10 Things you Should Know About Your 401k

November 22, 2023

In this episode of FIN-LYT by EWA, Matt Blocki and Ben Ruttenberg dive into the world of 401(k) retirement plans, sharing valuable insights and expert advice on crucial aspects you need to know to make the most of your retirement savings.

Whether you’re just starting your career or nearing retirement, this episode has something for everyone who has an employer provided plan.  Included in this episode are discussions on Roth vs. Pre-Tax Contributions, Employer Match, After Tax Contributions, 401k loans and much more.

Tune in to this episode of FIN-LYT by EWA for a comprehensive guide to optimizing your 401(k) and maximizing your savings strategy.

Episode Transcript

Welcome to Ewa’s FinLit Podcast. Ewa is a fee only RAA based out of Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time. It. Welcome, everybody, today’s Finlet podcast. We are talking about 401 KS, joined here by Ben Ruttenberg. Ben, more importantly, before we talk about 401 KS, I know your team most avid Ohio State fan I’ve ever met had a big win over Penn State last week, so you’re feeling extra confident. I noticed an extra step in your step this week. I want to get your predictions. Are they going to go undefeated during the regular season?

 

Yeah. No, I feel great. It was a great win. Really happy with the defense this year for Ohio State in regards to are they going to go undefeated? It’s all going to come down to the game in Ann Arbor on Thanksgiving weekend, and depending on if they’re cheating or not, we’ll probably play a large.

 

Factor in State cheating.

 

No, we don’t want to get too much into a rabbit hole here, but yeah, there’s been some interesting news stories.

 

About the University of Michigan at Wisconsin you’re not worried about.

 

I mean, it’s going to be a good game. Luke Fickle is the head coach at Wisconsin who played at Ohio State, and he’s a great coach. And Camp Randall Stadium in Madison is definitely on my bucket list for places to go visit. I’ve just heard amazing things about the campus itself, and it’s supposed to be an awesome place to watch A.

 

So you’re not worried about Minnesota, you’re just you’re only worried about Michigan.

 

I think Ohio State will win all of their games before the Michigan game.

 

Yes, at Michigan. You don’t like saying that, do you?

 

Yeah, it’s going to be a tough game. Again, it totally depends on if they know what plays are coming or not.

 

All right, we’ll see. Well, thanks for the update, Ben. All right, so ten things you should know about your 401K. Let’s start with number one. Ben, we’re big proponents of Roth, and a lot of people have the misconception that they can’t fund a Roth because their income is too high. So walk us through what’s number one?

 

Yeah. Number one thing you should know about your 401K is most plans will allow you to make Roth contributions. The general traditional 401K is a pretax contribution that is a tax deduction today. The growth inside of a pretax 401K is completely tax free. The downside to a pretax 401K is that when you do go to take it out in retirement, all of your distributions are taxable at your ordinary income rate. Roth 401K completely flipped, so no tax deduction on your contributions today. But once the money is in a Roth 401K, it grows completely tax free. You could roll it into a Roth IRA in retirement, and then all the distributions are completely tax free as well.

 

So the misconception is if you wanted to fund a Roth IRA, which is a completely separate universe, there are income limitations for whether or not you can do that directly, even if you’re single, if you’re married, filing jointly, 401K, there are no such income limitations. So you could make a million dollars a year and still max out your Roth 401, no problem, regardless of what your income is.

 

Well, common thing I’ve heard from clients and from just the general public is I’m going to be in a lower tax bracket when I retire, so why wouldn’t I do pre tax now? I’m earning a lot. I can get that deduction that may be the highest rate, and then when I go take it out later, I can get out a lower rate. So why would you tell me to do Roth?

 

Yeah, so I think there’s a couple point I’ll get to your question in a second. But even if we just take tax rates completely out of the picture, there are a couple other huge reasons why we support getting money into Roth as much as we can. Number one, money inside of a Roth account is not subject to what are called required minimum distributions, or RMDs. Money. That is real quick.

 

You said the key thing. You said roth. You’re rolling it to a Roth IRA, which is the key thing there. They’re going to be no required minimum distributions. It has to be rolled to a Roth IRA, which is completely tax free, penalty free to do that when you retire. But I just want to clarify that’s right. Yeah. Why is that important?

