Time to Ditch Your 401(k)? No Way! - Adviser Investments

Time to Ditch Your 401(k)? No Way!

September 23, 2020

Episode Description
FEATURING Kari Wolfson, Andrew Busa and Matt Schumaker

A number of recent articles have criticized 401(k) plans, the centerpiece of many peoples’ retirement savings. Is it time to reconsider using the 401(k) as a key tool to deliver financial peace of mind? Hardly.

Join our wealth management and financial planning experts for this engaging lesson on why the tax-advantaged benefits of 401(k) plans remain a must-have for most retirement savers. Tune in as we debunk costly misconceptions and provide clear advice to help you make the most of your 401(k) plan, including:

  • Understanding your plan’s rules and what’s included
  • How and why to automate savings
  • Mastering withdrawals and after-tax savings
  • Keeping an eye on fees
  • How to avoid rollover pitfalls
  • …and much more!

We’re big believers in these workplace savings plans—we employ them for our own retirement savers at Adviser Investments, and this illuminating discussion explains why we put such stock in them. Click above to listen now!

Click here for a copy of the Key Financial & Tax Planning Data sheet referenced in the podcast.

Episode Transcript

Kari Wolfson:

Does the 401(k) plan no longer make sense? Maybe not, according to a recent Bloomberg article and several others that have surfaced lately in the news. It’s a bit shocking to read, as retirement plans have long been considered one of the best ways to save for retirement. Today we’re going to be exploring how you can unlock the true potential of your 401(k) and discuss what we have identified as the five major misconceptions of 401(k) plans. We want to make sure that you’re taking full advantage of all of the benefits offered in your plan.

Kari Wolfson:

Hi, this is Kari Wolfson, and I’m an account executive and certified financial planner here at Advisor Investments. We’re here with another Advisor You Can Talk To podcast. Today I’m joined by two of my colleagues, Andrew Busa, a senior financial planner and certified financial planner, and Matt Schumaker, an account manager. Welcome to you both.

Andrew Busa:

Good to be here. I’m looking forward to getting into this one, just talking about the articles that you mentioned, Kari, that have recently come out against 401(k) plans, and we’ll see throughout this episode, there’s been some oversimplification there. We’re looking forward to digging into that, and I can’t wait to get into those misconceptions that you mentioned, either.

Matt Schumaker:

I completely agree, Andrew. First off, just want to thank you, Kari, for the introduction and letting us join you on this podcast. Looking forward to discussing some little-known features and benefits of 401(k)s, such as the various myths about how they’re taxed. As you’ll hear, we’re big believers in the value 401(k)s. We use them ourselves at Adviser Investments, and we think they’re a smart, simple savings tool for people, both young and old. One striking statistic that stood out to me was that only 32% of Americans are taking advantage of 401(k)s and investing in one, while nearly 59% of Americans have access to them.

Kari Wolfson:

Perfect. Now let’s get started. Before we discuss the five major misconceptions of 401(k)s, let’s begin with a few of the basic things to keep in mind when you are initially signing up for a 401(k) plan. Andrew, can you get us started?

Andrew Busa:

Right, so there are really three basic things that you want to find out immediately when you either first sign up for your 401(k) or you first get hired at a new job. So number one is, know the ground rules. So this means, understand if there’s a company match available to you because that’s free money that the company is offering you, so you want to take advantage of that. Also, know what the participation investing rules are. So certain companies, certain plans, you might need to be there for a certain amount of time before you can even participate in the plan, and then for vesting, you may need to be an employee there for a certain amount of time before all of that money is really yours if you were to leave. So know the ground rules.

Andrew Busa:

Number two is, educate yourself on what the investment options are. This is going to vary from plan to plan. I know, Matt, you’ve done some research on this and have some actually surprising statistics to share.

Matt Schumaker:

There was a study done a few years ago, and on average, a 401(k) plan has about 10 options. While, for some people, this might be exactly what they’re looking for, it’s very simplified and easy for you to pick a few options, people, a lot of investors, might be looking for more options.

