent over a lifetime on home purchases increases resources available for other goals.  Monthly mortgage payments are higher during the first 15-years of a 15-year loan but are non-existent after 15 years.  The ability to end mortgage payments after 15 years is extremely important for a person nearing retirement, especially if this person is reliant on a traditional retirement plan, with fully taxed disbursements.  The elimination of all mortgage debt prior to retirement allows retired workers to reduce 401(k) distributions, avoid tax and avoid rapid depletion of their 401(k) plans in years where the market is down. 

Concluding Remarks:

Many real estate brokers favor the use of 30-year mortgages because it allows the buyer to entertain the possibility of a more expensive home.  Many financial advisors favor the use of a 30-year mortgage because it allows the household to make larger contributions to retirement plans and brokerage accounts.  These advisors often overstate the potential tax savings from the use of 30-year mortgages and often fail to discuss the extreme importance of total elimination of the mortgage prior to retirement.

The use of a shorter term mortgage allows a home buyer to accumulate equity quickly. Potential homebuyers should be able to calculate the impact of their mortgage choice on their future mortgage balance and future equity. Go to Excel Hint 4 for a discussion on how to calculate the future outstanding mortgage balance.

The use of a 15-year mortgage requires the homeowner to have a larger liquidity cushion to avoid payment problems from unforeseen events.  Many people with low levels of liquid assets at the time of the house purchase and mortgage origination should refinance to a 15-year mortgage after increasing their annual income and their liquid assets.

Economic Risks: Substantially higher interest rates starting in 2022

Interest rates will rise substantially in the next few years. Many current financial planners and portfolio managers are ill prepared for this likely scenario.

Background on Interest Rates:

  • Interest rates have been abnormally low since the 2008 financial crisis. The average 2021 10-year interest rate was 1.45%.  The average 10-year Treasury bond interest rate between 2011 and 2021 was 2.11%.  The average 10-year interest rate during the 2008 to 2010 financial crisis was 3.38%.  By contrast, the average 10-year treasury rate stood at 4.71% between 2000 and 2007, 6.67% between 1990 and 1999, 10.59% between 1980 and 1989, 7.50% between 1970 and 1979 and 4.97% between 1963 and 1969. See this chart by Macro Trends for annual data.  
  • The Federal Reserve Board has been tremendously accommodative over the last three years due to COVID with the current discount rate at 0.25%. However, the Fed taper program is ending and most market participants are expecting three increases in the discount rate next year.
  • The Federal Reserve Board has control over the interest rate at the discount window but does not control long-term interest rates, which are affected by inflation and inflationary expectations.  The primary determinant of inflationary expectations and long-term interest rates is wage inflation.  Price inflation cannot occur for a sustained period unless the cost of creating goods and services increases. Wages are the major source of the cost of goods and services.
  • Many analysts believe that inflation is peaking.  I am less sanguine. Many people concerned about COVID have left the labor force.  This trend could accelerate because of the CDC decision to reduce the quarantine period for people exposed to COVID.  Older people who left the workforce early due to COVID may not return.  The decline in both legal and illegal immigration has reduced labor supply.  My forecast is for sustained wage and price inflation regardless of what happens to the supply chain.  Note, that these factors impacting labor supply are not directly controlled by monetary policy.

This increase in inflation will inevitably lead to higher interest rates.

Consequences of higher interest rates:

A prudent investor considering bonds compares current interest rates to historic ones and assumes some sort of movement towards the mean.  This analysis suggests there is currently very little upside and substantial downside in holding traditional fixed-income assets or fixed-income funds. Treasury bond interest rates will inevitably rise creating real financial hardships for investors, retired people living on 401(k) funds and borrowers.