 

Yeah. So money that’s in a pretax account. So say you funded a pretax 401K for many years. You roll that into a traditional IRA. Once you’re retired again, you’ve never paid taxes on that money. You got a tax deduction when you made the contribution, and all the growth was tax free. So at some point the government says, you’ve been sitting on this account for 50 years. It’s time for us to start getting our cut. So at the age of 73, the government says, whether you want to or not, you’re going to have to start taking distributions from this account. Generally, it’s somewhere around 4% of the account’s value. And where that could be an issue is, let’s say you’re in your 70s, you don’t need to take any money out.

 

But the government says, hey, your RMD is due, you have to take it out, and the market’s down. The last thing we want to do is actually have to take a distribution sell at a loss, lock in that loss. Roth completely opposite. No RMDs. So let’s say same situation we’re in, our seventy s, the market does go down. We don’t have to take money out if we don’t need to. A lot more flexibility and autonomy about how we can use our money. And it really helps climbing down the mountain, so to speak, avoiding sequence of returns risk when we are in retirement.

 

Yeah, which I think is probably the number one thing that’s not talked about enough in financial planning and retirement planning is the sequence of return risk. But essentially, if you’re alive and taking money out, being able to have the option to not take something out while it’s at a drop could I mean, it’s millions of dollars. If you have a couple of million entering retirement and you get the sequence of return risk addressed correctly, you’re going to save millions of dollars versus if you have everything slammed into a pretax four hundred and one K. And if the market’s up or down, doesn’t matter. You have to take spend, not reinvest it. We’re going to have huge problems. That’s a great point. Forget about taxes. Are they higher, lower now for the country?

 

Are they higher or lower for you as an individual based upon your income and lifestyle? The sequence of return risk is the number one reason we recommend Roth. So thanks for breaking that down.

 

Yeah, of course.

 

And then, so what if I’m a high income earner with that concern about the taxes? And how would you address that? So obviously you address the sequence of return risk. Like, forget about the taxes, but what if I say, Ben, I’m still worried about the taxes, I just want to get the tax game correctly. How would you respond to that?

 

In an ideal world, yes, you’re in a high tax bracket now. You’re funding a pre tax account, and then when you retire, you’ll be in a low tax bracket and it’s all going to work out perfectly. But we’ve analyzed this. We’ve studied clients that have transitioned from high income earners, top of their field, transitioning into retirement. There are still a lot of income sources that you are going to show that are going to eat up those low tax brackets. So that 10%, 12%, 22% rates, those are generally filled up by your Social Security, any RMDs, if you’re in that age where you need to start taking money out, dividends and interest from your account, if you’re subject to any if you have any guaranteed income sources.

 

So all of those things that maybe you’re not thinking about when you say, oh, I’m going to be in a lower tax bracket, well, those are eating up those tax rates that you in your mind were saying, well, I’m going to take distributions at those low rates. So if you already have Social Security coming in and interest in dividends and potentially RMDs, now any distributions that you’re taking on top of that are not subject to those low rates. Whereas if you were in a Roth, again, those income sources would still take up those low rates, but then any distributions on top of that would be completely tax free.

 

Yeah, that’s a good, great point. So a couple things to add to that or just highlight to that are if you’re a high income earner and you accumulate, you’re going to be maxed out on Social Security payments. You’re going to most likely have a lot of non qualified money. And then on the non qualified money, if they’re qualified dividends or capital gains, they get treated at a lower rate. The amount of capital gains you have still show up as income throughout the year. So when it comes time to take your required distributions out of a pretax part of your 401K, they’re not coming out at a lower bracket.

 

Regardless of whether you’re living at a high or lower lifestyle is kind of regardless if you’re a high net worth individual, not a high net worth, high net income, high net worth individual and you go to retirement, whether you like it or not, you’re still going to have tax issues. And so having this money in the Roth, we’ve analyzed this many times. Most of the times it boils down to maybe saving 37% now, which is the top federal rate, and then taking it out at 32% later for most individuals. And so the 5% tax difference that you could save, we typically respond well. In general, the country could decide that tax rates should be higher to offset that 5%.

 

But definitely when it comes to sequence of return risk, when it comes to Medicare premiums being surcharged, we have tons of resources about why that’s important. It’s worth it to do Roth and we’re going to get to number two in a second, which is employer match, but for most people they already have so much money that’s going to be subject to taxes later. And this Roth is just a great opportunity to get money that’s going to be tax free. And in general we recommend to have at minimum, if you have a balance sheet over a couple of million dollars where you’re going to have some tax issues, have two thirds of your money is okay to be taxed later, but at least have a third of your money that’s available tax free. So that could be a mix of basis in a brokerage account.

