In this episode, Peter answers listener questions about 401(k) accounts.
Listen now and learn:
- How to choose between a Roth and Traditional 401(k)
- Best practices for choosing mutual funds in your 401(k)
- When is the right time to make withdrawals from your 401(k) in retirement
Listen Now
Show Notes
Welcome to the Long Term Investor. Today I’m answering listener and reader questions about 401(k) accounts. As a reminder, you can reply to any of my emails with your questions or visit TheLongTermInvestor.com to submit questions at the bottom of the page.
Let’s dive in.
Question #1: Use 401(k) to leave my job at 55?
I’m 46 and have been working for the same organization for almost 25 years – one that has a defined benefit pension plan. I’ve also been contributing to my 401(k) since I started working.
As I ponder retirement age, I wonder if it’d be a sound strategy to use my 401(k) as a means to leave my job at age 55 and bridge the gap to 62, when the pension benefits would be unreduced. I’m concerned that using a significant portion (or all) of the 401(k) would be too risky leaving me with “only” the pension.
Of course, there are other factors at play, but generally speaking, I’m trying to understand/anticipate any obvious pitfalls with this approach.
Here’s the thing, you save into a 401(k) so that you have money to fund your retirement. So there is 100% nothing wrong with tapping your 401(k) while waiting for your pension benefits to kick in.
I suppose the real question is whether you have enough money to really be financially independent. It sounds like you could benefit from a Monte Carlo analysis that runs thousands of scenarios on your investments and retirement cash flows (pension, Social Security, etc) to calculate the likelihood you can meet your lifestyle objectives without running money.
This is actually the very first thing we do at Plancorp with someone, regardless of their age, because it also tends to uncover opportunities to minimize taxes and allocate capital more efficiently.
I would also note that if any portion of your 401(k) is in a Roth, then you are probably best rolling the Traditional portion of your 401(k) into a Traditional Rollover IRA and the Roth funds into a Roth IRA because your Roth account is something you don’t want to deplete this early in retirement. You might also consider investing the Roth and Traditional IRAs differently, which you can’t do when they are still in the 401(k) account.
Question 2: Should I shift my 401(k) contributions from pre-tax to Roth?
I’m an engineer and a super nerd when it comes to financial spreadsheets, etc. Actually, I use Quicken to track spending by categories over a rolling 10 years.
I could go on forever, but I guess one of my big “questions” is whether or not to shift my 401(k) contributions from pre-tax to Roth. Right now, everything in 401(k) is 100% pre-tax, and I max it out (I’m solidly in the 22% bracket, regardless of pre-tax vs Roth). I also max out a Roth IRA and an HSA, which is invested as much as it can be, and I am not reimbursing for medical expenses as of the start of 2021.
By starting Roth 401(k), I’m “locking in” that 22% rate and I completely understand that I might have income that falls in a higher marginal tax bracket when I retire, particularly if I utilize Roth conversions.
As it stands, I plan to go from 15% pre-tax to 15% Roth in April, because I think it’s good to have different levers to pull just in case. Of course, that 15% Roth will be like putting 20% pre-tax, so I’m kinda increasing 401(k) contributions depending on how you look at it!
There’s a lot to digest here.
First of all, this person’s savings rate is excellent. Based on the information provided, I would guess his savings rate is about 20%, and maybe a little bit higher. It also sounds like a pension is in play, so this person seems to be on track for plenty of financial freedom later in life.
One of my Peter-isms, as a few of my colleagues at Plancorp call it, is that a good savings rate can offset a lifetime of poor financial decisions.
So that’s the good news here. Now to address Roth vs Traditional 401(k)….
Let’s level set real quickly.
Both Traditional and Roth 401(k) accounts allow your savings to grow tax-free. With the Traditional 401(k), you get a tax deduction on the contributions you make. That’s why people, like this listener, refer to them as “pre-tax” accounts — because you are funding the account using dollars that aren’t taxed as ordinary income. When you withdraw the money in retirement, you owe ordinary income tax on any appreciation and income earned on your contributions.
