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ericvick · 3 years

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3 Reasons Your 401(k) Is Not Enough for Retirement

A 401(k) plan has many benefits for employees who are saving for retirement. It allows them to make salary-reduction contributions on a pretax basis (and also on a post-tax basis in some cases).

Employers that offer a 401(k) can make non-elective or matching contributions to the plan, which means more money for employees. They also have the option to add a profit-sharing feature to the plan. What’s more, all earnings to the 401(k) plan accrue on a tax-deferred basis.

Key Takeaways

Although 401(k) plans are an excellent way to save, it may not be possible to set aside enough for a comfortable retirement, in part because of IRS limits.

Inflation, plus taxes on 401(k) distributions, erode the value of your savings.

Plan fees and mutual fund fees can reduce the positive impact of compound interest on 401(k) accounts. One solution is to invest in low-cost index funds.

If you have to dip into your 401(k) early, you generally will have to pay a penalty—as well as taxes—on the amount you withdraw.

Limitations and Restrictions on 401(k)s

On the downside, caps are placed on 401(k) contributions. IRS regulations limit the allowed percentage of salary contributions. In 2020 and 2021, the maximum contribution to a 401(k) is $19,500. For someone who makes more than $150,000 per year, contributing the maximum will give them a savings rate of only 12.67%. And the more someone makes above $150,000, the smaller their contribution percentage will be.

The problem is that a savings rate of 12% is probably too low to reach a comfortable retirement. “A savings rate below 10% is definitely too low,” says Andrew Marshall of Andrew Marshall Financial, LLC, in Carlsbad, California. If you’re 50 or over, you can add a $6,500 catch-up contribution to that amount, for a total of $26,000 in 2020 and 2021, but your money won’t have as long to grow.

Employers can make elective contributions, regardless of how much an employee contributes, but there are limits on these too. In 2021, the limit on total contributions to a 401(k) from any source is $58,000, rising from $57,000 in 2020. All 401(k) contributions must be made no later than December 31.

There are also restrictions on the ways in which employees are able to withdraw these assets and when they are allowed to do so without incurring a tax penalty.

Given these basics of 401(k)s, even if you save the maximum amount, your 401(k) is probably not enough for retirement. Here’s why.

Inflation and Taxes

The cost of living increases constantly. Most of us underestimate the effects of inflation over long periods of time. Many retirees believe that they have plenty of money for retirement in their 401(k) accounts and that they are financially sound, only to find that they must downgrade their lifestyle and may still struggle financially to make ends meet.

Taxes are also an issue. Granted, 401(k)s are tax-deferred, and they grow without accruing taxes. But once you retire and start making withdrawals from your 401(k), the distributions are added to your yearly income and they will be taxed at your current income tax rate. Like inflation, that rate may be higher than you anticipated 20 years ago. Or perhaps the nest egg that you have been building in your 401(k) for 20 or 30 years may not be as grand as you might have expected.

Marguerita M. Cheng, CFP®, RICP®, chief executive officer of Blue Ocean Global Wealth in Gaithersburg, Maryland, put it this way:

All dollars are tax-deferred, which means that for every $1 you save today, you will only have about 63 to 88 cents based on your tax bracket. For our higher-income earners, this is an even more serious issue as they are in the higher tax brackets. A $1 million balance isn’t really $1 million for you to spend in retirement.

David S. Hunter, CFP®, president of Horizons Wealth Management, Inc., in Asheville, North Carolina, adds: “We tell our clients to plan on 30% of their 401(k) going away. It’s going to end up in Uncle Sam’s hands, so don’t get attached to 100% of that value being yours.”

Fees and Compounding Costs

The effect of administrative fees on 401(k)s and associated mutual funds can be severe. These costs can swallow more than half of an individual’s savings. A 401(k) typically has more than a dozen fees that are undisclosed, such as trustee fees, bookkeeping fees, finder’s fees, and legal fees. It’s easy to feel overwhelmed when you’re trying to figure out whether you are being treated fairly or being fleeced.

This is in addition to any fund fees. Mutual funds within a 401(k) often take a 2% fee right off the top. If a fund is up 7% for the year but takes a 2% fee, you’re left with 5%. It sounds like you’re getting the greater amount, but the magic of the fund business makes part of your profits vanish because 7% compounding would return hundreds of thousands more than a 5% compounding return. The 2% fee taken off the top cuts the return exponentially. By the time you retire, a mutual fund may have taken up to two-thirds of your gains.