 

That could be Roth money, which is all tax free after 59 and a half. And assuming the five years has passed since the rolled money or converted money into Roth or basis in a life insurance contract, make sure a third of your balance sheet is available tax free. That’s going to save a lot of problems and issues when it comes to the control of your money, sequence of returns, when it comes to tax risk, et cetera. And I really like sleeping at night, I think. Me too.

 

Yeah.

 

So in the reality, a lot of people make decisions today to save taxes today. But if you think about the grand scheme of things like your money is a support system for your life. By design, you should have control of it, and a Roth is how you have ultimate control of your money. Okay, thanks for the detail breakdown, Ben. So you decide to max out the Roth, which what’s the max of the Roth, by the way?

 

Yeah.

 

Or pretax, you can do one or other what’s the max?

 

Yeah. So in 2023, we’re filming this now, if you’re under the age of 50, it’s 22,500. That’s for a Roth or pretax 401k. If you’re over the age of 50, there’s an additional catch up contribution that’s allowed.

 

So 30,000 total is the so $7,500 extra if you’re over 50.

 

Yeah.

 

Okay, perfect.

 

It’s just the deferral. We’ll talk about the actual limit in a later point here, but just from.

 

Your salary deferral, you’re going to look over 50 after Ohio State loses to Michigan, you’re going to be pulling all your hair out. Can you still put in the 7500, or is it based on looks or actual age?

 

I think you were saying something about an employer match, but you can go ahead.

 

It’s fine. All right. I know they lost last year, so hopefully they redeem themselves. But anyways, okay, so employer match. There’s the common misconception. That the limits. You just said the $22,500. Let’s just assume you’re under 50, which you are. You can split that. Like, you could do half Roth, half pretax. A lot of people think that the match is part of that max, let’s say well, my employer has given me, $6,000 in a match. That means do 22,500 -6000 that’s not the case, so there’s this max of what this is called the 402 G limit. And then there’s also the max of the entire 401K. So you have to think about your 401K as a giant bucket with about four different compartments in it. So the first point the Roth versus pretax, that’s the first compartment. The second compartment is the match.

 

And this all goes in pretax. Right now, that’s what the IRS allows employers to work. So the total bucket, if you’re under 50, that’s allowed to go into this thing is $66,000 a year. Or if you’re over 50, it’s $73,500 per year. So just to be clear, you can fully max out a Roth of pretax up to 22, five per year, and the match is on top of that. Now, there’s a couple of things to look out for when it comes to your employer match, especially if you’re a high income earner. Ben, walk us through these.

 

Yeah, a couple of notes. And these will be plan specific, so feel free to contact and coordinate with your benefits and HR department to specify with your plan specifically. But it’s important to note how your employer match works. Some plans. Let’s say you want to completely max it out over the first few months of the year, that’s great. You can contribute the full 22,500, but some plans will spread out that employer match over the course of the year. So if you don’t evenly contribute month to month in order to max out, you could potentially be missing out on free employer matching contributions because generally speaking, once your employee deferral stops, the match stops as well. So if you max it out too quickly, some plans will actually stop that employer match. So this is very easy to coordinate with your HR and your benefits.

 

If you are in a position to max out your 401K early, make sure that you’re not missing out on any sort of employer match while you’re doing that.

 

No question. How does vesting work? So like if I start a start maxing out my Roth and I get this match and then I leave the next year, do I lose everything? What happens?

 

Yeah. So again, every vesting schedule is going to be different. There are two specific ones that we’re going to talk about in a second. But before we do that, your employee contributions are always yours, period. So Matt, if you start a job, contribute to a 401K, you contribute $10,000 to your 401K. Your employer contributes some and then it grows a little bit. The 10,000 that you contribute is always going to be yours. You can always move it wherever you.

 

Want plus the growth. But if I leave too quickly before the vesting works, then I’d lose the free money that my company gave me.

 

Correct.

