401(k) – Changes and Regular or ROTH

Some of you may have heard that this year’s Nobel prize for Economics went to Richard Thaler…or some of you might be wondering, who the heck is Richard Thaler??

He won for his contributions to Behavioral Economics, showing how human traits affect supposedly rational markets. He co-wrote a great book called, “Nudge“. The reason I bring him up is he’s partly responsible for helping convince Congress to overall the 401(k) a decade ago. Congress use his theory in 2006, “Save more for Tomorrow.”  His big take away, instead of Companies asking their employees to sign up for 401(k), he encouraged employers to automatically sign-up employees for their 401(k)s. They could then choose to opt out. That was the nudge to get people to save for their futures. How big of an impact did this auto-enrollment have?  One 2015 Vanguard paper suggested that the practice more than doubles plan participation rates to more than 91% of workers from 42%.

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Now, not all employers offer this, but the numbers are growing. You may worry, I can’t afford to be automatically enrolled, the amount companies are auto-enrolling employees is low (between 1-2%). Some companies have also adopted the auto-escalation where you can have them automatically increase your contribution rate by 1% every few years. The plus side to any of this is for those that would have not contributed to their 401(k)s now have a small nest egg building. From his research, Thaler saw that even though people rationally knew they needed to save for their retirements, they ultimately kept delaying the day  they would start contributing. Human nature.

So why am I writing about this today. Well, the 401(k) has been under scrutiny with Congress lately to figure ways to create tax reform. Suprisingly, over the weekend Thaler tweeted that he thought this was a possibly progressive idea. I was more than a little shocked. They current ideas in Congress is to lower the pre-tax 401(k) contribution limit from $18,000 to $2,400! I’m going to keep my ears open to see him explain his reasoning further.

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I do know that most people in the US don’t max out their 401(k). Just roughly 12% of people contribute the maximum.  The average US worker saves 6.8% of their wage per year in 401(k). This article has some sobering statistics on state of US saving for retirement. The other surprising fact that the total workforce in US, only 1/3 have access to 401(k)s at their jobs!

The reason I actually started to write about this today was actually to talk about the difference between a Traditional 401(k) and a ROTH 401(k) that more and more employers are offering.  A traditional 401(k) is funded with pre-tax dollars and a ROTH 401(k) is funded with after-tax dollars. The main reasoning to utilize either is based on your current tax bracket and relative age, and what tax bracket you believe to be in at retirement.

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Typically, if you are just starting out in your career, you’ll be in a lower tax bracket so you’d want to contribute to your ROTH 401(k) (if your employer has one). That way you take advantage of being in a lower tax bracket now, and when you retire the money your contributed is TAX-FREE…yes, TAX-FREE! Then conversely, when you are more established in your career and are in a highly tax bracket then it might make more sense to contribute to a traditional 401(k) because you are assuming once retired you will drop down to a lower tax bracket, then when you withdraw your 401(k) you pay less taxes then if you had taken it earlier.  There are other notions of maximizing your tax benefits with a traditional 401(k), by converting your 401(k) to an IRA when you leave your employer/retire, then afterwards doing what is called a Roth Conversion, making your IRA an ROTH IRA. But that’s a story for another day.

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