According to the Bureau of Labor Statistics around 29 percent of people with access to a 401(k) plan choose to not contribute to their plan. In addition, The Employee Benefits Research Institute (EBRI) reports that in 2015 around $92 billion was removed from 401(k) plans prior to retirement. The combination of people refusing to contribute to their 401(k) plans and people taking premature contributions will result in many people with inadequate retirement income. The rules governing 401(k) plans need to be changed so that fewer people choose to forego making contributions and distributions prior to retirement are limited to a certain extent.
Current rules governing contributions to 401(k) plans provide significant financial advantages to workers who contribute. The contributions are not subject to federal or state income tax in the year they are made. Returns on investments are not taxed until retirement. Many firms match or partially match employee contributions. Many financial advisors believe that workers who fail to contribute, especially those at firms that provide an employee match, are irrational.
There are several rational reasons why some workers forego contributions to 401(k) plans. Recently reported statistics indicate that around 40 percent of households do not have enough savings to cover a $400 bill. A person without a basic emergency fund could be late on her mortgage or rent, unable to pay for a doctor or emergency room or fix a car. A decision to place funds in a 401(k) plan that leads to late payments on bills will lead to late fees, a bad credit rating, higher borrowing costs and other adverse financial outcomes.
A decision to make substantial 401(k) contributions might result in a person selecting a 20-year student loan over a 10-year student loan. Consider a married couple with $60,000 of combined student debt at a 5 percent interest rate. Lifetime student debt payments are $19,000 lower if student debt is repaid in 10 years rather than 20 years. Many student borrowers could only afford the shorter-term student loan by reducing 401(k) contributions.
A decision to make substantial 401(k) contributions might force a person to take out a 30-year mortgage over a 15-year mortgage. A person taking out a $400,000 30-year mortgage at 3.9 percent would have an outstanding balance of $257.000 after 15 years. The 15-year mortgage would have been totally repaid, and in addition the borrower would have obtained a lower interest rate. Again, many student borrowers can only afford the shorter-term mortgage by reducing 401(k) contributions.
In some states a person with assets in a 401(k) plan are not eligible for food stamps or Medicaid for nursing home expenses. Go here for a paper on how retirement savings impact eligibility for food stamps. Go here for a paper on how retirement savings impact eligibility for Medicaid nursing home expenses. The underlying assumption behind such laws is the worker who comes upon bad times must deplete her retirement account prior to receiving any financial assistance from the government.
Many people retire early often because of the loss of a job or for health reasons. People who retire early and have all of their funds in a 401(k) plan will be worse off than people who have saved both inside and outside their retirement plans both because early distributions from a 401(k) plan are subject to a 10 percent penalty and because distributions from conventional 401(k) plans are fully taxed.
Many older workers must choose between paying off their mortgage prior to retirement or increasing the amount of funds they place in their 401(k) plan. Financial planners tend to favor additional accumulation in 401(k) plans over more rapid paydown of mortgage debt. This choice often fails to work out well because people with a mortgage in retirement must, all else equal, make a larger distribution than people without mortgage obligations and the entire distribution from the conventional 401(k) plan is fully taxed. The higher 401(k) distributions due to the need to make mortgage payments is especially difficult for retirees when a market downturn occurs at the beginning of retirement.
A household that is 401(k) rich and cash poor faces substantial financial risks. Some households with 401(k) wealth but other financial needs raid their 401(k) plan and pay a 10 percent penalty in addition to tax on their early distribution leading to inadequate funds in retirement. These problems could be reduced by changing the rules governing distributions from a 401(k) plan.
Three rules should be modified. First, workers should be allowed to withdraw 30 percent of funds contributed to a 401(k) plan without financial penalty. Second, the worker should be prohibited from withdrawing any other funds from the 401(k) plan (the other 70 percent of contributions and all returns if any) until after age 59 ½. Third, loans from 401(k) plans would be prohibited.
This combination of rule changes incentivizes workers to make additional contributions to their 401(k) plan while assuring that they do not raid their account prior to retirement.
The provision for penalty-free withdrawal creates an emergency fund inside a 401(k) plan. The provision for penalty-free withdrawal will allow a worker with student debt or mortgage debt to pursue a more aggressive repayment strategy while simultaneously saving for retirement.