 

Okay, so that match, there’s two options you mentioned. The two options are one, companies will either elect into a three year cliff, which means after three years 100% of the free money is yours. And moving forward every year, all of that free money is then yours once you’ve satisfied the three year rule. Or other companies will do a graded schedule where it’s 20% gets vested every year over five years. So if I left after three years, I’d get all of my money that I put in plus the growth of my money, plus 60% of the free money from the employer I would take. But if I had stayed there five years in that second option, then I’d keep 100%. And then after the five years, 100% of that free money plus the growth is mine moving forward. So two options there.

 

And so I think it’s based we’re going to piggyback number two and number three. So number three here you have listed is the tip is percentage contributions in some plans are based upon full income and some plans are based upon IRS allowable compensation. Now in every plan the match is going to be based upon the IRS comp limits. So for example, right now the comp limits are $330,000. So if you’re making half a million dollars and the match at your company is if you put in six and you get 3% match, are you going to get 3% of 500, which would be 15,000?

 

No.

 

How does that work? Break that down for us.

 

Yeah. So every year the IRS comes out with what’s called a maximum allowable compensation limit. So right now for 2023, it’s 330,000. So in that exact example, in that example, excuse me, if you make 500,000 a year and you contribute 6% to your four hundred and one K and get a 3% match, the 3% match is just based on that 1st 330,000 of income. It’s not based on the full 500,000 that you have.

 

So in that case, that person would get 900 a year of free money, free match versus 15,000.

 

That’s correct.

 

And most people think, oh, I get 15,000. No, they stop after 330. So with that being said, we’ve seen plans where when you go in and elect so let’s say someone’s making a million dollars a year, they’ll let you contribute percentage based upon your full income, but they’ll only match you up to that 330. So sometimes we see people max out too quickly and they lose some of the free money. Because some plans, when you stop contributing, the plan stops contributing. So you have to be aware of how this works. If you’re a high income earner. And we’ve seen some plans, actually one plan specifically, and the plan just changed was allegian Health Network. They actually have to put in your contributions based upon the 330 limit as well.

 

So there’s lots of things here and what’s at stake here, free money is at stake because you have to know how the plan works. So for example, if I’m a million dollar income earner and the max, I just elect to put in 7%, well, that’s 70,000 a year. If the plan allows me to do that, I’m going to max out so quickly because the 22,500 Roth, I’m going to hit that in like three or four months and then the match stops, then I lose eight months worth of matching. So if it’s based upon the 330, I’m going to say, well, that’s about 7% of my income to reach the 22,500, and I want to reach that from January all the way through December. Then I’m going to get all the free money throughout the year.

 

And on the opposite end of that, sometimes there is a spillover. Like there’s this after tax bucket, which we’re going to talk about where you want to go heavy because then you can continue to go after you’ve reached the 22,500 and you’ll still get the free money. You’ll go from Roth to then after tax and you’ll get the match on all of that the whole way through. So bottom line is you need to know your plan inside. Now if you’re a high income earner, et cetera. Okay? So tip number three is know are the percentage contributions based upon your full income or the IRS allowable compensation limit. The match is always or profit share is always going to be based upon the IRS allowable compensation limit. Ben, you pointed out that’s 330,000 for 2023.

 

You have to figure out your percentages are going to be based upon either your full income or some plans, only the total comp limit and what’s at stake, the matching, the free money. So figure that out. Number four, you have access to after tax contribution. So give us a high level overview. There was a tax code 20 14 54 that was passed that allows you to convert after tax to Roth. What’s the word on the streets for this strategy?

 

Yeah. So this goes back to your analogy of your 401K as one giant bucket. This is just another one of those buckets that your plan may allow contributions towards. It’s called an after tax bucket. So generally how this works, and you said you can convert after tax to Roth. The big strategy here that we implement with clients that have the cash flow to do this is, number one, they max out their Roth 401K deferral 22,500. If you’re under the age of 50, they get any sort of employer match. Like you said, the actual limit of money that you can put in your 401K every year is $66,000. So we can make up the difference from that $66,000 number plus what you’ve already contributed, plus the match into what’s called an after tax bucket. That’s going to be somewhere around 34,000 a year.

 

That 34,000 can be converted to Roth. Some plans allow you to do it once a year. Some plans allow you to do it twice a year that could be converted to Roth with very little tax consequence to get essentially $66,000 a year into your Roth 401K. This strategy is called a mega backdoor Roth. Not every plan allows for after tax contributions, but if you have the cash flow to do so and your plan does allow it money inside of a Roth. Again, back to what we said earlier, a lot of tax advantages and it’s also asset protected. So this is a strategy that we use very frequently if your plan allows it for high income earners.

