Financial Tip #2: Prioritize debt reduction over saving for retirement

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

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

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

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

  • The decision to initially forego saving for retirement and earmark all available funds towards repayment of student debt leads to a substantial reduction in lifetime payments on student debt.  Two examples of the magnitude of the reduction in lifetime student loan payments are presented below.
  • A student borrower starting her career with $30,000 in undergraduate loans could take out a 20-year student loan leading to a monthly payment of $198.82 and lifetime loan payments of $47,716.   Alternatively, this student borrower could forego contributions to her 401(k) plan, increase student loan payments by $565.4 per month and pay off her student loan in 61 months.   The new total student loan repayments are $33,837, a total savings of $13,879. 
  • A second borrower with three student loans — a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00% — choosing the standard 20-year maturity on all loans has a monthly payment of $775 and realizes total lifetime payments of $200,633. The modification of the private loan to a five-year term initially increases the monthly student loan to $1,065.  The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years and earmarks the reduced loan payment to further loan reduction is $146,271.  This is a total lifetime savings of $54,362. 
  • The student borrower who rapidly reduces or eliminates all student debt can increase savings for retirement once the monthly student debt payment falls or is eliminated. Furthermore, the rapid elimination of the high-interest-rate private student loan could facilitate refinancing of the remaining student debt at favorable terms.
  • The failure to maintain a good credit rating will lead to higher borrowing costs on all consumer loans and on mortgages in addition to higher lifetime student loan payments.  
  • Assumptions on the impact of credit quality on interest rates were obtained for credit cards from WalletHub, for car loans from  Nerd Wallet, for private student loans from Investopedia, and for mortgages from CNBC.  The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.  The monthly cost of bad credit depends on the interest rate differential, the likely loan amount, and the maturity of the loan. The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.  The analysis also assumes the borrower only paid interest on credit card debt and loan maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.  Based on these assumptions, the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.
  • A person who fails to eliminate debt could end up with higher borrowing costs for their entire lifetime.
  • Increasingly, young adults are tapping 401(k) funds prior to retirement to meet current needs.  Often individuals who raid their 401(k) plan prior to retirement incur additional income tax and financial penalties.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely withdraw 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds.  New entrants to the workforce who prioritize the reduction of student debt over saving for retirement will be less like to raid their retirement plan and incur tax and financial penalties. 
  • Note from Tip #3 that people using Roth IRAs or Roth 401(k) plans are less likely to pay penalties and taxes on disbursements on retirement savings because the initial contribution to a Roth can be disbursed without penalty or tax.  People with debt should start saving for retirement through relatively small contributions to Roth accounts rather than large contributions to traditional plans.
  • Many people who fail to prioritize debt payments struggle with debt burdens for a lifetime and fail to realize a secure financial future. A CNBC portrayal of the financial status of millennials found many adults near the age of 40 were highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.  A 2019 Congressional Research Service Report found the percent of elderly with debt rose from 38% in 1989 to 61% in 2021.   The Urban Institute reported the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019.  A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.  Many of these problems and financial stresses could have been avoided if the student borrower entering the workforce had initially focused on debt reduction and the creation of an emergency fund rather than saving for retirement.

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

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

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

A Modified Roth IRA


Many people, for a wide variety of reasons, are failing to save enough for retirement. The proposal presented and evaluated here seeks to expand retirement savings by replacing 401(k) plans with a modified Roth IRA.  

The modified Roth IRA maintains key features of current Roth IRAs but adds additional sources of contributions in the form of employer matching funds and contributions for low-income households from the government.  The modified Roth IRA creates incentives for young people and people with debt to start saving for retirement early in their career and prevents people from disbursing their entire retirement accounts prior to retirement.  The tax incentives for contributions to the modified Roth could increase workforce participation.  The introduction of the modified Roth is more equitable than the current system, which favors workers at firms with generous but expensive 401(k) plans.

