How much should I contribute to my 401K or 403B?

401K plans and their cousins, 403B plans (as well as 457 plans and Federal Thrift Savings Plans – these types of plans are collectively known as “qualified” plans) provide a great way to save for retirement.  Employee contributions are tax deductible, and the earnings are tax deferred until their withdrawal.   There are no earnings restrictions as there are with IRA accounts, and this applies to traditional 401K as well as ROTH 401K contributions.  Making contributions to a 401K or 403B plan is convenient as it is typically withheld from the employee’s paycheck.  Oftentimes, employers will match employee contributions, and sometimes they will make additional profit sharing contributions as well.

The maximum which an individual may contribute to a 401K or 403B plan is $18,000 for the 2017 tax year.  Persons 50 or older may contribute an additional $6,000 per year.  These employee contributions are deferred from the salary of the plan participant, and are not included in the participant’s adjusted gross income.  Employer matching contributions are determined by the employer’s policy and are usually specified in the plan documents and summary plan description.

How much you should contribute to your 401K plan will depend upon your age, income, tax bracket, and investment objectives and retirement goals.  It is recommended, however, that you “max out” the employer match if there is one.  Not doing so will leave money on the table which would have been easy to obtain.

Retirement plans for business owners

As a business owner or self employed individual, there are options available for funding your retirement in addition to those options which are available for anyone with earned income, such as traditional and ROTH IRA accounts.  The most common types of retirement accounts for business owners are SEP-IRAs and 401K plans, which will be reviewed in detail in this article.  For information on additional options available, please see this article on defined benefit pension plans for small business owners.

SEP-IRA retirement plans

A SEP-IRA account is the same as a traditional IRA in most ways.  The only substantial difference is that with a SEP-IRA, the participant can contribute up to 25% of compensation, or $54,000 for 2017 ($60,000 for persons ages 50 or older), whichever is lesser.  This could end up being substantially more than the contribution limit for a traditional IRA account, depending on the compensation of the participant.  In order to be eligible to establish a SEP-IRA, you must own a business (this includes being self employed).  If you have any employees, they are eligible to have a SEP account as well, and must be included if they meet certain criteria (worked for the business for 3 of the previous 5 years, attained age 21, and had at least $600 in compensation.  These requirements can be made less restrictive in the SEP-IRA plan document).  SEP-IRAs have the main advantage of being easy and relatively inexpensive to administer.

401K retirement plans

A business owner, including a self employed person, has the option of establishing a 401K plan for his or her self and employees.  The participant can contribute 100% of compensation, up to the limit ($18,000 for 2017 plus a $6,000 “catch-up” contribution if age 50 or older).  The business owner can also make a non-elective contribution of up to 25% of compensation.  The rules related to the non-elective contribution are a bit more complex for a self employed individual but are in the same general range.  401K plans are in general a bit more time consuming and costly to administer than SEP-IRA plans, however they have the main advantage of having larger contribution limits than SEP-IRAs.  They also allow the participant to take loans against their 401K balance, something which is prohibited by the IRS rules pertaining to IRAs, including SEP-IRAs.


ROTH 401K and ROTH IRA income limits

ROTH 401K and ROTH IRA accounts provide retirement savings options which are fully tax free upon withdrawal as long as they comply with certain IRS rules.  A disadvantage of ROTH IRA accounts is that they are restricted to lower income earners.  In order to contribute to a ROTH IRA for the 2017 tax year, your adjusted gross income must be less than $196,000 if you are married filing jointly and less than $133,000 if you are filing as single or head of household, and the amount of the allowable contribution phases out as it approaches these limits.

A ROTH 401K plan, unlike a ROTH IRA, has no income limits for the participant.  Regardless of income, for the 2016 tax year an individual may contribute up $18,000 to a 401K account (ROTH or traditional).  This limit increases to $24,000 for participants age 50 or older.  Unlike a traditional 401K plan, contributions made to a ROTH 401K are made on an after tax basis.  Keep in mind that employer contributions to a 401K plan, unlike ROTH 401K employee contributions, are always taxable to the plan participant upon their withdrawal.

Whether or not a high income earner should contribute to a ROTH 401K plan depends on a variety of factors.  On one side of the argument, a high income earner is in a high tax bracket and may be better off contributing to a traditional 401K as the immediate tax benefit could be significant.  On the other hand, ROTH 401K accounts have numerous advantages related to tax free withdrawals as well as limited rules related to required minimum distributions.  A careful analysis should be done of your financial situation, with particular attention paid to your tax bracket now and your expected tax bracket in retirement.


Retirement plan limits and deadlines for the 2016 tax year

Below is a summary of key retirement plan information for the 2016 tax year.


