Spring is the perfect time to check in on your 401(k) and make sure your plan is optimized for this tax year. Here are three simple things to make sure you are maximizing the tax and investment benefits available to you.
1. Am I on track to maximize my contributions?
Most 401(k) plans offer an employee match. The most common match is up to 3% of your compensation. Setting your deferral rate greater or equal to the amount matched is the first step in making sure you are optimizing your 401(k). Contributing anything less would leave “free” money on the table.
The next step is to contribute the maximum amount to your 401(k) on a pre-tax basis. For 2022, the IRS has set the maximum employee contribution at $20,500. If you are over the age of 50, you can contribute an additional $6,500. The maximum contribution for 2021 was $19,500, with a catch-up contribution limit of $6,500.
TIP: You can review your W-2 from the prior year to confirm whether or not you contributed the maximum. Box 12 Code D reflects 401(k) contributions.
For those in the highest tax brackets, maxing out your 401(k) contributions and electing to make those contributions pre-tax is an easy way to reduce your tax liability. For those in the lower tax brackets, or for those who want tax diversification, elect to defer your employee contributions into the Roth portion of the 401(k). Contributing funds to your Roth 401(k) can be tax advantageous in the long-term. Not all employers offer a Roth 401(k) retirement option, but it’s worth investigating if your employer does.
2. Is there an after-tax option I can take advantage of?
Some 401(k) plans offer an additional feature that allows you to make after-tax contributions to your 401(k) in excess of the $20,500 limit. This is often referred to as the “Mega Backdoor Roth” strategy, as the after-tax contributions can be converted to a Roth IRA with little to no tax impact. This is a fantastic way for high income earners, that are ineligible to contribute to a Roth IRA, to accumulate balances in Roth accounts, while still maximizing the tax savings that come from making pre-tax contributions.
It’s becoming more common for larger companies, like Microsoft and Amazon, to include this option as part of their 401(k) benefit offering. It’s important to note that for these plans, the combination of employee contributions, employer matching, and after-tax contributions cannot exceed $61,000 per year, or $67,500 for individuals 50 years of age and over.
For example: a Microsoft employee under the age of 50 would have a maximum pre-tax 401(k) contribution of $20,500, which Microsoft would then match with a contribution of $10,250. An additional $30,250 can be contributed with after-tax dollars, and then converted within the 401(k) to a Roth 401(k) – or converted outside the 401(k) to a Roth IRA.
BOTTOM LINE: If there is an after-tax option as part of your 401(k), maximizing these contributions will help grow your portfolio in a tax-advantaged way.
3. Have I optimized the investments within my 401(k)?
There are two ways to approach investing in your 401(k). The first is to recognize this is an account you are unlikely to touch before the age of 59 1/2. Even if you retire early, this is typically one of the last accounts you will look to pull from to cover regular living expenses due to the tax consequences upon withdrawal. Therefore, the investments in your 401(k) typically have a long-time horizon and should be invested aggressively (mostly in stocks) to optimize growth over time.
Furthermore, given the tax-deferred structure of this account, holding “tax-inefficient” investments in a 401(k) is optimal from a tax perspective. A tax-inefficient investment is one that creates income taxed at an ordinary income tax rate — such as taxable bonds. Another example would be investments that tend to kick off capital gain distributions, such as actively managed mutual funds.
The second approach and most common way to invest your 401(k), is to pick an investment election that either matches the 1) target allocation you’ve selected for your overall portfolio or, 2) a target date fund approximate to the year you plan on retiring. Selecting a target date fund allows you to rest assured the investments within your 401(k) will be automatically rebalanced without having to manually place trades. Most target date funds automatically move towards a more conservative allocation as you age—a convenient feature that will help you stay on track for retirement.
This spring, as you finalize your tax return and consider ways to reduce your tax bill for next year, review your 401(k) plan to be sure you have set your contributions to maximize the options available to you.
Please reach out to your Coldstream wealth management team with any questions on your 401(k) and how it may be optimized within the context of your overall financial plan.