Description of the modified Roth IRA:

  • The basic rules governing worker contributions to the modified Roth are identical to rules governing current Roth IRAs. Contributions are fully taxed during the year the contribution is made.  Contributions as with current Roth rules.  Contributions cannot exceed wage income of the household.  All employee contributions to the modified Roth IRAs can be withdrawn without tax or penalty at any time.  All disbursements from the modified Roth after age 59 ½ are untaxed.
  • The modified Roth allows for additional contributions from employers, from people hiring an independent contractor, and from the government.   The rule allowing non-taxed compensation to independent contractors will allow more people to work independently and save for retirement.  The government contributions are only available for workers from low-income households and will not exceed $10,000 over the lifetime of the workers.
  • Disbursements from investment returns, government contributions and employer contributions would not be allowed until age 59 ½.  
  • The maximum allowable employee contribution to the modified Roth account is $10,000 per year, indexed for inflation.

Advantages of the modified Roth account:

  • There are strong incentives for young people to open a Roth account and start saving as soon as they enter the workforce.   The modified Roth account expands gains from saving at a young age because matching contributions would compound for years.
  • People entering the workforce with student debt often delay or forego 401(k) contributions. There is less incentive to delay contributions to a Roth retirement account than a traditional one because contributions can be used for emergencies or for debt reduction without penalty or tax.  The modified Roth maintains this advantage and allows for additional matching contributions, which will compound over time.
  • Many young adults now routinely distribute a substantial portion of their 401(k) savings early in their career often when switching to a new position.   The rules of the modified Roth IRA guarantee that a portion of retirement savings, employer and government contributions cannot be withdrawn until age 59 ½.   This proposal substantially reduces shortfalls in retirement income caused by early distributions. 
  • Many employees work at firms that do not offer 401(k) plan or work at firms that do not match employee contributions.  The modified Roth IRA will provide for some matching funds for workers
  • Independent contractors do not have access to matching funds from people hiring them.  The modified Roth allows for matching contributions for people hired as independent contractors.  The matching contributions for contract employees would be the outcome of a negotiation between the firm and the independent contractor.   
  • Workers at firms without employer contributions could obtain matching contribution.
  • Some current 401(k) plans lock workers into a high-fee 401(k) plan, which leads to a substantial loss in retirement wealth.  The modified Roth account described here allows workers to choose a low-fee investment vehicle from a firm like Fidelity, Schwab, or Vanguard.
  • Unlike the child tax credit, the government contributions to the modified Roth are only available for households with wage income.  The combination of tax-free retirement savings and some matching contributions from employers or the government could induce some people to remain attached to the workforce.
  • Some people will choose to report income they otherwise might have reported because without reported income they will be ineligible to contribute to the modified Roth an ineligible for matching contributions. 

How to pay for the modified Roth IRA:

  • The selection of the modified Roth leads to lower use of 401(k) plans and lower loss of tax revenue from decreased 401(k) usage.
  • Additional tax revenue from the introduction of the modified Roth account could be obtained by reducing allowable contributions to 401(k) plans. 
  • A tax of 1 percent of Roth balance over $2,000,000 would recoup some revenues and would be more equitable than current required minimum distributions.
  • The increased retirement savings induced by the modified Roth IRA could lead to a phased change in the Social Security retirement age from 62 to 63 to reduce the long-term Social Security deficit.
  • Part of the cost the modified Roth could be offset by a reduction in the child tax credit.   The combination of a modified Roth and a smaller child tax credit would remain favorable to low-income households and would expand labor force participation relative to current subsidies.

Concluding Remarks:

Many policy proposals either improve equity and reduce economic growth or worsen equity and increase growth.  The additional subsidies created in the modified Roth proposal are both progressive and pro-growth.   The new subsidies stimulate savings by low-income households, workers without access to the most generous 401(k) plans and new entrants to the workforce with high levels of debt and low levels of liquid assets for emergencies.  The new subsidies, in sharp contrast to some existing subsidies like the child tax credit, stimulate workforce participation, which will lead to higher economic growth.

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.


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. 

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.  

Quick Tip: Invest in Roth Not Conventional Retirement Plans

  • Households paying little or no income tax in working years should select a Roth retirement account over a conventional one.  
  • The gain from the exemption on tax or deduction from a contribution to a conventional retirement account during working years is negligible for these taxpayers.
  • The potential reduction in tax during retirement from use of Roth is huge and from several sources.   The Roth distribution is not taxed.   Substantial Roth distributions lower marginal and average tax rates.   The Roth distribution reduces Social Security benefits subject to tax.  The Roth is not subject to a required minimum distribution, which improves tax planning.
  • The choice between Roth and conventional accounts can be a bit harder for higher income taxpayers.  These taxpayers may have access to Roth 401(k) plans at work that allocate contributions to a Roth account and employer matches to a conventional account.
  • The lack of tax on inherited Roth IRAs allows many beneficiaries to avoid large taxes during peak working years.
  • Roth accounts can be used as an emergency fund because contributions can be distributed without penalty or tax.

