by Irvin G. Schorsch III, CFP®, CIMA, AIF®
Since 401(k) plans were created in 1980, many professionals in the financial planning community have viewed maxing out contributions to 401(k)s as a wonder drug for investors worried sick about saving for retirement. Rather than telling patients, "Take two of these and call me in the morning," many financial planners tell their clients, "Save the max every year, see me for your diversification strategy, and call me when you're ready to retire."
On one level, this one-size-fits-all diagnosis makes sense. 401(k)s provide the gifts of an up-front tax break, tax-deferred growth, and, in many cases, employer matching contributions-seemingly three healthy supplements for any retirement portfolio. These benefits have made 401(k)s the largest savings vehicles many investors use in their entire lifetime. For investors in the highest tax brackets, it would be especially foolish not to enjoy these gifts to the fullest by contributing the maximum amount possible, right?
But just as medical treatments have become more advanced and precise over the past 30 years, so too should the advice financial planners give their clients about saving for retirement. In the current environment of rapidly changing tax laws, rising federal deficits, and economic volatility, the trusted remedy of maxing out 401(k) contributions is not the cure for what ails many investors. In fact, many retirement portfolios will experience a positive multiplier effect by combining smaller doses of 401(k) contributions with a variety of investment alternatives.
Regardless of an investor's current tax bracket or estate planning goals, it always makes sense to contribute enough to trigger the full employer matching contribution. An instantaneous double-digit to 100 percent return on your investment is pretty hard to beat. If you come across another investment promising that kind of return, be sure to report it to your friendly, neighborhood SEC or FINRA official.
Contributing enough to capture the full employer match is a no-brainer. Once all the free money has been captured, however, the decision gets trickier. This is where financial advisers really need to do their homework by learning and embracing their clients' long-term objectives and fears. This decision-making process also involves helping clients sort through the realities of today's tax landscape.
Roth IRA Conversions Are Just What the Doctor Ordered for Taxable Estates
Now that all investors, regardless of their income level, can convert a traditional IRA to a Roth IRA, the case for maxing out 401(k) contributions is much less compelling for many investors. This is particularly true for investors who anticipate leaving a taxable estate to their children, grandchildren, or other heirs.
These investors would likely benefit from making the minimum 401(k) contribution required to capture the employer match, putting the rest in a traditional IRA, and then converting the IRA to a Roth IRA. Although taxes will be due on the conversion of any deductible IRA contributions, the tax bill will likely be a small price to pay to access the Roth IRA's tax-free growth and lack of required minimum distributions, both of which are powerful wealth-transfer tools across multiple generations. An additional benefit of a Roth conversion is that the taxes paid on the conversion are removed from the estate and are a de facto gift to the heirs.
The Danger of Deferring Taxes
"Taxes deferred are taxes saved." Or at least that's how an old tenet of tax planning goes. That concept forms the rationale for maxing out 401(k) contributions. But in light of the outlook for income tax rates, it might be time to retire that adage. When you compare where tax rates on the wealthiest Americans are now with where they have been and where they are likely going, it's easy to see why the up-front tax break provided by 401(k) contributions might not be such a sweet deal.
As figure 1 illustrates, U.S. taxpayers are currently enjoying a period of historically low marginal tax rates. But you don't have to be a financial news junkie to surmise that this period of low rates will soon be coming to an end.
Sources: IRS and Tax Policy Center
In 2011, the highest marginal tax rate is scheduled to increase from 35 percent to 39.6 percent, and the capital gains tax is scheduled to increase from 15 percent to 20 percent ... and that might be just the beginning.
Those relatively modest increases won't be enough to pay for everything the U.S. government currently has in its shopping cart. The federal deficit has skyrocketed in recent years, with two wars being waged overseas and several rounds of stimulus funding being pumped through the economy. The massive reform of the healthcare system will likely only add fuel to the fire. Someone is going to get stuck with the bill, and it's a safe bet to assume that the wealthiest taxpayers will be asked to do most of the heavy lifting.
As the likelihood of higher tax rates increases, so too does the attractiveness of Roth IRA conversions for high-income investors. By diverting retirement funds to an IRA, which can be converted to a Roth IRA, rather than maxing out 401(k) contributions, investors give themselves the option of paying the taxman today instead of in the future.
Muni Bonds: Another Hedge Against Higher Taxes
Roth conversions are not the only way to protect a retirement portfolio against higher tax rates. Municipal bonds and their tax-exempt interest provide an effective hedge against rising tax rates for high-income investors.
