Tag: #401(k) plans

Financial Impacts of 401(k) vesting requirements

Many people with unvested 401(k) contributions, who lose or change jobs for a wide variety of reasons, end up losing retirement wealth. Should workers with unvested benefits choose to forego 401(k) plans in favor of Individual Retirement Accounts or Health Savings Accounts? Should 401(k) vesting requirements be eliminated to better assist workers who are struggling to save for retirement?


Employer matching contributions are often called “free money.” Virtually, all financial advisors recommend workers take full advantage of employer matching contributions to 401(k) plans.  

However, workers at firms with 401(k) plans with vesting requirements do not immediately own the employer match.  

Information on the prevalence of 401(k) vesting requirements is found here.

  • Around 56 percent of plans have vesting requirements which delay receipt of the ownership of the 401(k) match. 
  • Around 30 percent of firms use a graded vesting schedule where the employer match vests over a five or six year period.
  • A saver with a 401(k) plan that has three-year cliff vesting will lose all benefits unless she stays at a firm for three years.

Many workers especially young adults will leave the firm prior to fully vested and will lose some or all the unvested employer matching contributions.  The high level of job mobility, especially among young adults, leading to a likely loss of some retirement wealth due to vesting requirements, is documented by this BLS report.

  • Americans born in the early 1980s had an average of 7.8 jobs between age 18 and 30.
  • Young adults from age 27 to 30 had on average 2.2 jobs during that period of life.

There are many reasons why people leave one job for another.  In 2022, 50 million people quit their jobs, there were 15.4 million layoffs and 40 percent of Americans had been laid off or terminated from a job at least once in their life.  A recent Gallup report found that 60 percent of respondents reported they were emotionally detached at work and that 19 percent of respondents reported being miserable.  

All workers with unvested 401(k) contributions who switch jobs will lose retirement wealth due to the change in their employment status, regardless of the reason for the switch in jobs.  

People in a work situation where their place of employment offers a 401(k) plan with slowly vesting employer contributions should forego contributions to the firm-sponsored 401(k) plan and consider some other tax-preferred investment vehicle.

Investments in Individual Retirement Accounts and Health Savings Accounts are both preferable to investment in a 401(k) plan when the receipt of matching contributions is uncertain.

Individual Retirement Accounts often have lower fees than 401(k) plans and the fee differential can result in a large loss of lifetime income as discussed here.  The use of short-term bond and CD ladders inside an IRA can substantially reduce risks associated with interest rate changes compared to investments in bond ETFs inside a 401(k) plan.

Health Savings Accounts allow for an immediate tax deduction, are available for immediate health expenses without penalty or tax and provide penalty-free access to all funds after age 65.  The use of funds in a Health Savings Account reduce medical debt and the number of people forgoing necessary medical procedures.  Finance tip number eight states that contributions to health savings accounts must take on a high priority even at the expense of contributions to 401(k) plans.

The Secure Act 2.0 mandated automatic enrollment for new workers inside 401(k) plans.  The existence of vesting requirements creates an incentive for savvy workers to opt out of their 401(k) plans.

There are compelling arguments for a new law outlawing all vesting requirements on firm 401(K) plans, even if this change increases turnover and training costs for some firms.   Taking money from an employee that the employer chooses to terminate or leaves because she is miserable seems unfair and is a recipe for low productivity.  The next generation of workers is likely to have a higher Social Security retirement age because of pending Social Security deficits.   The forfeiture of employer contributions because of vesting requirements will reduce the accumulation of retirement wealth. 

It is time for policy makers to abolish 401(k) vesting requirements.  People currently subject to 401(k) vesting requirements need to consider other investment options.

Question One: A question on fees and 401(k) plan rollovers

Even a slightly higer fee level can lead to a large loss of wealth. Don’t abandon your 401(k) to the whims of your ex employer.

True or False:  People with a small amount of funds in a 401(K) plan should leave funds in the employer-based 401(k) plan when they switch jobs.

False:  Many companies will move funds of departing employees to high-fee low-return IRAs.  These IRAs will not benefit their owners.  

Discussion: 

  • The Secure Act 2.0 mandated automatic enrollment of new workers in the firm’s small 401(k) plan.
  • Many employees routinely leave 401(k) assets at their old employer.
  • Employers routinely move assets left behind in 401(k) plans to high-fee low-return IRAs.
  • Prior to the Secure Act 2.0 employers had the right to transfer all 401(k) plans with assets less than $5,000 to a high-cost IRAs.
  • The Secure Act 2.0 increased the transfer right to all plans with less than $7,000 in assets.
  • Even relatively small differences in retirement plan fees can lead to a large decrease in accumulated assets as shown in Example Two, here.