Under current law, workers are allowed to distribute their entire 401(k) account prior to retirement. This outcome could be forced upon a worker who loses his job in order to obtain Medicaid or food-stamp benefits. The new rule by prohibiting most distributions prior to retirement will leave all workers with most funds in their 401(k) funds at retirement.
A final advantage of the rule change is that it allows more workers to reduce their tax obligations in retirement. Under current tax rules, contributions to 401(k) plans result in tax savings in working years and higher tax obligations in retirement. Some taxpayers use Roth accounts to minimize future tax obligations. The new rules create a simpler way for workers to minimize their tax obligation in retirement. They can simply transfer 30 percent of their funds outside of their 401(k) account and purchase either stock, which is taxed at long term capital gains rates or an inflation linked Treasury bond, which is taxed at preferential rates.
The current 401(k) rules are not working for a lot of people, especially people with limited liquidity and large debts in relation to their income. The proposals presented here provides incentives for people who can’t contribute to start savings and also helps current savers reduce their tax obligations in retirement.
Many financial advisors believe contributions to 401(k) investments should almost always be their client’s top priority. They sort of recognize that people who can’t pay their current bills on time and have no funds for basic emergencies need to limit or even forego contributions to illiquid retirement accounts. However, in almost all other circumstances financial advisors favor expanding 401(k) contributions over other financial priorities.
My view is that financial advisors tend to overprioritize the importance of 401(k) contributions at the expense of several other financial priorities. Many households should lessen the accumulation of 401(k) growth when it leads to higher borrowing costs, increased lifetime debt burdens, and outstanding mortgage obligations in retirement. Households need to evaluate the impact of excessive reliance on 401(k) savings on tax obligations in retirement, the impact of 401(k) fees on retirement savings, and how use of alternative assets outside a 401(k) account might reduce financial risk in retirement.
Six goals – (1) Improved liquidity, (2) reduction of lifetime debt payments, (3) accumulation of house equity and mortgage reduction, (4) reduction of tax obligations in retirement, (5) reduction of 401(k) fees, and (6) management of financial risks — can lead a person to delay or reduce 401(k) contributions. We consider circumstances where these six financial goals might override the need to increase 401(k) contributions.
Many young adults are leaving college with substantial debt and little or no funds saved for emergencies. These individuals need to reduce debt, create a fund for emergencies. They are not in a position to tie up funds in an illiquid retirement account.
Failure to create an emergency fund and eliminate credit card debt could lead to a deterioration in a borrower’s credit rating, which could result in much higher interest rates and a lifetime of higher borrowing costs. A person with good credit could obtain an interest rate around 60 less than a person with bad credit for a private student loan or an auto loan. A mortgage rate could be 40 percent lower for the person with good credit.
I considered the impact of credit quality on lifetime interest payments for a person with good credit and a person with bad credit. My example involves people with three loans – a $15,000 auto loan, a $40,000 student loan and a $300,000 mortgage. The person with good credit pays $159k less than the person with bad credit over the life of the three loans. The largest potential savings from good credit is associated with the mortgage because it is the largest loan.
Low liquidity and high debt could lead to a great deal of discomfort and distress. In the case of a natural disaster, this could involve the difference between staying in a public shelter or flying away to a vacation. Many people without credit or cash will find it difficult to move to a new city even if the move will lead to a higher paying job. Bad credit can make it difficult to be approved for an apartment, may result in required down payments on utilities or cell phones, may result in the denial of a job opportunity, and higher insurance premiums.
A person who decides to tie up funds in an illiquid retirement account and allows her credit rating to deteriorate will have high borrowing costs and a more stressful life. These adverse impacts could be avoided through the following steps.
Establishment of a substantial fund for emergencies prior to tying up funds in an illiquid 401(k) account.
Evaluate the likely impact of contributions to your 401(k) plan on your ability to repay your loan. Make sure all bills will be paid on time prior to starting 401(k) contributions
Reduce 401(k) contributions and make additional debt payments as soon as debt payment problems occur.
Lifetime Debt Reduction:
Some financial analysts acknowledge that reduction in high-interest rate credit card debt should be a high priority but are okay with long term student loan or mortgage obligations because these loans have lower interest rates. The problem is that student loans and mortgages are often huge and lead to large lifetime debt burdens.