Retirement plan deadlines and limits for the 2016 tax year
plan type  deadlines contribution limit
Traditional and ROTH IRA plan must be established and contribution must be made by the tax filing deadline, no extensions $5,500, $6,500 if age 50 or older
SEP IRA plan must be established and contribution must be made by the tax filing deadline, including extensions 25% of wage or salary compensation or $53,000, whichever is lesser
SIMPLE IRA new plan must be established by October 1 $12,500, $15,500 if age 50 or older
401K plan plan must be established by the end of the calendar year.  contribution must be made by the tax filing deadline, including extensions $18,000, $24,000 if age 50 or older for employee deferrals, $53,000 for total contributions, including employer contributions
Solo 401K plan plan must be established by the end of the calendar year.  contribution must be made by the tax filing deadline, including extensions $18,000, $24,000 if age 50 or older, plus 25% of compensation, or 20% of self employment income, up to a limit of $53,000, or $59,000 for an individual age 50 or older
Defined benefit pension plan contribution must be made by September 15 for plan with fiscal year ending December 31 of prior year benefit amount can not exceed $210,000 or average of highest 3 years of compensation.  Contribution limit is based upon actuarial computations based upon these benefit limits


IRA rollovers and transfers

IRA rollovers and transfers involve the tax deferred movement of funds between different retirement accounts.  Oftentimes there will be a need or desire to move funds from one retirement account to another.  This will occur, for example, after leaving an employer, or when moving your IRA from one financial institution to another.  If these movements of funds are conducted in accordance with IRS rules the account participant can avoid taxable events which normally occur when withdrawing funds from retirement accounts.

IRA rollovers

An IRA rollover is the movement of funds from an employer sponsored retirement plan, such as a 401K or 403B plan, to an individual retirement account (“IRA”).  If done in accordance with IRS rules, the rollover will not result in a taxable event for the account participant.

In rare cases it is possible to perform a direct, trustee to trustee transfer of funds from the 401K plan to the IRA.  Such transfers are typically initiated by the receiving financial institution or trustee.

In the majority of cases, however, rollovers are accomplished by having the 401K plan custodian generate a check payable to either the receiving financial institution which has custody of the receiving IRA account or directly to the 401K participant.  In order to comply with IRS rules and not have the 401K plan withdrawal be treated as a taxable event, funds must be rolled over to the receiving IRA account within 60 days.  This is true even in cases where the 401K plan custodian generates a check payable to the custodian of the receiving IRA account.

IRA transfers

An IRA transfer is a movement of funds from one IRA custodian to another.  These transactions can usually be executed by means of a direct, trustee to trustee transfer, typically initiated by the financial institution on the receiving end of the transfer.

Similar to how IRA rollovers are executed, a transfer can be accomplished by having the financial institution which has custody of the IRA generate a check payable directly to the receiving financial institution.  A transfer executed in this manner must be completed within 60 days in order to avoid having the withdrawal deemed to be a taxable event.

Alternatively, an indirect transfer can be accomplished by having the financial institution which has custody of the IRA generate a check payable to the account holder.  The account holder then has 60 days to roll the funds over to the new IRA account at the receiving financial institution or trustee.  Keep in mind that oftentimes when performing such an indirect transfer, taxes will be withheld by the outgoing custodian.  It is important that the full amount of the withdrawal be rolled over to the new account in order to avoid any taxable event associated with the withdrawal.

Asset location

Where assets are “located” has a significant impact from both a tax perspective and an asset protection perspective.  Assets can be placed/located in retirement accounts, taxable accounts, life insurance policies, annuities, trusts, corporations, and LLC’s.  This can be a complex subject overall.  We will briefly discuss here a comparison between ROTH retirement accounts and traditional retirement accounts, a comparison between retirement accounts and taxable accounts, as well as some discussion of life insurance policies and annuities.

Retirement accounts – ROTH accounts versus traditional accounts

Assets in retirement accounts typically accumulate and grow tax deferred (in the case of traditional 401K, 403B and IRA accounts) and in the case of ROTH 401K and ROTH IRA accounts can be withdrawn tax free.  For this reason, a case can be made for placing assets which have the capacity to generate the largest long term gains (such as small cap stocks) into ROTH accounts, while placing the assets which are lower risk and do not have the capacity to generate large long term gains (such as U.S. treasury bonds) into traditional accounts.  A careful analysis should be done of the tax bracket now and the expected tax bracket during retirement.

Taxable accounts versus retirement accounts

As taxable accounts do not have any tax deferral features, a case can be made for placing growth, non dividend paying assets into these accounts, and placing dividend paying assets into retirement accounts and reinvesting those dividends and interest.  This way, the investor can benefit from the long term capital gains taxes which are typically lower than the income taxes which are levied on dividends and interest.

Annuities versus taxable accounts

Assets in annuities grow tax deferred, with the basis determined by the amount contributed to the annuity.  For this reason, a case can be made that it is advantageous to place dividend-paying assets into annuity contracts while placing non-dividend paying, long term appreciating growth assets outside of annuity contracts.  This way, dividend generating assets can accumulate and grow tax deferred inside the annuity contract, and the investor can benefit from the lower capital gains taxes on growth assets held outside the annuity contract.