The logic of the automatic enrollment provision in Secure Act 2.0 was to encourage workers to start saving early for retirement because automatic enrollment was in their best interest.  Automatic transfers of 401(k) assets to well-run low-cost IRAs would also be in the best interest of workers but the law does not mandate or even recommend automatic transfers to low-fee highly diversified accounts.  

The combination of automatic enrollment and not automatic transfers seems to benefit the wall street firms sponsoring high-cost retirement accounts.

The Secure Act 2.0, a law that was passed with bipartisan support, does more for Wall Street investment firms than workers. It does seem as though that modern capitalism does more to manipulate rules to the advantage of the firm over the consumer than in providing a good reliable product or service.

Problems caused by the forced transfer of abandoned 401(k) assets to high-cost IRAs are discussed in this New York Times article.  Financial tip #5, presented in this list of tips, makes the case for routinely moving 401(k) funds to low-cost IRAs. 

The Choice Between Fixed Income Funds and Direct Purchases of Bonds

Whenever possible investors should seek out tax-preferred savings vehicles, which allow for direct investments into Treasury securities and hold Treasury bonds and notes instead of fixed-income funds. People saving for retirement or higher education can minimize risk by matching future obligations with specific bonds.


Introduction:

Many tax-preferred retirement accounts and 529 funds restrict investment choices to a small set of stock and bond ETFs or mutual funds.  The allowable investments inside a 401(k) plan are selected by the plans sponsor. For example, the Thrift Savings Plan (TSP) offered to federal employees has several funds and an option for mutual fund investing but does not allow workers to purchase Treasury Securities directly through the Treasury or through a broker.

Most individual retirement accounts (IRAs) and brokerage accounts allow for direct investments in the stock of individual companies, Treasury securities, agency securities, and corporate bonds.  Individual investors at Fidelity and Vanguard with an IRA account can purchase the same assets as investors with a brokerage account at the firm.

Individuals saving in plans that are not tax preferred can purchase bonds either through a brokerage account or through Treasury Direct.  Series I savings bonds can only be purchased directly from the Treasury and are therefore not available for retirement savers or for people utilizing 529 plans for college savings.

Retirement savers with an IRA can purchase Treasury Inflation Protected Securities (TIPs) through their brokerage company.   Whether this option is available through a 401(k) plan depends on the investment options chosen by the plan’s provider.  Most 401(k) plans that I am aware of do not allow for direct purchases of TIPs. 

Many financial advisors, including one mentioned in this CNBC article, favor the use of bond ETFs over direct purchases of Treasury securities.  The prices of the bond funds touted in this article appear highly variable. 

The use of bond funds instead of direct investments in bonds often results in inferior financial results.  Both bond prices and bond ETF or mutual fund prices vary inversely with interest rates.  The difference in financial exposure stemming from holding a bond and the financial exposure from holding a bond fund is that the bond holder can avoid losses by holding the bond until the maturity while returns for the holder of the bond funds are always dependent on interest rates.

All 401(K) plans have bond fund options. Many 401(k) plans have an option for short-term bonds that primarily invest in inflation protection securities.  However, even short-maturity bond funds designed to protect investors from the eroding effect of inflation can result in substantial financial losses for investors.

The returns for VIPSX are -10.45 % over a one-year holding period and 1.02 percent over a 10-year holding period.  Other short-term bond funds seeking to protect investors from inflation including STPZ and VTIP do not appear to be meeting their objective in the current macroeconomic environment.

There is one sure fire way to insulate your portfolio from inflation, the purchase of Series I bonds.  However, the IRS imposes an annual limit on the purchase of Series I bonds, and Series I bonds cannot be purchased in IRAs, 401(k) plans or 529 plans. Most household with most of their financial portfolio inside a retirement plan cannot purchase enough Series I Savings bonds to insulate themselves from inflation.

The performance of both long-term Treasury bonds and bond funds has also been miserable.  See BND, AGG, and FNBGX and look at the chart with the longest time span of historical prices.

Advantages of Direct Investments in Treasury Securities:

Investors who purchase a Treasury security at a positive yield and hold the Treasury security to maturity will never experience a nominal loss on the security.  

However, many investors will sell a long-term security prior to its maturity.