Matt Schumaker:

That’s where this thing called the self-directed brokerage option comes into play. What this does is it unlocks your 401(k) and opens you up to a wider universe of funds that you can use. It still has all the same principles of a 401(k), but it pretty much allows you to invest in any stock, bond, mutual fund, ETF type investment product that you typically would have access to in a brokerage account. With that, it increases your options, and allows you to speak with your advisor and maybe help to develop an investment strategy using funds that they would recommend, that you typically wouldn’t have access to in your 401(k).

Matt Schumaker:

Something that we found too is, 77% of 401(k)s are actually invested in what’s called a target date fund. The target date fund is … it is a fund that has a retirement date set out in the future. So, for example, if you’re a younger employee, you’re working, you might plan to retire in 2050. So companies like Vanguard will have a Vanguard 2050 retirement fund that will start aggressive as you’re younger, and the mix will be more towards equities as opposed to fixed income. As you near retirement, that mix will shift, and your fixed income portion of the account will grow more, and then the equity portion will shrink.

Matt Schumaker:

So while we think the target date fund is good for some people, it may not be good for others. So that’s where that self-directed brokerage option comes into play, especially when a lot of 401(k)s, the only option you would normally have is that target date fund.

Andrew Busa:

Yeah, so again, that’s why just knowing what your investment options are upfront are so important, and if you have this brokerage option available to you, just knowing that is super important.

Andrew Busa:

Then number three, the third basic thing to know, just know what the fees of your plan are. So, for example, that brokerage link will have a fee associated with it. Of course, there are going to be fees with the underlying mutual funds that you’re considering for your 401(k), and then your 401(k) plan may also be paying some sort of an advisory fee if that’s the arrangement that they’ve set up. So just knowing all of that is important.

Andrew Busa:

So, again, those three basic things to find out immediately. Number one, the ground rules, number two, the investment options, and finally, know what the fees of your plan are.

Kari Wolfson:

Exactly, Andrew. Now let’s move on to our five misconceptions. These are some of the most common issues that tend to trip people up when they are thinking about their 401(k) options. The first misconception is that you can only put pre-tax money into your 401(k). Andrew, what are your thoughts?

Andrew Busa:

So that first misconception is really a good one, Kari, and I don’t see this mentioned in the articles that you talked about at the beginning of this podcast, is that in these articles, it’s kind of assuming that all the contributions that you’re making are pre-tax, meaning you’re making contributions to a traditional 401(k). What that means is that the contributions are deductible against your current year taxes, meaning you’re lowering your taxable income.

Andrew Busa:

What’s becoming more common, though, is that Roth 401(k) options are being offered at a lot of these 401(k) plans. So why that’s important is that, let’s say that you want to make a contribution to a Roth IRA, but you find that your income is too high. So there are phase-outs that can get hit pretty early on, once you start earning a good amount of money, that you wouldn’t be able to contribute to a Roth IRA.

Andrew Busa:

So what’s special about a Roth 401(k) is that there are no income limitations. So no matter how much you’re earning, you can put money into your Roth 401(k) if it’s offered to you. So once the money is in there, it’s growing tax-deferred, and then any withdrawals that you make are tax-free once you’re able to do that. Of course, there’s no deduction on the way in, but it’s good to have that tax diversity on the other end, when you reach retirement.

Kari Wolfson:

That’s huge because a lot of people, they see Roth and they just assume that if they’re over the income limit, they can’t make the contribution.

Andrew Busa:

Right.

Kari Wolfson:

So it’s really important to point out that there are not income limits within the Roth 401(k) option. That’s huge.

Andrew Busa:

Exactly. Yeah, and there’s no required minimum distributions for a Roth IRA or Roth 401(k) when you hit that age. Right now, it’s at 72. So that’s just another advantage of that.

Matt Schumaker:

That’s right, Andrew, and we believe Roth money can be extremely valuable as a legacy piece. Not all plans offer the Roth 401(k), but we would encourage you to explore your plan documents and capitalize on this offering if available. You can actually split your contributions between both Roth and traditional, and it wouldn’t look any different to you from a logistical standpoint.

Andrew Busa:

Yeah. That’s an area where you’ll really just look at it from year to year, to decide what’s most beneficial to you, right. It’s going to vary, depending on how much income you’re making. That’s something to definitely check with your advisor on, talk to your CPA about it.