Lifetime debt payments can be reduced by around 18 percent by selecting a 10-year student loan over a 20-year student loan and by around 20 percent by selecting a 15-year mortgage over a 30-year mortgage.
Many people can only afford the payment on the shorter-term loan by reducing payments to their 401(k) plan. People need to consider actions that minimize lifetime debt payments even if these actions result in lower contributions to a 401(k) plan.
Here are some options.
Young adults who take their first job after college but plan to reenter school should almost always save for their graduate school tuition rather than tie up funds in a 401(k) plan.
Student borrowers should attempt to take a 10-year student loan rather than a 20-year student loan if at all possible. Income based replacement loans and public service loans that offer the possibility of loan forgiveness exist; however, the Department of Education has refused to discharge some of these loans and reliance on these loan programs is a risky financial strategy. A 10-year loan may be the most effective way to limit your lifetime student loan payments.
Borrowers should consider repaying their student loans in fewer than 10 years to further reduce interest payments.
The use of a 15-year mortgage rather than a 30-year mortgage probably requires total elimination of the student loan and may require that you delay purchasing your first house. One problem with this approach is that when housing prices rise a delay in the first house purchase will result in a higher house price.
Mortgage Debt Elimination:
More and more older people must pay mortgages during retirement. One study using Census Department data found that people over 60 were three times higher to have a mortgage in 2015 than they were in 1980.
Many financial advisors are okay with their clients taking a mortgage into retirement and recommend additional catch-up 401(k) contributions over additional mortgage payments. This is often terrible advice.
Stocks tend to have higher returns over other asset classes over long term investment horizons. However, stock returns over a 5-year to 10-year time frame are often quite low. By contrast, a dollar invested in reducing the mortgage balance results in a certain return.
During working years contributions to 401(k) plans are exempt from income tax. However, during retirement all disbursements from traditional 401(K) accounts are fully taxed as ordinary income. A person with an outstanding mortgage in retirement will, all else equal, have to disburse a larger amount than a debt-free person. The larger disbursements lead to a higher tax obligation in retirement.
Moreover, a person with a large mortgage balance in retirement may not be able to reduce 401(k) disbursements during a market downturn, which may lead an increased risk of the person outliving her savings.
People who pay off their mortgage on or before the date they retire tend to have planned for that outcome. Often this outcome entails taking out a 15-year mortgage when purchasing their final home. The simplest comparison involves a person planning to retire in 15 years who takes out either a 15-year or 30-year fixed rate mortgage. For purposes of illustration assume the loan amount is $450,000 and the interest rates are 3.8 percent for the 30-year loan and 3.3 percent for the 15-year loan. This is similar to current mortgage rates. The outstanding loan balance after 15 years of payments is $0 for the 15-year loan compared to $287k for the 30-year loan.
People need to make the elimination of mortgage debt prior to retirement a high priority in their financial plan. The following steps should be considered.
Taking out 15-year mortgage rather than 30-year mortgages on all homes purchased during their lifetime, even if higher mortgage payments result in the borrower having to reduce 401(k) contributions.
Rolling over all funds received from the sale of a home into the down payment on the purchase of the subsequent home.
Foregoing 401(k) catch up contributions at age 50 in order to accelerate mortgage payoff prior to retirement.
The decision to take a 15-year mortgage rather than a 30-year mortgage and the decision to reduce your 401(k) contribution could increase your current year tax liability. However, the tax reform act of 2017 reduced the number of homeowners who claim the mortgage deduction on their tax return. My view is that financial advisors and clients often place too high a priority on immediate reductions in tax obligations and should be more focused on reduction of risk and long-term financial objectives.
There are two major tax benefits associated with 401(k) contributions. Contributions to conventional 401(K) plans are exempt from tax in the year the contribution is made. All capital gains and investment income accumulate tax free until the income is disbursed from the 401(k) account. As a result, contributions to a 401(k) plan are a highly effective way to reduce current year taxes and to forego taxes until disbursements in retirement.
During retirement all disbursements from conventional 401(k) plans are taxed as ordinary income, which for most people is a substantially higher rate than the tax on capital gains on assets held outside a 401(k) plan.
Increased 401(k) contributions decrease current year taxes and delay tax obligations. People with a high concentration of their wealth in 401(k) accounts have higher tax obligations in retirement. People must consider the tradeoff between immediate tax reduction and future tax obligations.