Investors should not purchase either a long-term bond or a long-term bond fund when interest rates are extremely low, as they were during the pandemic, since at that time interest rates were certain to rise and bond prices certain to fall.

Investors can spread out bond purchases over several months to assure monthly access to liquid retirement assets.  The purchase of six-month Treasury bills on six consecutive months would allow for monthly access to liquid assets.

The price risk of a Treasury security goes towards zero when the security nears its maturity date.  An investor needing funds shortly before the maturity date could sell the asset without a substantial loss, even if interest rates rise. By contrast, short-term bond funds have no maturity date, hence the price of the fund will fall if interest rates rise.

Investors can match the maturity of bonds that they hold with future liabilities.   This is an especially important feature for parents saving for college tuition who could match bond maturities with tuition payment due dates. 

However, 529 plans commonly used for saving for college generally do not have an option allowing for direct investments in Treasury securities.  Instead, the plans allocate investments into bond and stock ETFs or mutual funds.   The price of funds inside college 529 plans, even the short-term bond funds, vary substantially with market conditions.

Both savers in 529 plans and savers in retirement plans often save through a life-cycle fund that shifts assets from stocks to bonds as investors near retirement.  However, the component of the Lifecycle fund invested in a bond portfolio will fall in value when interest rates rise. 

Both bond and stock funds fell in tandem during the past year.  Lifecycle investing did not protect investors during the latest market downturn. 

Most retirees put all funds in instruments without a maturity date and base disbursements on a guideline like the four percent rule.  The four percent rule is not going to work if the value of both your stocks and bond funds simultaneously declines as they did most recently.

Retirees could and should purchase Treasury bonds and schedule the maturity of the bond for different dates each year.  The retiree would even consumption and reduce depletion of retirement assets by consuming from maturing bonds when the stock market is low and consuming from stock ETF distributions when the stock market is high.

Retirees with assets in bonds that mature on specific dates are better prepared for retirement than retirees with assets that have all savings tied up in funds without maturity dates.

Concluding Remarks:  The tax code provides preferences for investments in tax-preferred retirement accounts and 529 plans.  Congress recently passed legislation mandating automatic contributions to 401(k) plans. Financial advisors strongly recommend use of these tax-preferred savings vehicles.

Tax preferred savings vehicle often have limited investment options.

Tax-preferred savings plans often do not allow for the direct purchase of Treasury or government agency fixed-income securities with specific maturity dates, which could be matched with spending obligations.  

Moreover, financial advisors often advocate the use of bond funds instead of bonds with specific maturity date. 

Congress, through the tax code and their mandates and financial advisors through their insights guide investors to suboptimal higher-risk financial choices.

David Bernstein an economist living in Denver Colorado has written extensively on health and financial policy including a recent article outlining a 2024 Health Care Reform Proposal and an evaluation of President Biden’s student debt discharge proposal.

A 2024 Retirement Security Agenda

Pension and Social Security reform are inextricably linked because many retirees are highly dependent or Social Security, many workers nearing retirement are not in good financial shape and young adult are spending retirement funds early in their career. The recently enacted Secure Act 2.0 does very little to assist workers who are having the hardest time saving for retirement. Republicans and Democrats are far apart in their ideas on how to fix Social Security and neither party recognizes that meaningful enhancements in private retirement savings are essential to a successful Social Security reform. This post discusses ways to fix both the private retirement system and Social Security.

Introduction:

Many American workers are not preparing well enough for retirement.

Around half of older workers do not have any funds in a defined contribution plan (401(k) or IRA.)

The median amount of retirement assets for people with retirement plans is around $109,000.

Around 13.7 percent of the 65-and-over population lives in poverty.

More older workers are entering retirement with mortgage debt or consumer debt.

Many older workers cannot remain in the workforce because of poor health.

Economic downturns tend to result in a larger increase in unemployment for older workers than for younger or middle-aged workers.

Around 40 percent of older Americans are entirely dependent on Social Security.

Current law links future Social Security payments to the balance in the trust fund. Projected decreases in the trust fund would lead to a 20 percent in Social Security benefits in 2035, barring changes to the trust fund or current law.

Nearly 60 percent of young workers between the ages of 18 and 34 have already taken funds out of their retirement accounts to maintain current spending.   Early disbursements from retirement plans by young adults are especially high for people with high levels of student debt.

The traditional 60/40 portfolio held by many retirees loses substantial value in a period where the stock market falls, and interest rates rise. 

Congress and the Administration have not prioritized retirement income issues and are not close to addressing the looming Social Security problem.