Andrew Busa:

But in these articles, taxation was one of the major criticisms over why 401(k) plans aren’t the best choices anymore. Even though taxes are historically lower today than they have been in the past, meaning the benefit of making a traditional 401(k) contribution is diminished because the benefit is, of course, based on your marginal tax bracket for the current year. So these articles were looking back to the 1980s when taxes were a bit higher.

Andrew Busa:

The 401(k), it’s still advantageous whether you’re making traditional contributions or Roth 401(k) contributions. It’s just going to depend on what your tax situation is for a given year.

Kari Wolfson:

I think Matt’s point that you can split it between the two, you don’t have to choose one or the other, and it’s flexible, you can change it year over year. I know when we’re doing financial plans and working with our clients, it’s not something where you set it in stone. You can change it over time. So if you do have that option, it is definitely something to consider.

Andrew Busa:

That’s a great point.

Kari Wolfson:

All right, moving onto the second misconception, which is, you can only contribute money to a 401(k) from your paycheck.

Matt Schumaker:

So there are other options for you to get money into your 401(k). I’m sure a lot of people listening to this podcast right now have been employed with other companies in the past that they had 401(k) plans with, and those plans may still be sitting with their former employers. There are options for a lot of plans that will allow for roll-ins. So what that does is it allows you to consolidate your 401(k) plans, continue that tax-deferred growth with that pre-tax money. It’s not taxable to combine 401(k)s, and really, like I said, one of the biggest benefits is that consolidation, so you only have to look at one plan.

Andrew Busa:

A caveat just to throw in there, too, Matt, if you’re considering a rollover from a 401(k) to an IRA, you also want to know a little bit about what’s called ERISA. So that’s Employee Retirement Income Security Act. Basically, what this does is it gives your 401(k) some additional creditor protection. Meaning, if you’re subject to a lawsuit, if there’s bankruptcy, your 401(k) has this special protection granted to it, and basically, when you roll from a 401(k) to an IRA, you’re losing that ERISA protection. Now IRAs do have their own measure of protection. That’s going to vary from state to state. So that’s just something to keep in mind, especially if it’s a large 401(k) rollover, just something to know, and your advisor should educate you on that if they haven’t.

Kari Wolfson:

All great points. So on top of your deferrals and employer contributions, you can also transfer old 401(k) money and continue to keep these additional benefits. The third misconception that we want to talk about is that you can only contribute up to the yearly maximum.

Andrew Busa:

This is a really good one, and one that really doesn’t get much press. But even just what you said there, Kari, that you can only contribute up to the yearly maximum, sounds reasonable. So what we’re talking about there are the contribution limits, which are indexed up every year. We’re not going to apply hard numbers, just because we want this to be somewhat evergreen, and lasts, and be relevant.

Andrew Busa:

So you have those yearly contribution limits, but you also have what’s called the Section 415 limits, which are much higher. Now, if your 401(k) plan allows for what’s called after-tax savings, you could theoretically contribute up to the yearly contribution limit and then contribute a much larger amount as after-tax to get up to that Section 415 limit, which, again, is a much higher amount. Well, why would anyone want to do that?

Andrew Busa:

So what you can then do is take that after-tax contribution that you just made, and if your plan accepts in-service distributions, you can take that amount of money and roll it right into a Roth IRA. So that means you could theoretically put a very large amount in one year into a Roth IRA if your plan allows this.

Andrew Busa:

So this misconception and this information, it’s really aimed at a small slice of listeners out there, because you need to have the cashflow on a yearly basis to be able to do this and your plan needs to also accept after-tax contributions, as well as in-service distributions.

Andrew Busa:

So this is an advanced strategy and not for everybody, but if you’re able to do this, and you have the cashflow to do this, it’s really something to consider because you can supercharge a Roth IRA very quickly over a few years if you’re able to get that money in there. So if you have questions about this, definitely talk to us, your advisor, your CPA. This is a really, really cool strategy.