 

Yeah, UPMC Allegheny Health Network two great examples that allow so like if I’m going back to Ben’s example, I’m a physician under 50. I’m putting 22,500 in my Roth. I’m getting 9900 match, which is the 3% capped on the 330,000 of income. The percentages could be higher, lower from the match. But just using that as an example, very common to be 3%. And that would allow another 34 quote you said 34. So 33,600 per year into after tax that could be converted Roth in all three of those. So back to that, we have one bucket. The one bucket is the 401. The first compartment is my Roth. The second compartment is a pretax component, which was given to me as a match for my employer.

 

And the third component is the after tax, which at the end of every year I can convert into the first compartment into Roth. And so, Ben, tell me, why would I not want to leave the after tax money in an after tax compartment? Why would I want to move that over to the Roth on a year to year basis by doing that mega backdoor Roth conversion strategy? What happens if I just leave the money? Let’s say I have $100,000 in an after tax account and I just let that sit there and it grows to $500,000 at retirement versus if you had 100,000 in after tax that you converted to a Roth and it grows to $500,000.

 

Yeah.

 

So you were disciplined. It took a lot of work. Every year you converted it over to Roth. So now I’m sitting here with 500,000 of after tax money. You’re sitting here with $500,000 of Roth, my 500 of which was contributed by me, 400 of which was market growth. What are the differences that we are going to now experience for the rest of our life?

 

Yeah. So let’s go with your example first. So you have the 500,000 of after tax. 100 of it was your basis, 400 of it was growth. If you say, hey, what are my tax consequences? The 100,000 that you put in, you get back tax free, penalty free.

 

Assuming I’m 59, assuming you’re 59 and.

 

A half, assuming the account has been open for five years, et cetera. The $400,000 of market growth. You are subject to ordinary income tax at whatever your ordinary income rate is at the time that you are making those distributions. So could be anywhere from 24, 32%, depending on how much Social Security you have, any sort of guaranteed income sources, so on and so forth. So not as tax efficient because that large amount of growth, $400,000 you are still subject to tax on.

 

Yeah, I’m just thinking, most likely someone’s able to afford to do this, they’re probably going to have enough assets. At minimum, they’d be at a 32% tax bracket on this. So let’s say 32 times 400. So if I were to liquidate, I would owe $128,000 in taxes. And the thing is, the 100 that you mentioned, tax free, I can’t just decide, hey, I’m going to take my basis out every this is subject to required minimum distributions. If I leave it till I’m 73. And if the 100 grows to 500 and grows to a million, then we have a $900,000 gain that’s all subject to taxes. So if I start taking it out through requirement of distributions, it’s a pro rada share. I get some basis out. I get mostly growth out.

 

And so most of every distribution for the rest of my life becomes taxable.

 

That’s right.

 

Now, for you, it’s a little bit different. Not very little bit different. It’s very different.

 

Yeah. Very different. So if this strategy is done correctly throughout the years and we’re diligently converting the after tax to the Roth every year. Again, we’re only subject to tax on the growth from the aftertax to the Roth each year that we do that. So let’s say I contribute $1,000 to an after tax account and it grows to $1,500 just using very simple numbers, and I do the conversion. That $500 of growth. That’s all that I’m paying taxes on each year. So in your example, we’re paying taxes on $400,000 of growth just because that grew and we let it sit. If we do this strategy every year, we’re paying very little tax, and in return, all 500,000 is completely tax free because it’s in a Roth.

 

We do these every year for these hundreds of physician I mean, a couple of hundred physician clients. We have UPMC and HN, and so they’re getting close like the 33,600. A lot of times we’ll see a market does 7% that year. That’s like a $2,000 growth. All the money wasn’t there. So typically we see like, $1,000 getting taxed. If you do $1,000 of taxable income on these mega backdoor off strategies over 30 years, that’s about what’s, round up and, say, $400 a year times 30. You’re going to pay $12,000 in tax during your working career to then save at a minimum $128,000 of taxes later. Because once that 500,000 of Roth is there for you have no required minimum distributions.