With a Roth 401(k), you use after-tax dollars to fund the account. So if you have a $10,000 paycheck and are at the 22% tax bracket (as this listener is), then you will have $7,800 from your paycheck to invest. Or, said another way, if you want to contribute $10,000 to a Roth 401(k), you have to earn about $12,820 to have $10,000 left after paying ordinary income tax.
Read More: 2023 Tax Numbers at a Glance
Lots of math…Anyways, you contribute after-tax dollars to a Roth, they grow tax-free, but then you make withdrawals 100% tax free. So that can be a big deal in retirement.
The only way to answer this question perfectly is knowing what tax law will be in the future and where you fall within that tax law.
If you knew that your tax bracket will be higher in retirement, then using a Roth today is undoubtedly the better choice. Similarly, if you knew that your tax bracket will be lower in retirement than it is today, then using a Traditional 401(k) will be better.
Read More: Should You Use a Traditional or Roth For Retirement Savings
Of course, this dynamic will change over time. For example, imagine you only save to Roth accounts for the first two decades of your career. If you continue only contributing to Roth accounts, you are setting yourself up to have a lower tax bracket in retirement because withdrawals from Roth accounts are completely tax free.
My general feeling is that anyone in their 20s and early 30s should use a Roth accounts when possible because you have enough time for the compounding to really work in your favor. But somewhere in your late 30s or early 40s, the math gets a little fuzzier and the Roth is a less obvious choice.
By your 50s ands 60s, how much you’ve accumulated in different accounts begins to drive the decision as you have a little better visibility on what your tax situation in retirement might be.
If you’re uncertain of whether to use Roth or Traditional, you could always split your contributions between the two, which is a strategy referred to as tax diversification. There are some people who recommend doing this split right out the gate because there is no guarantee that the rules on Roth accounts won’t change.
And 30 years from now, I think there is a reasonable chance that Roth accounts with a large amount of assets could be subject to different rules what is the case today.
One final small note is that this person suggests they will be doing Roth conversions in retirement. This is a great strategy for new retirees, but it does sound like legislation coming out of Washington may put an end to this strategy, so keep an eye on that.
Question 3: When to use a Target Date Fund over other options?
I’m 39 years old and have been maxing out my 401(k) my entire career while using a Target Date Retirement Fund. I just changed jobs and my new employer has also has Target Date Funds, but far more additional options than my previous employer.
Is there a rule of thumb for knowing when to use a Target Date Fund over other options? If I decide to use the other fund options, are there any best practices for selecting the right ones?
GREAT question. Target Date Funds start with an aggressive mix of stocks and bonds, and gradually becomes more conservative as you approach the target date.
I feel like they’re generally an effective option if you don’t have anyone helping you choose the right mix of investments. If you have an advisor, you should show him or her the options and let them make the determination for you. Even if you have a friend that’s an advisor, you might consider asking them to take a quick look.
For the clients we work with at Plancorp, we typically build them a custom allocation if the options are good enough (something I’ll touch on more in just a moment), but I feel like for the type of person we work with, Target Date Funds are fine for people that are multiple decades away from retirement.
But for people less than 20 years from retirement, the degree to which these funds become more conservative doesn’t seem optimal. Of course, as you are within 20 years or so from retirement, you really ought to have a financial advisor, so this would be just another one of the services they would help you with.
Now, as for picking other funds, it’s really hard to make broad statements on how to pick the best funds since every 401(k) plan’s offerings are so different, but I will share a few general thoughts.
First, you are generally best off choosing funds with the lowest cost. There is very robust research that shows fund cost and fund performance are related. Low costs should be your primary focus within a 401(k) plan.
Secondly, choose index funds over actively managed funds. I’ve referred to S&P’s Index Versus Active (SPIVA) Scorecard, which is updated twice a year. This scorecard compares active managers to their respective index benchmark over 1, 3, 5, 10, and 20 year periods. Across all time periods and asset classes, the vast majority of active managers fail to beat a simple index.
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About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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