Should I Max Out My 401(k)?

Howland Capital’s Five Core Beliefs When it Comes to Saving for Retirement

1. It is never too early to start planning for retirement. It is very simple.  The more you save and the longer you give your money time to grow, the more you will have in retirement.
2. It is never too late to start planning for retirement. Hindsight is always 20-20.  Everyone can look to the past and wish they had done things differently in life.  Not having started to save for retirement at an earlier age is a common regret.  However, starting late is far better than not starting at all.  Do not dwell on the past, and do not delay any more than you may already have.  For 2021, total employee 401(k) and 403(b) contributions cannot exceed $19,500.  However, if you are turning age 50 or older, you may contribute an extra $6,500 this year.  For IRAs, the maximum is $6,000 and an additional $1,000 for those 50 or older.  Do your best to make up for lost time and save as much as you can.  Taking advantage of these catch-up contributions can be a powerful way to save.
3. There are significant tax advantages to retirement savings, and tax savings can translate to far more money in retirement. 401(k) plans, IRAs, 403(b) plans and other retirement investment plans typically let your money grow in a tax deferred manner.  Because you do not have to pay taxes until you start withdrawing money in retirement, your  savings will grow at a faster rate.  For instance, let’s say you have a $100,000 retirement account and you also have a $100,000 taxable investment account.  Let’s say they are both invested in the same securities, earning a 7.5% pre-tax return, and your effective tax rate is 25%.  At the end of year one, your retirement account has $107,500 and your taxable account has $105,625 (you earned 7.5%, or $7,500 but had to pay 25% tax*, leaving you with $5,625 appreciation).  After year two, your retirement account has $115,563 (7.5% return on $107,500) and your taxable account has $111,566 (7.5% return on $105,625 and 25% tax on the year two gain).  That’s a big difference!  However, look out over 30 years and the difference is MASSIVE.  After 30 years, keeping the two accounts invested in the exact same way, earning 7.5% per year, your retirement account would be worth more than $875,000 while your taxable account would have $516,000.  The benefits of tax-deferred investing can be life-changing, no matter how much money you are saving.
4. So much of life is beyond anyone’s control, and no amount of planning can help avoid the inevitable. However, prudent and thoughtful planning can certainly help.  Saving for retirement and putting in place an estate plan can have a very large positive impact on your future.
5. Wealth can be a positive influence in your life. Money can be a huge source of stress in life.  However, it does not have to be, and with proper planning and the right assistance, it will not be.

Top Ten Recommendations for Saving for Retirement

1. Start as early as possible. The earlier you start, the wealthier you will become (see illustration below).  Let’s take the example of identical twins, both of whom have the exact same jobs, incomes, and spending habits.  Sibling A starts 401(k)** contributions of $250 per month, 30 years before retirement.  Sibling B waits ten years and starts 401(k) contributions of $250 per month, 20 years before retirement.  Both start working on the same day.  They both retire on the same day.  Both invest their 401(k) funds in the exact same way, earning 7.5% annual returns.  Thanks to the power of compounding, Sibling A, who started investing 30 years before retirement, has a 401(k) balance of nearly $350,000, again getting there by only investing $250 per month.  Sibling B, who also invested $250 per month but started ten years later and saved for 20 years – still a long time – retires with a 401(k) balance of nearly $140,000.  Sibling B invested 1/3 less time, but retires 60% less wealthy.  It pays to start early, so do not hesitate!