Better options might be to invest in low-cost index funds. Also, look at easy-to-use target-date funds, which are finding their way into more and more 401(k) plans, but check fees with those as well.

Lack of Liquidity

The money that goes into a 401(k) is essentially locked in a safe that can only be opened when you reach a certain age or when you have a qualified exception, such as medical expenses or permanent disability. Otherwise, you will suffer the penalties and taxes of an early withdrawal. In short, 401(k) funds lack liquidity.

“This is not your emergency fund, or the account you plan to use if you are making a major purchase. If you access the money, it is a very expensive withdrawal,” says Therese R. Nicklas, CFP, CMC, of Wealth Coach for Women, Inc., in Rockland, Massachusetts. “If you withdraw funds prior to age 59-1/2, you potentially will incur a 10% penalty on the amount of the withdrawal. All withdrawals from tax-deferred retirement accounts are taxable events at your current tax bracket. Depending on the amount of the withdrawal, you could bump yourself to a higher tax bracket, adding to the cost.”

The IRS discourages you from taking money out of your 401(k) by charging a 10% penalty on withdrawals you take prior to age 59½—unless you qualify for an exemption.

This means you can’t invest or spend money to cushion your life without a significant amount of difficult negotiation and a large financial hit. The single exception to this is an allowance to borrow a limited amount from your 401(k) under certain circumstances, with the obligation to pay it back within a certain period of time.

If you lose your job or income, the deal changes for the worse, as you have to fully repay the balance of the loan by the next federal tax-filing date, including extensions.

The Bottom Line

Since a 401(k) may not be sufficient for your retirement, it is important to build in other provisions, such as making separate, regular contributions to a traditional or Roth IRA.

Carol Berger, CFP®, of Berger Wealth Management in Peachtree City, Georgia, explains:

It’s always a good idea to have more options when you reach the “distribution” phase of your life. If everything is tied up in your pre-tax 401(k), you won’t have any flexibility when it comes to withdrawals. I always recommend, if possible, having a taxable account, Roth IRA, and IRA (or 401k). This can really help with tax planning.

“The reality is that many retirees will need to earn a bit of money during retirement to take the pressure off their retirement accounts,” adds Craig Israelsen, Ph.D., creator of the 7Twelve Portfolio, in Springville, Utah. “Having a part-time job will also help a person ‘ease’ out of the workforce rather than simply ending their working career cold turkey.”

#401k #Reasons #Retirement

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davidcdelreal · 6 years

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401k Limits for Highly Compensated Employees

Most people recognize that a 401(k) is one of the very best retirement programs available. If your company offers one, you should definitely take advantage of it. It allows for more generous contributions than most other plans available to employees, and often comes with an employer matching contribution. But what most people are less aware of is that there are 401(k) limits for highly compensated employees.

Understanding 401(k) Contribution Limits

The main attraction of 401(k) plans is the amount you can contribute. For 2018, that $18,500, up from $18,000 in 2017. You can also make a “catch up” contribution if you’re 50 or older. That adds another $6,000 to the contribution. If your employer has a matching contribution, it turns into a serious wealth accumulation scheme.

For example, let’s say you make the full $18,500 contribution. But you’re 50 years old, so you can add another $6,000. That’s $24,500 coming from you. Your employer has a 50% match, and contributes another $9,250, and you’re already fully vested in the plan. That brings your total contribution for the full year up to $33,750.

That’s the kind of money that early retirement dreams are made of. It’s also why 401(k) plans are so popular.

Additional Limits for Highly Compensated Employees

As attractive as that looks, there are serious limits on the plan if you fall under the category of highly compensated employee, or “HCE” for short.

The thresholds defining you as an HCE are probably lower than you think. I’m going to give the definition in the next section, but suffice it to say that if you fall into this category your 401(k) plan suddenly isn’t as generous.

In the simplest terms, contributions made by HCE’s can’t be excessive when compared to those of non-HCE’s. For example, if the average plan contribution by non-HCE’s is 4%, then the most an HCE can contribute is 6%. We’ll get into why that is in a bit. But if you make $150,000, and you’re planning to max out your contribution at $18,500, you may find that you can only contribute $9,000. That 6% of your $150,000 salary.

This is how the HCE provisions can limit 401(k) plan contributions by highly compensated employees.