Matt Schumaker:

Andrew, yeah, I’ve seen that referred to as the mega backdoor Roth, and that is a great way for you to increase those contributions each year. The IRS does come out with contribution limits, and they are adjusted for inflation each year, and they are greater than IRA limits, so it’s a great way for you to get pre-tax and tax-deferred savings to build up your retirement funds. If you are over the age of 50, you can contribute an additional $5,000 per year, and that’s what’s known as a catch-up provision. It’s a great way, again, for you to increase that retirement savings.

Kari Wolfson:

Matt, those are all important things to point out. I also just wanted to remind anyone who’s listening that we do put out those IRS updated limits each year in our key financial data fact sheet. You can find that linked to the podcast description. The next misconception to talk about is that you can only access your 401(k) money once you’re retired.

Matt Schumaker:

Kari, I think this is a great misconception to discuss because the purpose of a 401(k) plan is to save for retirement and to end up using those funds in retirement. But for a lot of people, it’s tough for them to show money away and not be able to touch it for 40, 50, 60 years, however long out you’re going into retirement. So there are ways to access your money. They may not be discussed in your general plan documents or with your plan administrator.

Matt Schumaker:

Two common ones that you’ll run into are what’s known as a loan or a hardship withdrawal from your 401(k). The loan is exactly what it sounds like, and would be similar if you were to go to your bank, except in this scenario, you’re tapping into your 401(k) balance. We don’t recommend this necessarily, because you do have to pay back interest over time. This interest would come out of your paycheck, and it would be taxed and then put back into your 401(k). Although it does go back in there, again, you do have that interest expense that you’d then have to pay, and not all plans offer loans. So that’s something that you’d have to speak with your plan administrator about.

Matt Schumaker:

The second option is what’s known as a hardship withdrawal, and this can only be used for heavy financial needs. Again, not all plans offer this, but it does enable you to take money out prior to your full retirement age if you do run into a scenario where you do have that heavy financial need. One thing to remember with hardship withdrawals is that you are immediately taxed on the money as soon as you take it out. Versus a loan, you do have that grace period, since you’re just borrowing the money, that you aren’t immediately taxed on it.

Kari Wolfson:

Okay. So kind of worst case scenarios, but good to know that there is the option if you did need it, versus thinking that it’s just locked in there, regardless of the situation.

Matt Schumaker:

Exactly, and now another option to access the money is what’s called the Rule of 55. Now, the Rule of 55 comes into play if you leave your job after the age of 55, whether by choice or some other variable that comes into play. So it gives you the opportunity to take money out of your retirement plan without penalty. So normally there’d be a 10% penalty if you take out any money until you turn 59 and a half, but you can use this Rule of 55 to take money out and use those funds as a bridge between starting a new job or anything that you would need the funds for.

Kari Wolfson:

Yeah, this is huge. I think especially if someone does get laid off and they’re close to retirement age, they’re worried that, will they be able to find another job or might need some supplemental income, it’s nice to know that you actually can take the money out from your 401(k) with this Rule of 55, without paying a penalty.

Matt Schumaker:

Exactly. Exactly. Then the last way for you to get money out would be what’s called an in-service distribution. This typically occurs with people who are currently working, and if the plan does offer it, they can roll over a portion of their retirement plan into an IRA for whatever reason, if they do need the funds prior to their retirement date, or if they would like to increase their investment options.

Kari Wolfson:

Yeah, no, that reminds me of someone we were working with. She had limited options in her 401(k), and the plan did offer an in-service distribution where we were able to roll that money into an IRA so we could manage the account for her with more investment option flexibility, and she was still able to make contributions that were going into her existing 401(k). So, definitely all things to consider, but probably on a case-by-case basis, so best to speak with your advisor and CPA.

Andrew Busa:

Yeah, for sure. Another one just to throw in here is that, of course the money has to come out at some point, right, for required minimum distributions, if you’re talking about traditional 401(k) contributions here. But if you’re continuing to work beyond RMD age, which right now in 2020 is 72, and you are not a 5% or greater owner of your company, you can actually delay those RMDs until you’re done working. So that’s an advantage just to keep in mind when you’re thinking about how and when to access your money once you reach retirement age. You could leave the money in there to keep growing tax-deferred.

Kari Wolfson:

Great point. So if you’re continuing to work and you don’t need the money, why pay the taxes?

Andrew Busa:

Exactly.