Documenting the lack of progress:

Our leaders are not moving us forward on efforts to increase private savings for retirement or on efforts to fix the looming Social Security problem.  

Congress has passed some legislation, most recently, the Secure Act 2.0, impacting savings through 401(k) plans and IRAs.  Unfortunately, the recently enacted law does more to benefit investment firms and high net-worth savers than the workers who are struggling the most to save for retirement.  A more complete description of the Secure Act 2.0 can be found here and some of its shortcomings are listed below. 

  • Delays in implementation of Required Minimum Distribution do not assist retirees with low levels of retirement assets, people who tend to deplete their retirement accounts early in their retirement.  Provision increases fees received by investment firms.
  • Shorter waiting period for participation in 401(k) plans does not shorten vesting requirement and may benefit relatively few workers because many part-time workers do not stay at the same firm for a long time.
  • A provision clarifying that employers can contribute matching funds to 401(k) plans for student loan payments does not assist workers at firms without a 401(k) plan or firms with a 401(k) plan that do not match employee contributions.
  • The automatic 401(k) enrollment provision and automatic increases in contribution will reduce savings through other vehicles and will lead to relatively little additional savings if funds are distributed prior to retirement.

Around 40 percent of retired households are totally dependent on Social Security and many more are highly dependent on Social Security.    Expansion of private retirement spending is important by itself and has major implications for Social Security reform efforts.  

The implementation of some Social Security reform proposals that would lead to abrupt changes in benefits could not be applied to workers nearing retirement without causing large increases in poverty among the elderly.   

The Social Security trustees project that automatic benefit cuts to Social Security could occur in 2035 and that automatic Medicare benefit cuts could occur as early as 2028.

Democrats and Republicans are wide apart on what needs to be done to prevent automatic cuts to entitlement programs.  Democrats stress the need for additional revenue.  Republican proposals often call for large benefit cuts, many of which are applied to workers nearing retirement.

One proposal that could receive some bipartisan support inside a larger package involves increasing the cap on wages subject to Social Security taxes.  Current rules apply Social Security taxes to the first $160,200 of wages.  Go here for a discussion of proposals to eliminate or modify the cap on Social Security taxes.

Republicans tend to favor plans to reduce benefits, raise the retirement age, and create private accounts to replace all or part of the current Social Security system.  Some of the Republican proposals discussed herewould result in quick changes impacting potentially impacting workers close to retirement.   For example, a proposal to increase the retirement age for full Social Security benefits by 3 months per year until 2040, when the full retirement age reached 70 would result in substantial poverty among the elderly because private retirement savings could not be increased in this time frame.

Timely changes to Social Security are essential to prevent automatic benefit cuts that would lead to large increases in poverty because of the lack of private retirement savings.  

Reforming private retirement savings:

Reforms of private retirement savings that expand savings for low-income and middle-income households are a prerequisite for meaningful Social Security reforms because so many households are dependent on Social Security.   

There are six problems preventing workers from accumulating sufficient retirement savings prior to retirement.  Steps must be taken to address each problem. 

First, workers are free to disburse all entire savings from their 401(k) plans prior to retirement. Around 60 percent of young workers have tapped part of their retirement savings prior to age 34.  Steps must be taken to restrict pre-retirement disbursements from retirement plans and to incentivize workers from reducing retirement savings prior to retirement.

Proposed policy changes to address pre-retirement leakages from retirement accounts include:

  • Prohibit pre-retirement distributions from retirement plans for 25 percent of all contributions.   The prohibited distributions could be used to purchase an annuity that would not pay out until the retiree reaches a certain age.
  • Require automatic rollover into IRAs for all workers making a job transition with 401(k) balances less than $50,000.  (Current law allows but does not require automatic rollovers.)
  • Prohibit loans from 401(k) plans. Replace loans with limited tax-free and penalty-free distributions from the newly created emergency funds inside a 401(k) plan.

Second, workers reliant on Individual Retirement Accounts (IRAs) have less generous saving incentives than workers with access to employer-based 401(K) plans. Workers dependent on an IRA without access to a 401(k) have a lower contributions limit, do not have access to an employer match, and do not have access to retirement incentives for student loan payments.

Proposed changes to rules that reduce or eliminate discrepancies between savings through IRAs and savings through 401(k) plans include:

  • Create automatic contributions to IRAs for people without access to employer-sponsored 401(k) plans, patterned after the rules that are currently applied to automatic enrollment into 401(k) plans.
  • Change tax law to allow for employers to make matching contributions to worker contributions to IRAs like the ones currently allowed for 401(k) plans.
  • Equalize IRA and 401(k) contributions limit and deductibility limits on IRA and 401(k) contributions.  
  • Change tax law to allow tax-free contributions to IRAs by firms hiring contractors or gig workers instead of direct employees.