 

Assuming you’ve rolled that to a Roth IRA when you retire and you have no taxes for you have no required minimum distributions. If it’s a Roth IRA, it goes to your kids tax free. You’re obviously much smarter than me being disciplined and doing the conversion every year over those 30 years.

 

And with all that extra money, I could go to all the Ohio State games I want. And maybe because you’re kind of on a more of a budget because you didn’t do this correctly, you can go to some pit games because I think there’s some extra seats.

 

Do you think Ohio State will still be there when you retire?

 

Yeah, I think so.

 

You don’t think they’ll decline? No, I’m just kidding. All right, so fifth tip is a lot of people don’t know they can have multiple 401 KS. And I’ll explain this one quickly, but there’s this bucket analogy. So what you can’t have is if I have this bucket with these different compartments in it, the first compartment in the bucket is what’s called a 402 G limit. That’s pre tax, or Roth. I cannot have more than one of those. That’s what’s called a 402 G in the tax code. It shows up on your W two every year. And once I do that once, I can only do that year one time. So I could have 2401K plans, but I cannot exceed 22,500 combination. If I have multiple 401K plans in that 402 G limit, what I can have is I can have two.

 

Or three or four or ten, it doesn’t matter. I can have multiple 401K plans. And each one of those 401K plans, the different compartments, with exception of that first one, can exceed 20,500. I could do in my day job. This 401K do the 22,500 Roth. The other compartments do the mega backdoor Roth, get 66,000. I could also have a side business where I start a can’t do the Roth directly, but I could put all money into an after tax up to 66,000 and then convert that right to a Roth utilizing the Mega back to a Roth. And so if that’s a separate 401K through a separate business, you can have multiple 401 KS. This is a common thing most people don’t know is they think I have a 401K, can’t have another one.

 

You can have multiple 401 KS if you have a business or a side hustle, et cetera.

 

Yeah. So let’s say I’m a physician, I work a normal W two job at a hospital, and I also have 1099 income from a consulting business that I have separately from that. You’re saying that I could max out my hospital four hundred and one K, I could do 22,500. If they allow after tax contributions, I could contribute to that to get the full Mega backdoor Roth up to 66,000. Great. And if I have the right amount of 1099 income from my consulting business, I can contribute 66,000 over here on a completely separate plan and have essentially 2401 KS going at the same time. Is that correct?

 

Absolutely. And many of our clients do. So, physicians, very common to have legal consults on medical malpractice cases, and they generate 1099 income, and they could either attach a Sep IRA to that why we don’t like that is that gets in the way of what called aggregation when doing a backdoor Roth IRA. Again, not the conversation today, because IRAs individual retirement accounts are a different universe than 401 KS. 401k is tied to your employer, but yes, you can have all three. So if you do this correctly, you can have your day job 401K or four or three B, same thing. Four or three B just means you’re at a non for profit. 401k means you’re at a for profit. So you have your four hundred and one K at a day job.

 

You have your 401K through your business, your consulting income, and then you can also have a backdoor Roth IRA if you don’t have aggregation issues. Okay, tip number six is, and this became part of the code, a lot of 401 KS have a default option that is what’s referred to as a lifecycle fund or a target date fund. This is much better than just leaving your money in cash. So let’s just be clear. But if you’re going to take the time to educate yourself and invest the money, we generally recommend to go into specific ETF funds versus a lifecycle fund. So Ben why do we recommend against, typically against lifecycle funds? What are some of the top reasons?

 

Yeah. So just taking a step back, you may see this. If you’re a young individual and you look at your four hundred and one K and you haven’t taken a look at this, you could be in like a target date 2050 fund. Which means that it’s assuming that your retirement is going to be near the year 2050 and your 401k is going to be investment allocated as such. So it’s going to be more equity driven early on and then as you approach the year 2050, it’s going to get more and more conservative and reallocated towards bonds as opposed to equities. A couple of reasons why we don’t recommend being involved in target date funds. Number one, it’s a very blanket fund that does not take into account your personal situation.

 

So just because you’re in a target date fund doesn’t mean that it knows whether or not you have Social Security, whether you have a pension or other guaranteed income, what is your actual income need going to be in retirement? What’s your family circumstance? All of those things need to be thought of and taken into account when you are developing your financial plan and your investment plan. And the target date fund is essentially just saying, basically giving you a cookie cutter recommendation for when you will likely retire.