Over 40 percent of U.S. households pay zero or negative federal income tax.  A CNBC article finds this number will increase n 2021 due to the family tax credit.   Under the current tax code, there are also a lot of people in the 10 percent tax bracket.

People don’t like paying tax.   I certainly get that.  However, people who are already paying zero or negative tax due to tax credits should pursue other financial goals in addition to tax reduction.

Many of these people will be asked to choose between a traditional deductible retirement plan or a Roth retirement plan.    

People not covered with an employer-based retirement plan can usually choose between a Roth and conventional IRA, although, there is an income limit on eligibility for Roth IRAs.  Many firms now offer both conventional 401(k) plans and Roth 401(k) plans.

The traditional deductible IRA reduces income tax during the year the contribution is made while the Roth IRA reduces tax in retirement.

The tax reduction for many working-age people who contribute to a conventional retirement account is small, maybe even negligible.

People with negative income tax due to a refundable credit will get a slightly larger refund if they contribute to a conventional retirement plan.  People in the ten percent tax bracket could get a savings of 10 percent of the 401(k) contribution, likely a small number.

The existence of a Roth IRA during retirement will substantially reduce tax obligations in retirement through multiple channels.   

  • The distribution itself is not subject to tax.
  • A large Roth distribution could substantially reduce marginal and average tax rates relative to a large distribution from a conventional retirement account.
  • The distribution from a Roth rather than a conventional account often leads to a reduction and maybe even elimination of the taxation of Social Security benefits because Social Security benefits are only taxed above certain AGI thresholds.
  • People with Roth accounts are not required to take a required minim distribution (RMD) after age 72.   The lack of a RMD requirement extends retirement income and improves tax planning.

Working-age people can reduce their tax obligations many ways.  They can take the family tax credit if they have children, they can contribute to a health savings account, or they can buy a house and deduct mortgage interest.  Many of these measures are generally not used or not available for older households.    For example, people over age 65 are covered by Medicare and generally do not contribute to a health savings account.  Most people over 65 have paid off their mortgage and no longer deduct mortgage interest or other housing expenses.  Few people over 65 have minor dependent children and can claim the child tax credit.

The decision to take a Roth instead of a conventional account can be a bit harder if you are in the top tax bracket.  Many of these households will work at a firm that offers both Roth and conventional 401(k) plan.   These taxpayers can send their contribution to the Roth account.  Employer matching funds are placed into a conventional plan.

There are other advantages with Roth IRAs.

Roth IRAs can be used as an emergency fund.   The IRS allows contributions from Roth IRAs to be withdrawn without penalty or tax because they are fully taxed at the time of the contribution.  People should not rely on a Roth as the primary source of funds for an emergency. There is also a limited window to repay funds taken from a Roth prior to retirement.    This benefit from the use of Roth accounts is extremely important because as indicated by my paper many people taking distributions from conventional accounts prior to retirement are struggling.

The use of Roth accounts allows recipients of an inherited IRA or 401(k) to avoid a large tax bill.  Under current tax law, all IRA funds must be distributed over a 10-year period.  Conventional retirement accounts, inherited by someone other than a spouse, are taxed as ordinary income.  Roth accounts are untaxed.  A person that inherits a conventional retirement account during peak earning years could have larger than anticipated tax bills.

The main message here is don’t let immediate tax avoidance dominate your investment, savings and even tax planning goals.  Think long not short term.  The narrower message here is use Roth not conventional retirement plans.

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.

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.

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.

Six Reasons 401(k) Contributions Should Not be Your Top Priority

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.

Improved Liquidity:   

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.   

Tax Considerations:  

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.

Financial Risks:

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.

Concluding Remarks:

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.  

Should you invest in a 401(k) plan, an IRA, or both?

Financial Tips:   When should a person use an Individual Retirement Account rather than a 401(k) plan?   When should a person leaving an employer convert her 401(k) plan into an IRA?