Third, the current tax preference for contributions to 401(k) plans and deductible IRAs favors higher income people with higher marginal tax rates.  Tax savings from expenditures from Roth IRAs in retirement also disproportionately benefit higher-income taxpayers.  Income related gap in subsidies could be altered by changes to the tax code.

  • Replace existing tax exemption for contributions to traditional 401(k) plans and the tax deduction for contributions to deductible IRAs with a tax credit.
  • Create a tax credit for first $2,000 contributed to a retirement plan and allow tax deduction for additional contributions up to a cap.

Fourth, many workers are now diverting retirement savings to health savings accounts and flexible savings accounts to pay for health expenses that are no longer covered by health insurance.  This is a growing problem due to the growing use of high-deductible health plans.

Proposed policy changes to offset the loss of retirement income due to the growth of cost-sharing between insurance companies and insured households include:

  • Allow for the use of health savings accounts for people with lower deductible health plans to reduce the need for large contributions to health savings accounts.
  • Change rules governing flexible savings account to allow people to place unused flexible savings account funds in a 401(k) plan or IRA rather than lose the unused funds.  It would be appropriate to tax funds transferred from a flexible savings account to a retirement account.

Fifth, fewer than 15 percent of retirees have an annuity inside their retirement plan.   The primary reason for the low level of annuity income is the cost of annuities.

  • Mandate that 25 percent of funds contributed to a retirement plan be used to purchase an annuity.

The source of funds for the mandatory annuity purchase could be the funds the person is not allowed to disburse prior to reaching retirement age.

The rule requiring all workers make an annuity purchase would lower annuity prices because voluntary annuity purchases are favored by healthy people with long life expectancy.   

Sixth, retirees often suffer when inflation erodes the value of bond and stocks. Many workers cannot afford to save much outside their retirement plan and current tax law does not allow individuals to purchase series I bonds inside a 401(k) plan or an IRA.  Many assets inside a 401(k) plan that proport to be inflation hedges lose value in an inflationary or high interest rate environment.

  • The most effective way to prevent reduction in retirement plan wealth in a period when inflation and interest rates rise, and stock prices fall is to allow and encourage the purchase of Series I savings bonds inside a 401(k) plan or IRA.  Series I savings bonds never fall in value and have substantial upside in an inflationary environment.   Go here for a discussion of advantages of Series I Savings Bonds.

The primary effect of the current restrictions on Series I Savings bonds is to increase the demand for financial assets and ETFs that are less effective in protecting investors from inflation than Series I Bonds.

Reforming Social Security:  

The expansion and improvement of private retirement savings options will reduce dependence on Social Security by future generations and allow for the consideration of a broader range of Social Security reform options including eventual reductions in benefits.

The Social Security reform measures considered here include:

  • A new tax earmarked for Social Security and Medicare.    The tax would be imposed on all forms of income and would have a progressive tax structure.
  • Increase in both the minimum retirement age for Social Security benefits and the age for full benefits, by one year each phased in over a 24-year period with a one month increase in the retirement age every two years.   The age at which people receive the maximum allowable Social Security benefit would remain unchanged.
  • Guarantee future Social Security benefits by allocating some general tax revenue towards future benefits if the Trust fund balance falls to a certain level.

Economic Notes on the Policy Package:

  • The combination of tax credits to stimulate private retirement savings, tax increases to fund current Social Security and Medicare benefits and long-term increases in the retirement age create a healthy macroeconomic environment and will lower household financial distress in retirement.
  • Short-term changes in tax revenue will be modest because losses in tax revenue from tax credits to stimulate private retirement savings are offset by increases in tax revenue from the new tax to maintain Social Security and Medicare benefits.
  • The phased in increases in the retirement age will not have an immediate impact on government deficits but will reduce future Debt-to-GDP ratios.   Since markets are forward looking the projected lower future debt burdens will have a beneficial impact on asset prices even if near term deficits rise. 
  • The tax base to continue funding Social Security and Medicare benefits should be relatively broad.  The tax could be imposed for all households making more than $50,000.  The tax would be progressive.  The marginal tax rate might range from 0.5 percent to a cap of 5.0 percent.  The tax would be applied to both wages and investment income.