Several recent tax changes have reduced the importance of the exemption of 401(k) contributions from taxes for some middle-income household. First, the increase in the standard deduction established in the 2017 tax law reduced potential tax saving from 401(k) contributions for some households with lower marginal tax rates. Second, households have increased contributions to health savings accounts, which are also exempt from federal and state income tax. These recent changes may have resulted in a decrease in 401(k) contributions.
There are several different ways you might minimize tax obligations during retirement. All of these techniques involve investing more funds outside your conventional 401(k) plan.
Funds placed in Roth accounts are fully taxed in the year they are contributed but are never taxed in subsequent years. Roth 401(k) accounts are a relatively new innovation not available at all firms. People with income above certain levels are not allowed to contribute to a Roth IRA. Financial advisors tend to do a good job analyzing the relative merits of Roth versus conventional retirement accounts.
The elimination of a mortgage prior to retirement will reduce required 401(k) disbursements, which are fully taxed.
Capital gains on stock not in a retirement account are taxed at a lower rate than the ordinary income tax rate. There are significant tax advantages with holding I-bonds issues by the Treasury and municipal bonds instead of bond funds inside a 401(k) plan.
It is important to consider both current year and future tax obligations when evaluating different investment opportunities and retirement savings options.
The importance of 401(k) fees
Many small firms with 401(k) plans charge fees of more than 1.5% per year of total assets. Fees exceeding 2.0 % per year are not uncommon.
Fees at this magnitude can substantially erode retirement savings. In a recent blog post I calculated lifetime fees for a worker who contributes to a 401(k) fee with an annual fee of 2 percent of assets. I found lifetime fees were roughly 25 percent of the 401(K) balance on the date of retirement.
Should you invest in a 401(k) plan, an IRA or both?
High 401(k) fees pose significant challenges to investors in the current low-interest rate environment. The current 10-year rate is around 1.5 % and the annual fee on some plans is over 2.0 %. This results in a negative return on bonds invested inside a 401(k) plan.
Experts argue contributions to a high-fee 401(k) plan are still appropriate when there is an employer match. Perhaps this is correct but there is something wrong with a system that provides people incentives to save in high fee accounts.
There are steps you can take to minimize the impact of high 401(k) fees.
Limit contributions to the amount needed to take full advantage of the employer match.
In the current low-interest rate environment, decrease 401(k) investments inside bond funds. Retain a balanced portfolio by purchasing bonds directly through the Treasury at Treasury Direct where there are no transaction costs.
On the day you leave your present employer convert your high-cost 401(k) plan to a low-cost IRA offered by Schwab, Vanguard, or Fidelity.
People need to fully evaluate fees charged by their firm’s 401(k) plans and adopt appropriate steps to reduce the impact of these fees on the erosion of their retirement savings.
I am concerned about two types of financial risks in 401(k) plans – (1) inappropriate investments options and (2) Interest rate exposure.
Inappropriate Investment Options:
There is a substantial finance literature indicating that low-cost index funds outperform high-cost actively managed funds. Some firm managers ignore this literature and choose actively managed funds. Often this choice leads to poor results and litigation. Below is a link to an article on litigation over 401(k) investment performance.
The optimal strategy for a person working for a firm with a 401(k) plan that has poor investment options may be to only contribute enough funds to take full advantage of the employer match. Employees at such firms need to consider opening an IRA instead of contributing to the firm 401(k) plan. The employee should then rollover their 401(k) funds into an IRA as soon as they leave the firm. (Some 401(k) plans may allow current employees to rollover funds into an IRA. I don’t know the rules on this.)
Interest Rate Exposure:
Interest rates remain below historical levels and central bank interest rates are actually negative in some countries. This situation will not last forever. When interest rates rise the price of bonds and the price of bond funds will decrease leading to losses.
Most 401(k) plans allow for investment in broad funds but do not allow for investments in government bonds with a specific maturity date. The advantage of investing in a government bond with a specific maturity date is the holder of the bond will receive the full par value of the bond on the day the bond matures. By contrast, the value of shares in a bond fund will be below the purchase price of the bond fund should interest rates rise and remain high.