 

Absolutely. And so the problems even go greater when you retire. Because when you view review our Investment Philosophy podcast episode, I’m not sure the number here, but when you go to retire, the whole purpose of asset allocations, having these different categories of investments, if one goes down, when you’re living your life in retirement, you don’t have to worry about the market going down because you always have a category you can choose to pull from without a loss. Essentially. And so a lifecycle fund, the way it works is if you sell out of it’s selling out across every single category. And so you’re guaranteeing on a given year where some stuff’s going up, some stuff’s going down that you’re selling at a loss. Well you want to have the option to pick just the stuff that’s up.

 

The stuff that’s at a loss is going to be there at a gain when the other stuff that you’re taking is at a loss. So you have full control of your investment choices. And the other thing you mentioned, which is really important Ben, is what’s called asset location. So if you imagine like your total investment portfolio is like a football team, well, lifecycle fund is forcing you to have the entire team just inside your 401K. So you’re going to have quarterback, wide receiver, offense, defense all inside there. Well, we’d much rather see you pick some more aggressive players and put them in your Roth over here where they’re all going to be tax free and then put the safer players in the pretax version of the 401K, which then all gets taxed.

 

And so for tax reasons, for distribution reasons, we like owning the individual asset classes and having the choice of where we can place those. And the lifecycle fund just forces you to own them all across the board inside that one fund.

 

Yeah, I was going to say, we’ve been talking a lot of football lately, so this is the analogy I’ll use. Think of like a Roth IRA and a Roth 401K, like a wide receiver, generally fast, athletic, think of an offensive lineman as a bigger person that has a completely different role than a wide receiver. Your Roth 401K, if it’s invested in a target date fund, as you get closer and closer to retirement, it’s going to shift completely to bonds. I’ll equate. Bonds to offensive linemen. In this analogy, your Roth IRA, you want wide receivers, you want equities, you want high growth because you’re never going to get taxed on that account again. If you have a target date fund inside of a Roth IRA, as you get closer and closer to retirement, it would be like having an offensive lineman playing wide receiver.

 

So that whole analogy is so important because we need to have you might have the right accounts open, you might have a Roth IRA or Roth 401K, but what’s inside each account is so important and that has to be taken a lot of care of.

 

That’s a good analogy. It’s so good that I’m going to send that with timestamp to Harbaugh and tell him to share with his offensive line for University of Michigan when they read before get them fired up.

 

Yeah, a lot of open lines of communication right now with that football program.

 

So that would be very just hating. All right, so let’s go to tip number seven. So avoid actively managed funds. So we did a podcast, ben and I and Nick on the Ewa team did podcast on international stocks, and in that we debunked why active management really has performed poorly. So if you look at the US. Stock market, 50% of actively managed funds, like, I think it’s a little bit more than 50%, if you look at one year periods outperform the index because they make big bets, but these bets are not sustainable over time. So if you look at 1020 30 year periods, you go out to 30 years of actively managed mutual funds. Less than 5% of them have outperformed the S and P 500 index, nearly impossible to have the alpha. So the value above the fee that’s being charged.

 

And so we generally recommend, if you’re in a 401K, Roth, four hundred and one K, et cetera, that you should go into ETFs. ETFs represent indexes, they’re much lower cost. And if you’re going to own an actively managed fund, you would only consider that typically in an international or emerging market space, that’s tip number seven is let’s keep the cost as low as possible. Let’s keep the returns as high as possible, which are typically achieved on a stable basis from asset allocating diversifying staying invested long term. And so the way you do that is you choose low cost options in the US market and some actively managed funds could be considered in the international space. Okay, tip number eight. So if you’re working at an employer that has multiple plans, sometimes you have a so we’re not talking about a 457 on the podcast.

 

We want to differentiate here for a second. So if I have a 401K then and my employer goes under, my employer goes bankrupt, do I have to worry about that 401K?

 

No, you may have to worry about your employer going bankrupt, but your 401K is completely safe. So money that is yours always is your IRAs. So any money that you have in a Roth IRA or a traditional IRA and then any money inside of your 401K plan is always yours even if the employer goes bankrupt.

 

What about 457? So oftentimes we get questions like madam Max on my 401K, Ben Matt, what should I do? This is 457, my friend’s doing it. I’ve heard I can save more in taxes. Why do we recommend this if it’s a governmental plan and not recommend it? Typically if it’s a non governmental plan, yeah.