Because many state and local governments are currently facing severe fiscal difficulties, yields on municipal bonds are strikingly high. As a result of the recession, many municipalities are experiencing budget shortfalls, which have resulted in downgrades by the credit rating agencies. These downgrades have also created tremendous opportunities for astute investors.
Although a downgrade is bad news for the government entity issuing the bonds, it can be a boon for investors, because lower credit ratings mean higher interest rates. California, which is the poster child for fiscal mismanagement, had its credit rating by Standard & Poor's downgraded to A-minus in January.1 As a result, the average yield for California municipal bonds maturing in 2020 was around 4.4 percent as of March 12, 2010.2 For an investor in the 35 percent tax bracket, that yield is equal to a 6.7 percent return on taxable income. And tax-exempt income becomes even more valuable as tax rates increase.
Even with these recent credit downgrades, the risk of default on municipal bonds is very low relative to corporate bonds. A study by Moody's found that the 10-year cumulative default rate for all Moody's rated municipal bond issuers from 1970 to 2000 was 0.042 percent. The 10-year default rate for Aaa-rated corporate bonds over that same period was 16 times higher, 0.675 percent.3
Defaulting on their debt is the last thing a state or local government wants-doing so would cripple their ability to borrow in the future. When push comes to shove, governments have many tools at their disposal, such as raising taxes or laying off government workers, to avert the doomsday scenario of defaulting on their bonds.
As an added enticement to invest in municipal bonds, some states' bonds are exempt from state income tax, in addition to the federal exemption.
Finding Shelter Against Inflation Fears
Inflation is another byproduct of the federal government's recent shopping spree that could undermine retirement portfolios. The risk of inflation increases the longer the Federal Reserve continues to have its hand outstretched to support state governments, municipal governments, banks, and other needy corporate borrowers through low interest rates. Although economists disagree on the likelihood of drastic inflation actually occurring, this is a very real threat in the minds of investors who lived through the inflationary days of the late 1970s and early 1980s.
For investors who are particularly concerned about inflation, Treasury inflation-protected securities (TIPS) provide an ultra-safe inflation hedge, relative to investing in gold or other commodities. In addition, institutional money managers have responded to growing inflation concerns among investors by launching new products designed to provide a diversified approach to hedging against inflation. BlackRock, for example, is considering creating a fund of funds that invests in TIPS, REITs, and commodities, according to InvestmentNews.4
Sometimes Maxing Out Makes Sense
It is important to realize that for some investors, the old standby-maxing out 401(k) contributions-is the best strategy. For example, an investor who does not have any heirs and plans to make large charitable donations throughout retirement should absolutely take advantage of the up-front tax break by maxing out 401(k) contributions. Because charitable donations from a 401(k) or rollover IRA aren't taxed as income, this charitable investor gets a tax break on both the front end and the back end. In baseball, a 4-6-3 double play is a pitcher's best friend. And in retirement planning, this kind of double play is an investor's best friend.
Another example of an investor who would be well served by maxing out 401(k) contributions is a high-ranking corporate executive at the peak of his or her earning power. If this investor expects to be in a significantly lower tax bracket during retirement, then the up-front tax benefit of a 401(k) contribution will likely be much more valuable than the back-end benefit of a Roth IRA.
Getting back to our medical analogy, the lesson for financial advisers is clear: know your patients. Giving out one-size-fits-all prescription for clients to max out 401(k) contributions could result in unnecessary income tax and estate tax bills, or even income streams in retirement that get outpaced by inflation. Today's dynamic tax and economic environment has created both the opportunity and the need to implement customized retirement savings strategies based on each client's personal objectives and concerns.
MarketWatch, "California downgraded by S&P, weighing on state's bonds." Jan. 13, 2010.
- Moody's, "Moody's US Municipal Bond Rating Scale." November 2002.
- InvestmentNews, "Fund groups add inflation hedges." March 7, 2010.
Alternatives to Maxing Out 401(k) Contributions
In today's economic and tax environment, maxing out 401(k) contributions may not make sense for investors whose goals are more complex than simply capturing an up-front tax break. Here are some alternative strategies for retirement funds:
The goal: Reduce a taxable estate
The solution: Contribute to a traditional IRA and convert to a Roth IRA
The goal: Hedge against rising tax rates
The solution: Roth IRA conversions or municipal bonds
The goal: Protect a portfolio from inflation
The solution: Invest in TIPS or inflation-protected funds of funds