Most 401(k) plans include a fixed income fund as an investment option and many 401(k) investors allocate a substantial share of their funds to the fixed income funds. These households could result in large financial losses once we return to a more normal interest rate environment.
My only recommendation on this problem is to consider investments in zero coupon Treasury bonds that are guaranteed to have a specific value on their maturity date.
The financial exposure associated with the eventual rise in interest rates is a scenario that keeps me up late at night. I don’t see an obvious solution.
Financial advisors have always stressed the importance of investing in 401(k) plans. This advice is better suited for people with high income, abundant funds for emergencies, and little or no debt than for the typical highly leveraged young adult.
Even after a young adult gets a decent job, eliminates onerous credit card debt and builds up a decent emergency fund there is a need to balance competing financial objectives. Often it makes more sense for a person to minimize lifetime debt payments and increase the accumulation of house equity than to increase contributions to a 401(k) plan. Many people can also obtain better financial results (reduced tax obligations in retirement, lower fees, and better investment opportunities) by reducing their wealth holdings inside a 401(k) account and increasing holdings outside a 401(k) account.
The author is an economist living in Colorado. He is the author of “Defying Magnets: Centrist Policies in a Polarized World.” This book can be obtained on Kindle or Amazon.
Increasingly, many Americans nearing the end of their work life find they have a large mortgage and must choose between paying off the mortgage or contributing more funds to their 401(k) plan. A large number of financial advisors advise their clients to increase 401(k) contributions rather than pay off their mortgage.
My view is that it is essential for people nearing retirement to eliminate their mortgage debt even if this goal requires some reduction in 401(k) contributions. I have two reasons for this view. First, as noted and explained in the previous section 401(k) plans are not capable of mitigating the impact of market down turns at the end of a career or during retirement. Intuitively, a person with no debt is much better able to withstand market downturns than a person with a mortgage. The Wall Street analysts always say don’t sell on a panic the market will come back. Well retirees with a large mortgage often have no choice but to sell.
Second, the financial risk considerations interact with another factor, the tax treatment of 401(k) plans. During working years mortgage interest and 401(k) contributions reduce income tax burdens. During retirement a person with a large mortgage payment and most financial assets inside a 401(k) plan will pay more in tax than a person without a mortgage.
All disbursements from a 401(k) plan are fully taxed at the ordinary income tax rate. A person with no mortgage disburses enough to cover discretionary expenses and taxes A person with a mortgage must disburse enough to cover discretionary expenses, the mortgage and taxes.
The disbursement to cover the mortgage leads to additional taxes because all disbursement from the 401(k) plan is taxed. MOREOVER, THE DISBURSEMENT ON FUNDS USED TO COVER THE TAX ON THE 401(K) DISBURSEMENT IS ALSO TAXED.
Part of Social Security is taxed for people with income over a certain threshold. A quick way to find out if part of Social Security benefit is taxable is to compare your income to the threshold for your filing status — $25,000 for filing status single and $32,000 for filing status married.
Higher disbursements from the 401(k) plan can increase your adjusted gross income beyond the threshold and increase the amount of the Social Security benefit subject to tax. Of course any 401(k) disbursement used to pay the income tax is also taxed.
So let’s take a household with all financial assets in their 401(k) plan with a $30,000 annual mortgage. This monthly mortgage is $2,500, not huge. Let’s assume that the person has to pay around $1,000 more in tax on Social Security benefits because of the additional disbursement to pay down the mortgage. A first order approximation of the amount of additional tax needed because of the additional $31,000 disbursement is $31,000 x the marginal tax rate for the taxpayer. For most filers the marginal tax rate would be around 25 percent in 2014.
So the taxpayer with the mortgage and the additional tax burden because of the additional 401(k) disbursement will probably disburse $39,000 more per year from their 401(k) plan.
This analysis puts a whole new wrinkle on the question how much money does one have to save in their 401(k) to have a secure retirement. The answer is much more if you have not paid off your mortgage.
Note that the disbursement to cover the unpaid mortgage must occur whether the market falls or rises.
Many people who choose to add to their 401(k) plan rather than pay off their mortgage prior to retirement are going to have sell their home and downsize. Downsizing may make sense but most people don’t want to downsize until they are fairly old.
Some people who end up selling their home may choose to rent rather than buy a new home. The main risk of choosing to rent throughout retirement is that home prices and rents may rise. This exacerbates longevity risk.
