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.