  • The increase in long-term interest rates will lead to a decline in the value of the bonds and losses for investors who sell their bonds after interest rates rise.   The increase in interest rates will also decrease the value of bond funds held in 401(k) plans.  During the 2008-2010 market downturn the decline in the value of stocks was somewhat offset by an increase in the value of bonds dampening the market downturn. The next financial collapse could involve decline of stocks and bonds in tandem.
  • The increase in bond yields will not simply result in a loss of real return to investors.   The actual market value of the bond and the amount received by the investor will fall when the asset is sold.  (I heard an analyst on CNBC state that the loss for investors stemming from an increase in rates would only be in real terms because the investment would not keep up with inflation.   This is categorically false.  An increase in rates even if only to the pre-2008 levels would lead to substantial nominal losses.) 
  • Bond holders who hold a bond to maturity will receive face value for their investment.  However, many bonds held in ETFs or mutual funds like VBMFX, have no maturity date.  Investors regularly sell shares in bond ETFs to fund consumption in retirement and the value of these shares falls when interest rates rise.
  • The cost of credit and loans moves with interest rates.  The interest rate on federal student loans has been explicitly linked to the 10-year Treasury rate over the last decade.   A rise in student debt rates induced by the increase in Treasury rates will reduce household spending and the ability to save for retirement.

A potential solution for investors:

  • A person concerned about inflation should consider purchasing up to $10,000 a year in I-Bonds from the U.S. Treasury.  The return on I-bonds is the sum of a nominal interest rate and the inflation rate.  People who cash in an I-bond less than five years from their purchase date will forfeit 3 months interest.   The current nominal interest rate on an I-bond is low but the current return from inflation is substantial. Also, people who purchased I bonds when interest rates were high have both a high nominal interest rate and returns from inflation.
  • Investors should purchase I-bonds up to the allowable limit every year.  Investors purchasing an I-Bond will not experience a capital loss when rates rise. Go here for a discussion of I-Bonds.

Excel Hint 6: The FV function and 401(k) fees

Hint 6: The Excel FV function is used to calculate the future value of a dormant 401(k) or IRA when the only difference between the two accounts is the level of fees.

The situation:    Finance tip #6 considers potential benefits realized by rolling over funds from a high-cost 401(k) to a low-cost IRA.   The retirement account is not accepting new contributions. The person at age 50 will either leave $500,000 in a 401(k) or move $500,000 to a Roth for 15 years.  The pre-fee annual rate of return on both the 401(k) and the IRA is 6.0 percent.  The 401(k) has an annual fee of 1.3 percent.   The IRA has an annual fee of 0.03 percent.

Question on use of Excel:  How does one calculate the value of the retirement account after 15 years?

Analysis:

This calculation can be completed with the FV function.  The FV function has arguments – Rate, Nper, Pmt, Pv, and Type.

  • The Rate is .047 for the 401(k) and 0.057 for the IRA.
  • The Nper or holding period is 15 for both accounts.
  • The PMT is 0 for both accounts.   (The worker is no longer making contributions.)  
  • The PV is the initial account balance, $500,000.
  • The type is 0 because the $500,000 exists in the account at the beginning of the period.

Results

  • FV(0.047,15,0,500,000,1) is $995,796.
  • FV(0.057,15,0,500,000,1) is $1,148,404.

Remember to go to finance tip 6 for a more complete discussion of factors impacting the choice between a high-fee 401(k) and a low-fee IRA.

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 moving401(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 #2: Prioritize debt reduction over saving for retirement

Tip #2: New entrants to the workforce, facing unprecedented levels of student debt, should prioritize debt reduction over saving for retirement.

Most students with substantial student debt should reduce or forego retirement savings until their debt levels become manageable.  Students entering the workforce with substantial debt could reasonably forego saving for retirement for the first three years of their career. Potential advantages of pursuing a debt reduction strategy and the creation of an emergency fund over saving for retirement include:

  • Reduced lifetime student loan interest payments
  • Improved credit rating and reduced lifetime borrowing costs
  • Reduced likelihood of raiding retirement plan and incurring penalties and tax
  • Increased house equity and reduced stress associated with debt

Discussion of advantages of rapid student loan reduction at the expense of saving for retirement:

  • The decision to initially forego saving for retirement and earmark all available funds towards repayment of student debt leads to a substantial reduction in lifetime payments on student debt.  Two examples of the magnitude of the reduction in lifetime student loan payments are presented below.
  • A student borrower starting her career with $30,000 in undergraduate loans could take out a 20-year student loan leading to a monthly payment of $198.82 and lifetime loan payments of $47,716.   Alternatively, this student borrower could forego contributions to her 401(k) plan, increase student loan payments by $565.4 per month and pay off her student loan in 61 months.   The new total student loan repayments are $33,837, a total savings of $13,879. 
  • A second borrower with 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% — choosing the standard 20-year maturity on all loans has a monthly payment of $775 and realizes total lifetime payments of $200,633. The modification of the private loan to a five-year term initially increases the monthly student loan to $1,065.  The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years and earmarks the reduced loan payment to further loan reduction is $146,271.  This is a total lifetime savings of $54,362. 
  • The student borrower who rapidly reduces or eliminates all student debt can increase savings for retirement once the monthly student debt payment falls or is eliminated. Furthermore, the rapid elimination of the high-interest-rate private student loan could facilitate refinancing of the remaining student debt at favorable terms.
  • The failure to maintain a good credit rating will lead to higher borrowing costs on all consumer loans and on mortgages in addition to higher lifetime student loan payments.  
  • Assumptions on the impact of credit quality on interest rates were obtained for credit cards from WalletHub, for car loans from  Nerd Wallet, for private student loans from Investopedia, and for mortgages from CNBC.  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 monthly cost of bad credit depends on the interest rate differential, the likely loan amount, and the maturity of the loan. 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 also assumes the borrower only paid interest on credit card debt and loan maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.  Based on these assumptions, the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.
  • A person who fails to eliminate debt could end up with higher borrowing costs for their entire lifetime.
  • Increasingly, young adults are tapping 401(k) funds prior to retirement to meet current needs.  Often individuals who raid their 401(k) plan prior to retirement incur additional income tax and financial penalties.  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 withdraw 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.  New entrants to the workforce who prioritize the reduction of student debt over saving for retirement will be less like to raid their retirement plan and incur tax and financial penalties. 
  • Note from Tip #3 that people using Roth IRAs or Roth 401(k) plans are less likely to pay penalties and taxes on disbursements on retirement savings because the initial contribution to a Roth can be disbursed without penalty or tax.  People with debt should start saving for retirement through relatively small contributions to Roth accounts rather than large contributions to traditional plans.
  • Many people who fail to prioritize debt payments struggle with debt burdens for a lifetime and fail to realize a secure financial future. A CNBC portrayal of the financial status of millennials found many adults near the age of 40 were 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.  A 2019 Congressional Research Service Report found the percent of elderly with debt rose from 38% in 1989 to 61% in 2021.   The Urban Institute reported 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.  Many of these problems and financial stresses could have been avoided if the student borrower entering the workforce had initially focused on debt reduction and the creation of an emergency fund rather than saving for retirement.

These problems will worsen if borrowers don’t start focusing on debt reduction over saving for retirement because many in the new cohort of borrowers are starting their careers with higher debt levels.

Concluding Thoughts:  Many financial advisors stress saving for retirement over debt reduction.  Fidelity, a leading investment firm, says young adults should attempt to have 401(k) wealth equal to their annual income at age 30.  Workers without debt and with adequate liquidity for job-related expenses can and should contribute.   Their returns will compound overtime and they will have a head start on retirement.

The Fidelity savings objective is unrealistic for most student borrowers with debt. The current cohort of people entering the workforce has more debt than any previous cohort.  Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009.  The decision by a new worker with student debt to go full speed ahead on retirement savings instead of creating an emergency fund and rapidly retire student debt can and often does lead to disaster.  The young adult choosing retirement saving over debt reduction pays more on debt servicing, invariably falls behind on other bills, pays higher costs on all future loans, and often raids their retirement plan paying taxes and penalties.