You contribute the maximum amount each year to your 401(k), sacrificing a fatter paycheck today for financial security down the road, and for that, you should be proud. But if you aren’t setting additional savings aside to help cover your living expenses in retirement, you may find — as many do — that it won’t be enough. Not even close.
“Unless you started with a lot of money, or you save a tremendous amount of money each year, just maxing out your 401(k), even with an employer match, isn’t going to get you there,” said Quintin Hardtner in an interview, a financial advisor with Hardtner Wealth Strategies in Shreveport, Louisiana.
Retirement planning is, in many respects, a shot in the dark. You don’t know how long you will live, how the market will perform, or what your future expenses will be. Will you move to a lower cost state? What will your healthcare costs be? (Related: Retirement calculator)
To run a reasonable chance of maintaining your standard of living when you retire, many financial advisors recommend saving between 10 percent and 15 percent of your salary annually from the day you start working. Others, including Corey Schneider, a financial advisor with Sentinel Solutions in New York, New York, say it should be even more, as much as 20 percent.
For high-income earners, it is impossible to save that much using a 401(k) alone. Why?
The Internal Revenue Service sets limits on how much you may save on a pre-tax basis to your 401(k) or other defined contribution plan. That limit, which adjusts periodically to reflect cost of living increases, is $19,000 for 2019.1 (Those 50 and older can make additional catch-up contributions of $6,000 per year to their 401(k) in 2019.)
Thus, many workers will need to supplement their 401(k) payroll deferrals with investments in either an IRA or brokerage account as their incomes climb over their careers.
“A 401(k) generally does not allow you to save as much of your income as you should because of the caps,” said Schneider.
Inflation: Enemy Number One
While your 401(k) retirement account may look sufficient on the day you retire, Hardtner said retirement savers must factor in the insidious effects of inflation.
The gradual increase in the price for goods and services is the primary enemy for retirees on a fixed income, eroding purchasing power over time.
Consider: A person earning $250,000 per year who retires this year at age 65 would need $200,000 per year to replace 80 percent of his or her income. In 20 years, assuming a 3 percent annual inflation rate, that person would need $361,222 just to maintain the same standard of living, according to Calc XML’s inflation impact calculator.2
“My clients will sometimes say that when they enter retirement they won’t have as many expenses, and it’s true that their house may be paid off, but they don’t take into account inflation and how it impacts the value of a dollar,” said Hardtner. “When people realize that they have to take a more than 50-percent lifestyle cut if they generate the same retirement income 20 years from now as they do today, they are shocked. Who wants to take a lifestyle cut in retirement?”
The other challenge with 401(k)-centric saving is that a traditional 401(k) is funded with pre-tax dollars. That yields a deduction in the year you contribute, but it also means you’ll be facing a hefty tax bill when you start taking money out of the plan in retirement. And withdraw money you must.
The IRS requires taxpayers to begin taking required minimum distributions (RMDs) from their defined contribution plan, including 401(k) or 403(b) plans, on April 1 of the year following the year in which they turn 70-1/2. If you are still working for the company that sponsors your plan at that time, and you do not own 5 percent or more of the company, you can delay your RMD for as long as you remain employed.3
“People always think about maxing out their traditional 401(k) to get a tax deduction, but they forget to think about what their strategy is to pay their income tax on the way out,” said Schneider. “A lot of people are misled, thinking that they’ll be in a lower income tax bracket when they retire or that their traditional 401(k) will not be subject to income tax.”
Schneider said his firm recommends a diversified investment strategy for retirement that consists of both pre-tax (traditional 401(k)s), after tax (Roth 401(k) or Roth IRA), and cash or cash-equivalent assets for an emergency fund. Roth IRA and Roth 401(k)s do not require withdrawals until after the death of the owner.
Some financial advisors recommend setting three to six months’ worth of living expenses aside in a liquid, interest bearing account, but Schneider said those with higher incomes and jobs that are difficult to replace should sock more away for a rainy day. In some cases, he said, it may be prudent to have as much as two years’ worth of living expenses in cash or cash-equivalents.
For maximum flexibility, Schneider further recommends retirement savers consider a whole life, or permanent life insurance policy that guarantees not just financial protection for your loved ones, but a cash value component that can be tapped tax-free in case of emergency.
“If your policy is paid up at age 65, for example, you could take any dividends earned starting at age 65 to help you pay the income taxes on your 401(k) distributions,” he said. “Or, you could use the cash value if you retire into a bear market so you don’t have to lock in investment losses.”
But be aware that if you borrow from your cash value it reduces your policy’s cash value and death benefit, and interest accrues on your loan balance until it gets repaid or you die. Eventually, the interest could exceed the size of your cash value, which would cause your life insurance policy to lapse, triggering a possible taxable event on the earnings and denying your heirs a death benefit.
A financial advisor can help you make an informed decision.
(Related: Life insurance: Treat cash value with care)
The final reason your 401(k) account may put your retirement security at risk, if you have no other savings, is the changing mindset surrounding the so-called “safe withdrawal rate.”
Financial advisors have long debated the 4 percent rule, the rate at which many analysts previously believed that many retirees can safely siphon off money from their retirement accounts without outliving their assets.
The 4-percent rule of thumb, first proposed in 1994 by financial advisor William Bengen, is often used as a starting point for retirement planning. It is adjusted higher or lower depending on the amount you have saved, market performance, interest rates, and your guaranteed sources of income during retirement (pensions, Social Security, trust funds, annuities). It also assumes a cost-of-living increase each year to account for inflation.
While some have argued that the 4 percent withdrawal rate may be too conservative, especially for retirees who adjust their spending in response to market returns, a growing contingent of financial advisors, including Hartdner, say they believe it is actually too aggressive. Why? A combination of factors including increased market volatility and the low interest rate environment suggest that a rate closer to 3 percent — or even less — may be more appropriate, especially if the retiree hopes to leave a financial legacy behind.
“The biggest problem with a 401(k), if you solely depend on that, is that the recommended withdrawal rate was recently downgraded to 2.8 percent from 4 percent,” said Hartdner. “The 4-percent rate was first proposed more than 20 years ago, but we don’t live in that world anymore.”
As you sock money away for your future retirement, keep in mind that your 401(k) alone may not be enough. A diversified portfolio of taxable and tax-favored accounts, plus an emergency fund, may help insulate your nest egg against the effects of inflation, taxes, and the increasingly conservative withdrawal rate that many advisors recommend.
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1 Internal Revenue Service, “Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits,” Oct. 24, 2017.
2 Calc XML, “How does inflation impact my retirement income needs?”
3 Internal Revenue Service, “RMD Comparison Chart (IRA vs. Defined Contribution Plans), Dec. 29, 2017.