If you’re determined to be an HCE after the fact – like after you’ve made a full 401(k) contribution for the year – the contribution will have to be reclassified. The excess will be refunded to you, and not retained within the plan. An important tax deduction will be lost.

Here’s another little wrinkle…an HCE isn’t always obvious. The IRS has what’s known as family attribution, which means you can be determined to be an HCE by blood. An employee whose a spouse, child, grandparent or parent of someone who is a 5% (or greater) owner of the business, is automatically considered to be a 5% (or greater) owner.

Let’s dig down a little deeper…

What Determines a Highly Compensated Employee?

The IRS defines a highly compensated employee as one who…

Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or

For the preceding year, received compensation from the business of more than $120,000, and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

Boiled down then, there are three numbers to be aware of – 5% (ownership), $120,000 (income), and 20% (as in, you are in the 20% highest paid people in your company).

Right away, I think I know what’s going through your mind: $120,000 is highly compensated? I know, right? In much of the country, particularly the big coastal cities, like New York and San Francisco, that’s barely enough to get by. But this is just where the IRS drew the line, and we’re stuck with it. If I were to guess, I’d say the base is probably a number set years ago, it’s never been adequately updated.

The whole purpose of highly compensated employee 401(k) (HCE 401(k)) is to prevent higher paid workers from getting most of the benefit from employer-sponsored retirement plans. After all, the higher your income, the more you can pay into the retirement plan. An employee being paid $150,000 per year can contribute a lot more than someone making $50,000. The IRS regulation is designed to reduce this imbalance.

Non-descrimination Tests

I may be guilty of giving you more information here than you want to know. But this gets down to the mechanics of the whole HCE thing. If you’re an employee, you don’t have to worry about this – your employer will perform these tests. But it might be important if you are the owner of a small business, and need to actually perform the test yourself. If you don’t have an appetite for the technical, feel free to skip over this section.

To make sure all goes according to regulation, the IRS requires that employers perform non-discrimination tests annually.

401(k) plans must be tested to make sure the contributions made for lower paid employees are “proportional” to those made for owners and managers who fit under the category of highly compensated employees.

ADP and ACP Tests

There are two types of tests:

Actual Deferral Percentage (ADP) tests, and

Actual Contribution Percentage (ACP) tests

ADP measures elective deferrals, which includes both pretax and Roth deferrals, exclusive of catch-up contributions, of both highly compensated employees and non-HCEs. Using this method, the participants’ elective deferrals are divided by their compensation, which produces the actual deferral ratio (ADR). as calculated for both HCEs and non-HCE employees. (Stay with me now!)

The ADP test is met if the ADP for eligible highly compensated employees doesn’t exceed the greater of:

125% of the ADP for non-HCEs, OR

The lesser of 1) 200% of the ADP for non-HCEs, or 2) the ADP for the non-HCEs, plus 2%.

Then there’s the ACP test. It’s met if the ACP for highly compensated employees doesn’t exceed the greater of one of the following:

125% of the ACP for non-HCEs, OR

The lesser of 1) 200% of the ACP for the group of non-HCEs, or 2) the ACP of non-HCEs, plus 2%.

Are you still with me???

Notice that on each test, there’s the provision of “plus 2%”. That’s significant. The average 401(k) contributions of HCEs in the plan cannot exceed those of non-HCEs by more than 2%. In addition, collective contributions by HCE’s cannot be more than twice the percentage of non-HCE’s contributions.

One of the biggest problems with non-discrimination tests is that the results can be exaggerated if non-HCEs make relatively small percentage contributions, or if few participate in the plan.

As a highly compensated employee, you might max out your contributions every year. But employees who earn more modest incomes may go for minimal contributions. That can skew the results of the testing. Unfortunately, there’s no easy way around that problem.

What Happens if Your 401(k) Plan Fails the Test?

This is where the situation gets a bit ugly. The test can be performed within 2 ½ months into the new year (March 15) to make the determination. They’ll then have to take action to correct it within the calendar year. If the plan fails the test, your excess contribution will be returned to you. You’ll lose the tax deduction, but you’ll get your money back and life will go on.

There’s a bit of a complication here too. The excess contribution to the plan during the last tax year will be refunded the following year as taxable income to the HCE. That means that when you get your excess contribution refund, you’ll need to put money aside to cover the tax liability. Better yet, make an estimated tax payment to avoid penalties and interest. That’ll be important if the excess refunded is many thousands of dollars.

