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Contribute Now, Save Later: Taxes and Your 401(k)

Most people are aware that their 401(k) is an excellent tool for retirement savings. In fact, Americans with access to a 401(k) plan are making contributions across the board – 52% of millennials, 75% of Gen X, and 80% of baby boomers contribute regularly. The majority of people who contribute on a regular basis are contributing up to their employer’s match, which is a great way to maximize retirement savings. Beyond that, 32% of high-income earners are making the highest allowable contribution to their accounts ($18,500 in 2018, $19,000 in 2019).

All of this is fantastic news and indicates that Americans may be better prepared for retirement than some doom-and-gloom reports suggest. However, the prominent use of the 401(k) raises a few questions. Namely, do you actually know how a 401(k) works? And what’s the best way to maximize this savings vehicle as you continue toward saving for retirement?

How 401(k) Plans Work

If we’re investing thousands of dollars each year into a 401(k), it’s important to have a baseline level of knowledge about how the plan functions – and how you can use it to its full potential. 401(k) plans are the primary way that the American workforce saves for retirement. The plan works in a relatively simple way:

An employer sponsors a 401(k) for their employees. The employees decide how much they want to take out of each paycheck to contribute to their account. The employer can decide whether or not they want to match a percentage of their employees’ contributions. For example, many employers match at least 3%. To put that in real terms, if $4500 represented 3% of your salary and you saved that throughout the year into your 401k, your company could put in an additional $4500 just by participating in the plan.

The deductions are taken out of your paycheck before taxes are calculated, which means you’re funding your retirement savings with pre-tax dollars. This lowers your taxable income, which can be a huge benefit to high-income earners. Your employer takes on all of the additional responsibility for the plan, including deciding what investment options you have, making sure it’s run correctly, hiring the vendors they need to run the plan, and deciding which employees are eligible to participate.

Don’t have a 401(k)? Many physicians, and other professionals who work in public service have a 403(b). 403(bs)s work similarly to 401(k)s, but are the primary retirement savings vehicle for the majority of tax-exempt organizations, including cooperative hospital service organizations.

Contribution Limits and Information

Contribution limits often change from year to year, so it’s important to check in semi-regularly to know how much, exactly, you can contribute to your 401(k). For example, in 2018 employees could legally contribute up to $18,500 to their 401(k). However, in 2019, the annual limit has been raised to $19,000.

It’s important to note that these limits don’t include employer matching programs – you’re only limited by how much money you put into the account, not your employer. If you’re thinking about maxing out your contribution limit this year or in the future, make sure you do so in a way that doesn’t jeopardize any employer match you may receive. Some companies, for example, only match a percentage of your contributions if you continue to contribute throughout the year. So, if you choose to max out your contributions in the first or second quarter, they may stop contributing a matching percentage in the third or fourth quarter. Not all companies have this policy, but it’s wise to be mindful and do your due diligence before making any decisions about maxing out your contribution.

Taxes

The funds you contribute to your 401(k) are all pre-tax. This means if you contribute $19,000 to your 401(k) in 2019, you’ll be reducing your taxable income by $19,000. This can be a game changer for many high-income earners who are in an uncomfortably high tax bracket and are working to lower their taxable income. However, don’t be mistaken – you’ll still owe taxes on those funds eventually.

Your invested funds grow in your 401(k) until you need them during retirement. At that time, you’ll start to take Required Minimum Distributions (RMDs) from the account. If you choose to “roll over” the account when you retire to an Individual Retirement Account (IRA), you’ll take RMDs from your IRA throughout retirement. These RMDs are taxed as regular income throughout your retirement, and you face steep penalties if you fail to take them on time.

If you have a Roth 401(k), you need to keep a few additional tax-strategy concepts in mind. First and foremost, contributions to your Roth 401(k) are taxed upfront, but grow tax-free forever. This means if you’re young and are in a lower tax bracket, you’ll pay fewer taxes on your retirement savings contributions now as opposed to when you would be taxed at a future income tax rate through a traditional 401(k). The new tax law makes this especially true because, in 2018, the tax rates are lower – so you could potentially save even more. Keep in mind that some companies offer a Roth 401(k) and an employer-matching program for contributions, but their match will typically go into a traditional 401(k).

What If I Leave the Company?

If you leave the company you work for, you don’t take your 401(k) with you. Instead, you can either:

  1. Roll the 401(k) from your old employer to a new 401(k) (or other workplace retirement account) at your new employer
  2. Roll the 401(k) from your old employer to either a Traditional IRA or a Roth IRA (if you meet the income qualification limits)

Sometimes, an IRA is a better option because there are more investment choices, and you have more flexibility to use the account as you choose. You should speak with a financial planner to help you determine what your best course of action is.

Have questions about your 401(k)? Reach out! We’d love to hear from you.