Required minimum distribution rules for retirement accounts

Certain retirement accounts are subject to required minimum distribution rules upon reaching a certain age, typically 70 1/2.  At this point, the account participant is required to withdraw a certain amount from the account(s) each year, and these withdrawals are usually subjected to income tax.  The participant may withdrawal more than the required amount and still be in compliance with the rule.  The rules apply to IRA accounts, SEP-IRA accounts, SIMPLE IRA accounts, 401K plans, 403B plans, 457 plans, and other defined contribution plans.  Note that ROTH IRAs are not subject to the rule in most cases.

The amount of the required minimum distribution is based upon age and marital status, and is determined based upon mortality tables.  The details of the calculation will not be covered here, however most account custodians will calculate the required minimum distribution for the account owner.

Retirement account withdrawals

Retirement account withdrawals

How should withdrawals be taken from retirement accounts?  Factors include investment style and the amount which is withdrawn each year.  The manner in which  withdrawals are taken from retirement savings account has a significant impact on how long these assets will last.  A common practice in the financial services industry is to use Monte Carlo simulations to estimate probabilities of certain outcomes occurring with respect to how withdrawals will affect the retirement assets over time.  In this article we will illustrate how retirement account withdrawals can have different results by using two simple examples.

Can I take a loan against my 401K or IRA?

It is often tempting to take a loan or withdrawal from a retirement account to satisfy a financial need such as making a down payment on a house or paying off another debt.  Taking such loans and withdrawals is highly discouraged as it depletes retirement savings and can have significant impact on these retirement savings in the long run.  It is a serious decision which should not be taken lightly.  In cases where retirement savings must be accessed prior to retirement, a loan has an advantage over a withdrawal in that it will not result in taxable income as long as it is paid back according to its terms. However, certain retirement accounts allow loans while others do not.  This article will discuss the rules applying to different types of retirement accounts.

IRA loans – generally prohibited

Generally a loan can not be taken using an IRA.  Using an IRA as collateral for a loan is prohibited by IRS rules, and can result in the IRA becoming disqualified.  There is an IRS provision which allows 60 days to rollover or transfer an IRA to another custodian if the distribution from the IRA is paid directly to you.  Keep in mind that in this scenario the taxes are withheld from the distribution so you will need to supply additional funds to complete the rollover or transfer.

401K loans – take with caution

In many cases a 401K participant can take a loan against their 401K account balance, if the particular plan allows loans.  You can check the plan document or summary plan description, or check with your company’s HR department to see if a loan is permitted.  Taking such a loan is usually quick and easy and is not subject to any underwriting processes.  The installment payments made on the loans are usually made through payroll deduction from the participant’s paycheck.  401K loans must be paid back according to their terms in order to avoid being deemed to be a distribution and thus subject to taxes.  The loan terms are usually five years or less, unless the loan is used to purchase a primary residence, in which case it can be longer.  Keep in mind that if you are separated from service with your employer while the loan is outstanding, it must be paid back in full according to its terms, usually within 60-90 days of termination, or be deemed to be a distribution and thus be taxable.  “Interest” which is charged on the loan is typically paid back into the participant’s account as payments are made.

401K hardship withdrawal

A hardship withdrawal can be taken from a 401K plan in certain situations.  Under most circumstances it is not advised to withdraw funds from an IRA or 401K account prior to retirement.  You will be subjected to income tax on the withdrawals at both the federal and likely state and local levels, as well as a 10% penalty tax if the withdrawal is taken prior to age 59 1/2 (unless you meet certain exceptions).  Perhaps more importantly, a withdrawal prior to retirement will have the effect of depleting your retirement savings as well as the future earnings on these savings.

In the case of a hardship withdrawal, you will need to meet certain requirements related to your hardship.  You will be unable to make contributions to the plan for a period of six months subsequent to the hardship withdrawal.  If your employer makes matching contributions to the plan, these will be suspended as well.

Choosing your 401K investments

Which investment options you choose in your 401K or 403B plan can have a significant impact on how your account will perform in the long run.  It is recommended that the assets in the 401K plan be allocated according to the time horizon and risk tolerance of the account owner, based upon an asset allocation model.  The asset allocation model has been shown to be one of the most critical determinants of long term investment portfolio performance.  Many 401K plans have limited investment options, although in most cases (but not always) they will have fund options available for each major asset class.  Sometimes there will be an option to invest in a self directed brokerage account, which allows the plan participant to purchase securities on the market, as opposed to choosing the from among the funds which are available in the plan.  We recommend following the steps below when determining the appropriate investment options.  We emphasize the importance of consulting the appropriate advisers in executing this process:

(1) Determine the appropriate asset allocation based upon your risk tolerance, time horizon and investment and financial goals

(2) examine the fund options in your 401K plan, and perform due diligence on the funds as necessary.

(3) allocate assets among funds as appropriate.  Investigate and allocate to self directed brokerage option within 401K if necessary