What happens if the problem isn’t identified and corrected within that timeframe?

It gets really ugly.

The 401(k) plan’s cash or deferred arrangement will no longer be qualified, and the entire plan may lose its tax qualified status.

There’s a bit more to this, but I’m not going to go any further. This is just to give you an idea as to how serious the IRS is about an HCE 401(k).

Highly Compensated Employee 401(k) Workaround Strategies

If you’re a highly compensated employee, are there any strategies to reduce the impact? Yes – none as good as being able to make a full tax-deductible 401(k) contribution, but they can minimize the damage.

Make nondeductible 401(k) contributions. You can still make contributions, you’ll just lose the tax deduction. That’s isn’t a complete disaster though. Those contributions will still generate tax-deferred investment income.

Make a 401(k) catch-up contribution. 401(k) catch-up provisions aren’t restricted by highly compensated employee rules. This offers potential relief – providing you’re 50 or older. 401(k) plans come with a catch-up provision of $6,000 if you’re 50 or older. If you’re determined to be highly compensated, you can still make this contribution.

Have your spouse max-out his or her retirement contribution. That is, if they’re not also considered a highly compensated employee.

Set up a Health Savings Account (HSA). This isn’t a retirement plan, but it will provide tax-deferred savings. That will help you build up a plan to pay health costs in your retirement years. For 2018 you can contribute up to $6,900 (married) or $3,450 (single). You get a tax break on your contribution.

Save money in taxable accounts. Naturally some sort of tax-sheltered savings plan is always preferred, especially if you’re seriously limited in your 401(k) plan. But this option should never be ignored. If you’re a highly compensated employee, but your retirement contributions are limited, you’ll need to do something to make up the difference.

Saving money in taxable accounts is a solid strategy. There are no limits on how much you can contribute. And even though you don’t get a tax break on the contributions or the investment earnings, you’ll be able to take money out as you need it, without having to worry about paying taxes on it.

The Humble IRA to the Rescue

An even simpler option is just to make an IRA contribution. There’s nothing fancy here, but if you’re a highly compensated employee, never overlook the obvious. There are three ways you can do this:

Make a contribution to a traditional IRA. Virtually anyone at any income level can make a contribution. But the tax deduction for a contribution – if you’re already covered by an employer plan – phases out at $121,000 for married couples, in $73,000 for singles . But if HCE status limits your 401(k) contributions, this will be a way to take advantage of tax deferral of investment income. Contributions aren’t nearly as generous as they are for 401(k) plans, at djust $5,500 per year (or $6,500 if you,re 50 or older), but every little bit helps.

Make a contribution to a Roth IRA. You can make a contribution if your income doesn’t exceed $135,000 (single), or $199,000 (married). There’s no tax deduction with Roth IRA conversions, but you will have deferral of investment income. Best of all, once you retire, withdrawals can be taken tax-free.

Make a non-deductible traditional IRA contribution, then do a Roth conversion. If you do, you can avoid the tax liability of the conversion. But you’ll be converting tax-deferred savings into tax-free with the Roth. One of the biggest benefits of this strategy is that there’s no income limit. Even if your income exceeds the thresholds above, you can make a nondeductible contribution to a traditional IRA, and then convert it to a Roth IRA.

Final Thoughts on 401k Limits for Highly Compensated Employees

If you’re an employee of a large organization, your employer has probably figured out how to avoid the HCE problem. It’s more of an issue for smaller employers. If you are the employer, this is a situation you’ll need to monitor closely. Your plan administrator should be able to help.

There are two of the ways to fix the problem. You can offer a safe harbor 401(k) plan, which is not subject to the discrimination tests. Otherwise, you can provide a generous employer match. The match can boost employee participation in the plan to well over 50%, which often fixes the HCE problem.

But if you’re a highly compensated employee in a small company, you won’t know it’s a problem until you get notification from your employer. That will come in the form of a return of what is determined to be your excess contribution, and a potential tax bill as a result.

Are you considered to be a highly compensated employee, or have you been in the past? Did you get hit with a refund and a subsequent tax bill? What are you or your employer doing to fix the problem?

The post 401k Limits for Highly Compensated Employees appeared first on Good Financial Cents.

from All About Insurance https://www.goodfinancialcents.com/401k-limits-for-highly-compensated-employees/

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