Most financial advisors believe that workers saving for retirement should invest in a 401(k). rather than an IRA.  Many government rules favor 401(k) contributions over iRA contributions.  First, employee contribution limits for 401(k) plans are around 3 times higher than limits for IRAs.  Second employees are allowed to make additional contributions to 401(k) plans but are not allowed to make similar contributions to IRAs.  Third, many employers routinely match employee contributions.   Fourth, the IRS imposes limits on deductibility of some iRAs but not the deductibility of 401(k) plans.   Fifth, the IRS restricts Roth IRA contributions for higher income households but does not restrict contributions to Roth 401(k) plans.   

IRS rules allow 401(k) plans to automatically enroll workers who do not opt out.  However, there are situations where people are better off investing in an IRA separate from their employer than in the firm 401(k) plan. 

The main factor favoring IRAs over 401(k) plans is the higher administrative costs of 401(k) plans.  Fees on 401(k) plans are applied to the entire 401(k) balance and are often between 1 percent or 2 percent per year.  These fees can substantially erode a workers 401(k) balance over the course of the workers lifetime. 

High 401(k) fees are more prevalent at small firms than large firms. People working at a firm offering a plan charging high 401k) fees and offering little or no employer contributions need to look at other investment options than their 401(k) plan. High 401(k) fees can substantially erode retirement savings.   These fees can largely be avoided by using an IRA rather than a 401(k) plan to save for retirement.

I constructed a spreadsheet to estimate the impact of high 401(k) fees at retirement savings.   The assumptions in a baseline analysis involved a person with a starting salary of $50,000 who works for 35 years and realizes wage growth of 2% per year over her entire career.  This person contributes 10 percent of her salary to a 401(k) plan and earns an annual return of 7%.

When fees are 2 percent of the end-of-year 401(k) balance the total fees over the entire 35-year career are slightly more than $153 k compared to an ending balance of slightly less than $600 k.   

By contrast, when 401(k) fees are 0.5 % (a reasonable fee structure that exists at many firms) total fees over the 30-year career are around $48 k and the ending balance is around $830 k.

Note the difference between ending balances of the two scenarios is much larger than the difference in fees because additional 401(k) income from the lower fee compounds at the average rate of 7 percent per year.

One possible strategy for a worker at a firm that match some employee 401(k) contributions is to make a small contribution to the 401(k) to take advantage of the employer match and then invest additional funds in an IRA. This strategy may or may not be feasible depending on IRS rules governing IRA contributions, deductibility of IRA contributions, and the individual’s household Adjusted Gross Income.

The 401(k) fees are applied to all assets in the 401(k) plan.   In the current low interest rate environment, the expected return on government bonds adjusted for 401(k) fees is negative.   In this circumstance, it may make sense to place more 401(k) funds in equity and accumulate debt investments outside of a 401(k) account where they are not subject to 401(k) fees.  One alternative, which many people overlook, is direct investment in Treasury bonds and bill at Treasury Direct.

Firms like Fidelity, Schwab, and Vanguard aggressively ask people who leave their employer to convert their 401(k) plan to an IRA.   This is the rare case where aggressive solicitation from financial firms is actually sound advice.  Fees on well-designed IRAs are often near 0.2%.  The decision to maintain funds in a dormant high-fee 401(k) plan could lead to a substantial loss in retirement savings.

One of the key selling points of conventional 401(k) plans is the ability of these plans to reduce current year tax obligations.   By contrast, Roth 401(k) plans and Roth IRAs do not reduce current year tax obligation but do reduce taxes in retirement.  A person with low current year tax obligations and the ability to reduce taxes through other means such as contributing to health savings account may choose to reduce or eliminate contributions to a conventional 401(k) plan.   This person might instead invest through a Roth 401(k) plan if available at her firm or through a Roth IRA.  The lack of a Roth 401(k) option may lead some investors who are concerned about tax obligation in retirement to consider a Roth IRA over a conventional 401(k) plan.

The issue of deciding between a 401(k) plan and an IRA is related to several other issues including – the choice between debt reduction and mortgage savings, the choice between investing in a health savings account or a retirement account, and the choice between a conventional and Roth IRA.    Other financial tips on these related issues will follow shortly.