Concluding Remarks:  Unless changes are made to rules governing Social Security and Medicare there will be automatic benefit cuts once trust funds assets are partially depleted. Many Republicans favor large and abrupt changes to Social Security benefits and the retirement age.  Any abrupt change in benefits would have an extremely adverse impact on household poverty and on aggregate demand.

A reduction in Social Security benefits that is not preceded by a substantial expansion in private retirement savings by the workers who are now having the most difficulty saving for retirement would lead to catastrophic financial impacts for many households.  This outcome can only be avoided by coupling private pension reforms with Social Security reforms.

David Bernstein is the author of A 2024 Health Care Reform Proposal.

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.

The case for greater use of Roth retirement accounts

  • Many workers should increase their utilization of Roth retirement accounts. 
  • Young workers should open a Roth account as soon as they enter the workforce.
  • There is very little downside for contributions to Roth accounts by low-income workers because the worker opening the Roth has immediate access to contributed funds without tax or penalty and the tax advantages from contributing to a tax-deductible account are small.
  • There is no reason to choose a traditional retirement account over a Roth if your marginal tax rate is zero and if the employer does not match contributions to a traditional retirement plan.
  • Roth contributions are likely to result in a better outcome than traditional contributions for most workers with a marginal tax rate less than or equal to 22 percent, especially when the employer does not match contributions.
  • Most workers at firms with matching contributions to a traditional plan should divert additional contributions to Roth accounts after maximizing the employer match. 
  • Roth accounts are usually superior to traditional accounts for workers without emergency funds or high debt levels who might tap retirement funds prior to retirement.
  • Households experiencing a decrease in income because they or their spouse temporarily leave the workforce should convert traditional retirement asset to Roth assets when their marginal tax rate is low.
  • People leaving a position can rollover 401(k) assets to an IRA and then convert the traditional IRA to a Roth IRA.
  • Some firms with Roth 401(k) plans allow for in-service rollovers.
  • Retired workers should spend from assets outside their retirement plan and convert traditional retirement assets to Roth assets prior to claiming Social Security and disbursing traditional retirement assets.

Introduction:

One of the most important decisions for workers preparing for retirement involves the choice between use of traditional and Roth retirement accounts.   

Contributions to the traditional retirement accounts are not taxed in the year the contribution is made. Contributions to the Roth IRA are fully taxed in the year of the contribution but are not taxed when disbursed prior to age 59 ½.   Moreover, Roth distributions are not included in AGI and do not increase the amount of Social Security subject to tax.

All funds (both initial contributions and investment returns) inside a deductible IRA or a traditional 401(k) that are withdrawn prior to age 59 ½ are fully taxed and subject to a 10 percent penalty.  By contrast, contributions to a Roth retirement account are fully taxed in the year they are made but disbursements of contributions from the account prior to age 59 ½ are not subject to a penalty or tax.  The tax penalty for early withdrawals from a Roth is only applied to returns on investment.

Many workers overutilize traditional retirement accounts and underutilize Roth accounts.  The tax savings from incremental contributions to a traditional retirement account are often small.  The cost of converting traditional retirement assets to Roth assets is often low. Retirees with a mixture of Roth and traditional retirement assets often have substantially higher after-tax income and are less likely to outlive their retirement assets than people with all retirement assets in a traditional retirement account.

A Roth retirement account should be a key feature of your financial plan. We discuss steps you should take to increase savings though Roth accounts:

Set up a Roth account as soon as you get your first job:

Any person with income reportable to the IRS regardless of age can set up a Roth account.   A teenager can and should establish a Roth. It is possible for a young person doing real work for a family business to establish a Roth, but this type of transaction could be audited by the IRS.

Most teenagers who work don’t think about setting up an IRA but there is basically no downside from Roth contributions by young workers.  The Roth contribution could be disbursed or spent if necessary and only investment income is subject to tax.  The gains if left in the account until age 59 ½ will compound for a long time and will never be taxed.  The mere existence of a Roth IRA in a student’s name does not reduce the ability of a student to qualify for financial assistance for college.   

A working teenage with modest income would never choose a deductible IRA over a Roth because there is no immediate tax savings for a taxpayer that earns less than the standard deduction, $12,400, and disbursements in future years could be subject to tax and penalty.  The teenager is entitled to a standard deduction of earned income plus $300 even if the parents claim the child as a dependent.

Most young adults entering the workforce should choose a Roth IRA over a traditional 401(k) plan or a deductible IRA when the firm does not offer a 401(k) plan with an employer match.