 

So governmental 457 plans, you are protected. Non governmental 457 plans are essentially considered deferred wages that have not been paid to you yet. So if you are contributing to a non governmental plan and your employer goes bankrupt, you could essentially lose that account balance. So when does a 457 plan make sense? Number one, if it’s governmental and you have that protection, generally speaking, again, this is going to be more on a case by case basis. But if you have the cash flow to max it out, if you have a roth option and you’re closer to retirement so you don’t have a long runway where something could go wrong, a 457 could make sense in that scenario.

 

Because, again, if you have a roth option, if you’re over 50, that’s 30,000 a year that we’re getting into a roth component that is going to make a huge impact on your financial plan. So again, more of an individualized conversation depending on your personal situation. But be wary of non governmental 457 plans because they don’t have the same protections as the 401K plans do.

 

That’s excellently put. So with that, while we’re on the topic, that brings us right to tip number nine though, which is some companies will offer for executives or high income earners what’s called a spillover plan. So an example of if you’re making a million dollars and you want to get a match of 3% on the first 330, that’s $670,000 of your income, that’s not getting that 3% match. So what some companies will do is they’ll continue that 3% match, but in a type of deferred compensation plan. So if we do recommend the deferred compensation plan, even if it’s subject to bankruptcy, if there’s free money on the table. And sometimes companies will offer these spillover to keep the free money going, like it should be on your total income as an executive or a high income earner.

 

Okay, tip number ten, and this is a lot of people, unfortunately, the median net worth in America right now for 65. It’s sad, I think because of financial literacy purposes is under $300,000. So pretty staggering statistics. So most people either have equity in their house or maybe some money in a 401K. So when they get in trouble, they end up having to liquidate their 401K. Well, you don’t have to liquidate it, you could take a loan from it. Generally in a good financial plan, we recommend never to take a loan inside of a reason for this is, one, you’re going to pay interest on it just like you would anywhere else. And interest rates probably typical to like if you take an equity line against your home.

 

But the difference between a home equity line of credit on your home and your 401k is when you take money out of your if you take a line against your house and you borrow it and you pay it back one, it’s not going to affect your net worth because your home is still appreciating while you do that. The difference is if you take the money out of your 401K, let’s say you take a $50,000 loan out of your 401K, that $50,000 isn’t growing well. So if you took this in what was a really good year? Yeah. Russell, 3000 things up 25%, $50,000, just missed a 25% gain. And so at that time, the interest rates maybe were only three or 4%. That loan, let’s say they’re 3%, it cost you 22 because you missed that 25. It cost you 28.

 

You missed the 25 plus you paid 3%. So that was probably the most expensive money that you could have ever obtained, even higher than like a high interest credit card. Now, on the flip side, if the market is goes down or that, then you could be smart, but generally that’d be like gambling because 75% of the time the market is going up. 25% of the time the market is going down. So 401K loans are the last place we’d recommend to go. We’d much rather see you go to a take a home equity line of your credit, of your house, maybe secure a brokerage account. The key difference between those two options are the assets that you haven’t touched by taking the line of credit against are still growing versus a 401K.

 

They’re not.

 

Anything else to add?

 

No. That’s well said. I think just the idea. Yeah. The circumstances behind taking a loan from a 401K can be hard too. If you take a loan out in June of 2023, and you leave your employer. So a lot of times well, this.

 

Is a good point.

 

Yeah. If you leave your employer, it has to be paid back by the tax year of next year. So if you take it out in June of 2023 alone, you leave, it has to be paid back by April of 2024. So generally when you take a loan, you’re thinking, I’m going to be here, I’ll work this out. But things happen. And if you leave your job, that could lead to serious financial stress because you wouldn’t have taken the loan out if you didn’t need to anyway.

 

Only time I’d say to take it is if it’s literally between the option of I’m going to liquidate my 401, pay taxes, pay penalties before 59 and a half, rather loan it and then try to get it back in. Obviously, if it’s a really short term time horizon, but in general, a good financial plan, you should create options, and this will be one of the last options we’d recommend. So that was it for our ten tips on a 401K. We could talk about this for hours. We want to keep this short and concise. Thanks for joining us and we will catch you next week. Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful to as many people across the nation as possible.

 

So hit the follow button, make sure to rate the podcast, and please share with any friends or family members that would also find this beneficial. Thank you very much.

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