Kari Wolfson:

All right, well, we’re onto misconception five. I can only have a 401(k) if I work for a large company.

Andrew Busa:

This is an important one, and again, it’s becoming more common. We’re seeing this more frequently. What we’re referring to here is that if you are starting your own business, and you’re set up as a sole proprietorship, or an LLC, or some sort of an S-corporation structure, and you are the only employee, or it’s just you and your spouse, you could also be eligible for this, you may be eligible to set up a solo 401(k) plan.

Andrew Busa:

So just because you’re not working for an employer, doesn’t mean you can’t have a 401(k) plan. So that’s important because all of the benefits that we’ve been talking about throughout this episode, that comes with Roth options, it comes with catch-up provisions, ERISA protection, right, all of that comes with the solo 401(k), and if you’re able to do this, this is really something worth exploring.

Andrew Busa:

You also could have the option of a SEP IRA, and these are both good options to consider. The SEP also allows you to put a large amount of money in to a retirement plan in a given year. Generally, the solo 401(k) is going to be a bit more flexible than the SEP on a year to year basis, with how much you can put in, and again, of course, you have those catch-up provisions with a solo 401(k) once you reach the age of 50, so keeping that in mind.

Andrew Busa:

We had a client that we were helping, who, they weren’t currently eligible for a solo 401(k). They were going with the SEP just because of how their business was structured, but they were thinking of doing some restructuring over the next couple of years. So we just told them, “Hey, keep in mind that you may want to consider transitioning to a solo 401(k) at that point, just because of the flexibility that it offers.”

Andrew Busa:

So if you are eligible for this, if you think you might be down the road, keep this in mind. Keep us in the loop, talk to your tax advisor, and we’re happy to help with this one.

Kari Wolfson:

Yes, that’s an excellent benefit that many people may not know about. So if you are starting your own business or are a sole proprietor, this is definitely an option you should look into. Now, Andrew and Matt, we’ve covered a lot of ground here. Before we close, I’d ask you to mention a few of the takeaways from our discussion. What are some important points for people to remember?

Andrew Busa:

I would say, just watch out for headlines. We’ve talked a lot about different nuances that come with 401(k)s, and, let’s face it, nuances often don’t make it into the headlines. So understand what works for your personal situation, and you’re going to do that by talking to your advisor, talking to your CPA. We’ve kind of echoed that throughout the podcast. So take those articles with a grain of salt.

Matt Schumaker:

That’s great, Andrew, and both to echo your sentiments and then to respond to the article that you referred to at the beginning of the segment, Kari, I think the 401(k) plan does make sense, and it has a lot of valuable tools and benefits. I think one thing to remember, too, is that the 401(k) is not set in stone. It’s constantly changing, as we saw with the introduction of the Roth option in 2001. Although, as Andrew talked about, the tax benefits may not be as great as they once were, they’re still very valuable to a lot of people, and it’s a wonderful way for you to build up your retirement savings over time and to focus on that tax-deferred compounding growth.

Kari Wolfson:

Yeah, no, I think that’s great. What’s better than automatic savings? You don’t have to think about it, you’re continuing to grow your money. So it’s such an important tool for retirement, and the articles can be misleading, so do your own research and take them with a grain of salt.

Kari Wolfson:

All right, great. Well, this is Kari Wolfson from Adviser Investments. Thank you for listening to The Advisor You Can Talk To podcast. If you’ve enjoyed this conversation, please subscribe and review our show. You can also check us out at www.advisorinvestments.com/podcasts. Your feedback is always welcome, and if you have any questions or topics you’d like us to explore, please email us at info@advisorinvestments.com. Andrew and Matt, thanks again.

Podcast released on September 23, 2020. This podcast is for informational purposes only. It is not intended as financial, legal, tax or insurance advice even though these topics may be discussed. Information and events addressed in this podcast, as well as the job titles, job functions and employment of the podcast’s participants with respect to Adviser Investments, LLC may have changed since this podcast was released. For more information on each individual featured in this podcast, see the Our People section of our website.

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What could be better than automatic savings? You don’t have to think about it and you’re continuing to grow your money. [401(k)s] are such an important tool for retirement.


Kari Wolfson, CFP®

Account Executive

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