Why Traditional Planning Won’t Work & How to Fix It
The main issue you face is your ability to fully fund your retirement without affecting your current lifestyle.
Multiple studies conducted by firms such as T Rowe Price and Charles Schwab state that it's reasonable to need 70-80% of your pre-retirement income while in retirement. On average, every pre-retiree would have to save approximately 33% of their gross pay to hit their retirement goal to achieve this.
Is this even possible? Let's find out.
While the 401(k) remains the most popular offering to employees of companies both large and small, some limitations can hinder executives and high-income earners from fully participating in the ability to save pre-tax dollars, such as the employee contribution limit of $19,500 ($26,000 if over 50).
While the employee contribution limits most commonly hinder maximizing the 401(k), the majority of high-income earners are at the mercy of the outcome of the actual deferral percentage (ADP) test. If non-highly compensated employees do not participate in the company plan, the amount that high-income earners can contribute may be restricted.
Individual Retirement Account or IRA
401(k) restrictions lead many high-income earners to fund an individual retirement account (or IRA) in addition to their 401(k).
The current guidelines only allow you to contribute up to $6,000 per year ($7,000 if over 50) to a traditional IRA.
The vast majority of advisors will tell individuals that they need to contribute to a Roth IRA, if eligible, for one simple reason, distributions will be tax-free later in retirement. In contrast, the distributions from the 401(k)/IRA will be taxable.
The problem is that highly compensated employees fall out of the IRS guidelines to participate in a Roth IRA, so they have to look elsewhere.
The next place that people look towards when investing for retirement is an after-tax brokerage account. They offer some tax advantages because capital gains will only be recognized when the stock or position is sold.
The main concern with a brokerage account is the management.
While 401(k) plans have investment options for the contributor to choose from, a brokerage account requires research by the account owner or investment advice from an advisor. Other than the typical Facebook, Amazon, Netflix, Apple, Google, many individual investors don't know where to go to ensure they are making sound financial decisions within their brokerage account.
Restricted Stock Units
You may have been offered Restricted Stock Units (RSUs) as a perk for taking a job role, or you could have been offered RSUs as a bonus or as additional compensation.
While RSUs can be a great investment tool, the risks need to be fully understood so you can position the rest of your portfolio to help compensate for the highly concentrated position.
Navigating these guidelines can be tedious and confusing when all you want to do is save money.
Here is why a different approach is required
- John is 45 years old and married with two children.
- His income is $250,000 per year in a 28% tax bracket
- Has $300,000 saved in his 401(k)
- Want's to maintain the same lifestyle he has today throughout retirement.
- Retirement begins at age 65.
- Comfortable with 80% of his pre-retirement income while in retirement ($144,000 after taxes)
According to a CNBC retirement calculator, John would have to save $80,064 per year, or $6,673 per month (32% of his salary).
- All accounts earn a 6% rate of return while saving (5% while in retirement)
- Maintains a 28% tax rate through retirement.
Let's say John can invest $19,500 a year until retirement into his company 401(k) with no company match.
At 65, John would have $1,846,518.74 in his 401(k), which would produce a net income of $91,761. This rate of withdrawal will ultimately deplete the account after the last withdrawal at age 90.
John's retirement funding is 64% of the way there with his 401(k).
The Backdoor Roth IRA
John is unable to participate in a Roth IRA due to his income. Still, he could participate in a backdoor Roth IRA which allows him to invest into a Traditional IRA then convert to a Roth IRA.
Assuming that John converts $6,000 a year until he is 50 and then begins converting $7,000 a year until retirement, John would be able to withdraw $19,441 tax-free from his Roth IRA to age 90.
This account will also be depleted upon the last withdrawal at age 90. With his 401(k) and Backdoor Roth IRA, John is on pace to achieve 77% of his retirement goal.
Currently, John's projected income in retirement is $32,797 short of hitting his goal.
To make up for this, John could invest $11,210 after tax ($15,569 pre-tax) each year until retirement.
Recap: John's Cost of Traditional Planning
(all of the above accounts will be depleted by age 90 in this example)
Under the above assumptions, John would accomplish his goal on paper; in reality, he most likely won't.
You want to enjoy your life today. Nice homes, cars, vacations (at some point after COVID), hobbies, kids, and so on.
The only constant is change, and change brings risk.
- Market risk. A 6% straight-line return doesn't account for market volatility.
- Tax risk. Where will tax rates be when John retires? With the National Debt and countless government programs needing funding, most likely tax rates will go up.
- Inflation risk. While some goods and services haven't changed over the years, others, such as healthcare, have skyrocketed.
- Capital risk. Will John have the ability to fully fund his retirement?
John now believes he won't have nearly enough for retirement, as traditional planning has led him to believe. What does he do now?
The CNBC calculator stated that John needed to save $80,064 a year to achieve his income goal during retirement. Currently, John is saving $43,402 or $36,662 less than what may be needed.
With his after annual tax income around $173,000, he feels the additional $36,662 is a stretch.
By merely repositioning what John is currently saving, his situation can be dramatically improved.
We will keep the 401(k) contributions on the same schedule as above ($19,500 per year for 21 years).
We will reposition the first five years of Roth IRA and Brokerage Account contributions and move them to another account. These contributions will equal $28,574 annually.
After year five, we are done and won't need to contribute to the brokerage account, saving John $179,360 in future brokerage account contributions.
Recap: John's Better Solution
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