Downsizing should be a choice not an outcome from a failed financial plan or worse the result of financial advisors putting their interests over your interests
Concluding thoughts on mortgage debt in retirement: An increasing number of households are retiring prior to their mortgage being entirely paid off. Surprisingly, the existence of a mortgage in retirement is often consistent with a financial plan developed by a financial planner.Many financial analysts and planners advise their clients to increase savings in their 401(k) plan rather than retire their mortgage.
These financial planners are not being upfront with their clients. Retirees with mortgage debt and all or most financial assets in a 401(k) plan are at the whim of the market and have a substantial tax obligation. The advice that put people in this position is in my view a form of malpractice.
Appendix to Essay on Mortgage Debt and 401(k) Assets in Retirement
The issue of whether to pay off a mortgage or contribute to a 401(k) plan for an older worker is related to the issue of mortgage choice, especially for older homebuyers. The following question addresses the interaction between mortgage choice and 401(k) investment strategy for an older worker.
Question: A 50 year-old person is buying a house and must choose between a 15-year mortgage and a 30-year mortgage. The mortgage choice will impact how much money the person can contribute to his or her 401(k) plan.
The person makes $80,000 per year. The initial mortgage balance is $400,000. The person’s 401(k) balance at age 50 is $200,000. The 30-year FRM rate is 3.9 percent and the 15-year FRM rate is 3.1 percent.
Discuss the advantages and disadvantages of two strategies (1) taking the 30-year FRM and investing 15% of salary in the 401(k) plan and (2) taking the 15-year FRM and investing 5% of salary in the 401(k) plan.
Let’s start with a reiteration of mortgage choice issues a subject previously broached in essay four.
Observations and Thoughts on Mortgage Choice Issues:
The monthly payment on the 30-year FRM is nearly $900 less than the monthly payment on the 15-year FRM. The higher mortgage payment on the 15-year FRM will all else equal require the person who chooses the 15-year FRM to make a smaller 401(k) contribution than the person who chooses the 30-year FRM.
After 15 years the 15-year FRM is completely paid off. The remaining loan balance on the 15-year FRM is around $257,000.
Note that gains from the quicker pay down on the 15-year mortgage are not dependent on market fluctuations. The gain from debt reduction occurs regardless of whether the market is up or down and regardless of when bear or bull makers occur.
Analysis of 15-Year Versus 30-Year FRM
Mortgage Interest Rate
Initial Loan Balance
Loan Balance after 15 years
Observations and Thoughts on Two 401(k) Contribution Strategies:
As noted in essay eight, the final 401(k) balance after 15 years depends on both the rate of return of the market and the sequence of the returns in the market. Outcomes are presented for two market scenarios. The first involves 7% returns for the entire 15-year period. The second involves 7% returns for 10 years followed by -4% returns for 5 years.
The difference in the final 401(k) balances (high contribution minus low contribution) under the 15-year bull market scenario is around $211,000.
The difference in the final 401(k) balance (high contribution minus low contribution) under the 10-year bull and 5-year bear scenario is around $131,000
Analysis of Different 401(K) Contribution Strategies
5% Contribution Rate
15% Contribution Rate
7.0% Return for 15 Years
7.0% Return for 10 years followed by -4.0% return for 5 years
The initial balance in the 401(k) plan for both scenarios is $200,000.
Additional insights on the tradeoff between 401(k) contributions and mortgage retirement:
The 30-year mortgage/high 401(k) contribution strategy results in major tax savings during working years compare to the 15-year mortgage/low 401(k) strategy. All mortgage interest is tax deductible and the 401(k) contribution is not taxed.
The 15-year mortgage/low 401(k) contribution strategy results in major tax savings during retirement compared to the 30-year mortgage/high 401(k) strategy. The previous example in this section demonstrated exposures for the person with mortgage debt in retirement when the person is dependent on 401(k) disbursements. Remember all disbursements from a conventional 401(k) plan including disbursement used to pay the mortgage and disbursements used to pay taxes are fully taxed at ordinary income rates. By contrast, the money gained from paying off the mortgage and most capital gains on owner-occupied real estate is not taxed.
Financial risks associated with a bull market persist through retirement as long as the saver allocates 401(k) assets into equity.