Around one-third of employees at private firms do not have access to a retirement plan and around 49 percent of employers with 401(k) plans do not match employee contributions.

The choice between a Roth retirement account and a traditional retirement account is straight forward when there is no matching contribution.  The after-tax contribution to a conventional IRA or traditional 401(k) plan is the pre-tax contribution minus the immediate tax savings. Workers should make contributions to Roth accounts when their marginal tax rates are low and make contributions to traditional deductible accounts when their marginal tax rate is higher. 

A person filing an individual return making $12,400 or a married couple filing a joint return making $24,800 in 2020 claiming the standard deduction would pay $0 in tax.  These taxpayers could also reduce tax on additional earning by contributing to a health savings account.

The savings from contributing to a deductible IRA would be $0 because the person does not pay any tax. It is basically irrational for this person to contribute to a deductible IRA instead of a Roth IRA because the tax preferences are larger from the Roth and there is no gain in working years from contributing to the deductible IRA.

Interestingly, it is also almost irrational for a person in the 0 percent tax bracket to fail to contribute to a Roth.   The worker has immediate access to his Roth contribution without penalty or tax and only pays penalty and tax on investment returns prior to age 59 ½. 

At higher tax rates the tax deduction from the traditional IRA becomes more valuable.  A taxpayer facing a 12 percent marginal tax rate for the last $6,000 in AGI would have identical working year spending by contributing $6,000 to a conventional IRA or $5,280 contribution to an after-tax Roth account.

When the last $6,000 is taxed at 22 percent the taxpayer can either contribute $6,000 to a pre-tax traditional plan and pay no additional tax or contribute $4,680 to a Roth and pay $1,320 in additional tax.

The potential tax savings from the use of Roth assets both to the taxpayer in retirement and the person who inherits the Roth account can be very large.  Most taxpayers are better off using a Roth instead of a traditional retirement plan if their marginal tax rate is less than 22 percent.

Consider selecting a Roth IRA over a 401(k) plan with matching contributions if you have high levels of debt and/or have not met 401(k) vesting requirements.

Many financial planners argue that all workers at firms with 401(k) plans that match employee contributions should maximize the employer match because the employer match is free money.  My view discussed here is that even when firms match employer contributions new workers with substantial debt should prioritize debt repayment over saving for retirement.

The failure to pay debt on time can lead to a bad credit rating and higher borrowing costs for an entire lifetime.  The contributions in a Roth can be used to avoid this outcome.

Many young adults entering the workforce with substantial debt in the form of student loans do not have funds for an emergency.   As a result, many young adults with traditional retirement plans disburse funds early and incur taxes and penalties.  A person with a Roth account could disburse Roth contributions without penalty and tax.  The retirement account would remain open and hopefully the worker would not touch capital gains.

Often new workers will not receive the employer matching contribution unless they stay at a firm long enough for the contributions to vest.   Many workers will be better off leaving for a better job instead of staying for the employer match. 

Workers who have not met the vesting requirement for employer matches and who are not likely to meet the vesting requirement should invest in a Roth IRA rather than a firm-sponsored retirement plan.

Contribute to a Roth IRA after taking full advantage of matching employer contributions to your 401(k) plan.

Many employers with 401(k) plans match employee contributions.  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.  

The employer matching contribution to 401(k) plans is an attractive benefit if you are not drowning in debt, have funds for basic emergencies and will not lose the matching funds or be unable to move to a better job due to a vesting requirement.

Workers can divert additional retirement plan contributions to a Roth IRA once they obtain the entire 401(K) match from their employer.   Direct contributions to Roth IRAs are not allowed for higher income workers, however, higher income workers can contribute to a Roth through a backdoor IRA. 

The strategy of contributing to a 401(k) plan to obtain the full employer match and then diverting additional contributions to a Roth IRA will leave the worker with a mix of traditional and Roth assets in retirement.

Consider contributing to a Roth 401(k) plan instead of a traditional 401(k) plan if one is offered at work.

Roth 401(k) plans became available January 1, 2006. Prior to that date, after-tax or Roth retirement options were only available through IRAs. Seven in ten firms now offer a Roth 401(k) option. However, only around 18 percent of workers contributed after-tax dollars to their 401(k) plan in 2016.