2. Set up automatic paycheck deductions (retirement contributions). This way you will not forget, and you probably won’t even miss the money.  Life can always get in the way, and it is easy to “need” money now rather than put it into your retirement savings.  Do your best to set up regular contributions and do not stray from your long-term plans.
3. Always maximize your employer’s match. There is no better way to immediately double your money, period.  Let’s say your annual salary is $100,000 and your employer matches 100% of your IRA contributions up to 3%.  If you contribute 3%, or $3,000, annually to your 401(k), that means your employer will match 3%, or $3,000.  In other words, you contribute $3,000 but you end up with $6,000.  This is a no brainer, and while we recommend contributing even more than 3% to your 401(k), if you contribute less than your employer’s full match, you are missing an opportunity for free money!
4. Open an IRA. If you are maximizing your 401(k), do not stop there!  Take further advantage of tax-deferred investing by opening an IRA.  You can save up to $6,000 ($7,000 at or above age 50) per year in an IRA, letting the money grow tax-free until you use it.  Invest the money wisely, or hire the right adviser to do this for you.  Make your money work for you, and you will be pleasantly surprised by how much it grows.
5. Beyond the employer match no-brainer, contribute as much to your 401(k) as you can possibly afford. The more you can save, the more flexibility you will have later in your career and in retirement.
6. Never (or almost never) withdraw funds early from your retirement accounts. Currently, the IRS allows you to begin withdrawing money from your 401(k) after the age of 59 ½.  While you technically can withdraw money from your 401(k) at a younger age, it will cost you… A LOT.  In fact, the IRS will most likely assess a 10% penalty on early withdrawals, and that is in addition to the ordinary income taxes you will owe on the withdrawal.  Here’s an example to consider:  You withdraw $1,000 from your 401(k) at age 45 and your effective tax rate is 25%.  Your $1,000 becomes $650 because you will pay $250 in taxes (25% of $1,000) and $100 in penalties (10% of $1,000).  That is a very high price to pay, and it can significantly reduce the funds you will have in retirement.  In fact, if you average 7.5% annual returns on your 401(k) between age 45 and 60, $1,000 would grow to nearly $3,000 in that time.  Per the example above, withdrawing $1,000 at 45 would only give you $650, but leaving it in place would give you nearly $3,000 by age 60.  Try not withdraw funds early from your retirement accounts!
7. Start an emergency fund. One effective way to avoid dipping into your retirement accounts is to start a rainy day fund for unplanned expenses.  Be disciplined and save for the inevitable life events that may necessitate your having to draw immediately from your reserves.  The more you can do this, the wealthier you will be in retirement.
8. Make your 401(k) investment selections carefully, and if you are unsure how to choose the best investments for your needs, seek the advice of someone who does. Choosing the right investments can be overwhelming.  Factors such as timing to retirement, your risk tolerance, differences in costs, performance, diversification, and appropriateness of each investment choice should all be considered.  You are working hard for your money, and your investments should work hard to grow your retirement savings.
9. Do not stop planning, even in retirement. For those in retirement (or contemplating retirement in the near term), continue to think long-term.  You want your money to last.  Come up with a plan for making your money continue to grow, by increasing in value, generating increasing income or both.  Your planning can include creating a budget, positioning your retirement savings in the appropriate investment vehicles, and balancing your investment account withdrawals between your IRA, 401(k) and taxable accounts, as appropriate.  Make sure you are receiving the maximum benefits from Social Security.  There are many considerations that come with the fun of retirement, and the fun can only increase with proper planning.
10. Protect your wealth and build a legacy. Everyone has an estate plan.  The question is whether they have a say in the details of that plan, or whether the government will determine it for them.  The best way to control for this is to have an estate plan in place.  Proper estate planning can help protect wealth and pass it on to whomever or whatever you choose.  What impact do you want to have on your family and the world?  Use proper estate planning to accomplish our goals.

Background on Howland Capital: Howland Capital is an independent registered investment adviser offering a customized approach to wealth management for individuals, families, foundations, and institutions. Our team is focused on the long term to ensure that wealth acts as a positive influence in our clients’ lives. We are committed to remaining independent in order to provide the stability and continuity that our clients deserve.

* 25% tax rate used for simplicity purposes.  In reality, the tax rate would vary significantly depending on what kinds of investments the account holds.

** Herein we discuss 401(k) investing, but the same ideas apply to other tax-deferred retirement savings accounts, including IRAs, 403(b), Roth IRAs, etc…