The Roth 401(k) plan has two advantages over a Roth IRA.  First, contribution limits are much higher for 401(k) plans than for IRAs.  Second, employers can match employee contributions to all 401(k) plan including Roth plans but cannot match contributions to IRAs. Note, employer contributions to Roth IRAs are placed into a traditional account and are fully taxed at retirement and are subject to tax and penalty if disbursed prior to age 59 ½.   Go here for a discussion of features and rules governing Roth 401(k) plans.

The decision rule for the choice between contributing to a traditional 401(k) plan or a Roth 401(k) plan depends primarily on the marginal tax rate of the worker, assuming the same level of matching contributions.  Workers should contribute to a Roth when marginal tax rates are low and contribute to a traditional plan when marginal tax rates are high.

The use of a Roth 401(k) plan will result in the worker retiring with a mix of traditional and Roth retirement assets, which substantially reduces taxes and improves financial outcomes in retirement.

Convert traditional retirement assets to Roth assets in years when household income is low:

Tax law allows people to convert traditional 401(k) plans and IRAs to Roth IRAs.  The conversion can occur at any age.  Most conversion of 401(k) assets occur after the employee departs from a firm and transfers 401(K) assets to an IRA.  However, some firms with Roth 401(k) plans allow for in-service conversions for older workers.

The amount converted is treated as ordinary income and the cost of the conversion is the additional tax paid due to the increase in reported income.   

The conversion of traditional retirement assets to Roth assets when the household has a marginal low marginal tax rate is profitable and can substantially reduce the likelihood of a person outliving her retirement resource.  The cost of conversion is zero if the taxpayer is in the 0 percent tax bracket or when the taxpayer earns less than total deductions.

The profitable conversion of traditional to Roth assets could occur when a person leaves the workforce for part of a year.  This commonly occurs when a person returns to school or when a spouse temporarily leaves the workforce.

Profitable Roth conversions can also be implemented early in retirement prior to the retiree disbursing funds from a traditional 401(k) plan or claiming Social Security benefits. The strategy of Roth conversions early in retirement described in this recent article requires the household  use assets outside of her retirement plan to fund current consumption.

Money converted from a traditional IRA or retirement account to a Roth is subject to the five-year rule.  Converted funds that are disbursed before five years from the end of the calendar year of the disbursement are subject to tax and a 10 percent penalty.

Contribute to a backdoor Roth IRA if you have excess cash at the end of a year.

Tax rules establishes limits on household income for allowable direct contributions to Roth IRAs.  Direct Roth IRA contributions are prohibited for single filers with income greater than $140,000 and married joint filers with income greater than $208,000.  (The phase out of direct Roth contributions occurs at $125,000 for single filers and $198,000 for married joint filers)

People with income above these limits can make indirect contributions to Roth IRAs by first contributing to a non-deductible traditional IRA and then immediately convert the funds in the non-deductible IRA to a Roth IRA.  This technique is called a backdoor IRA.

The contributions in the non-deductible IRA are not subject to tax at the time of the conversion because funds in the non-deductible IRA were taxed in the year the contribution was made.  The funds in the newly created Roth IRA are subject to tax and penalty if disbursed prior to five years from December 31 of the year of the conversion even after age 59 ½.   The goal of the five-year rule is to prevent immediate gains from the conversion. 

A reconciliation bill recently passed by the House would abolish backdoor IRAs. One rationale for abolishing the backdoor IRA is that it favors the rich.  However, many incomes do not have income levels persistently above the contribution thresholds and not all households making backdoor contributions are wealthy based on a lifetime income concept.  In my view, the proposal to abolish backdoor IRAs is misguided because tax law should encourage additional savings in good years.

 Concluding Thoughts:

People are becoming more aware of the advantages of Roth retirement accounts. Households retiring with a mix of both traditional and Roth assets are much better positioned than household that are dependent on traditional assets.  A recent CNBC article found that many millennials are now recognizing the value of Roth IRAs.  

However, the use of Roth accounts remains counterintuitive to many households. Contributions to Roth accounts and conversion of traditional retirement accounts are more profitable when household income and marginal tax rates are low when it is harder to save for retirement.  

Conventional vs Roth Retirement Accounts

Some Tips on Saving and Distribution Strategies

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

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

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

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

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

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

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

Tips on the Conventional vs Roth Decision

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The reduction in AGI and potential taxes can be considerable.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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How to minimize the impact of 401(k) fees

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

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

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

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

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

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

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

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

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

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

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

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

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

Mitigation of the adverse financial impact on high retirement fees:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Paying off the Mortgage Prior to Retirement

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Outline of an Alternative Financial Plan for the New Generation

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

Many households are struggling with historic levels of debt.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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