Love Future You
By Kevin Estes
It’s Almost Valentine’s Day
You know who could use some love? Future you!
It's the time of year many people receive their annual raise and bonus, making now a prime time to revisit saving.
Raise
Given recent changes in the cost of living, many companies have made big updates to employee compensation.
Keeping Up With Inflation?
Raises need to at least keep up with inflation.
According to the U.S. Bureau of Labor Statistics, the 12-month percentage change in the Consumer Price Index ending December 2023 was 3.4%.
If someone’s raise was below 3%, it might be because they:
received a recent raise,
accepted a promotion, or
are at the top end of their pay grade.
It might also be a sign of trouble in their current position.
Automatically Save More
Raises help employees save more without thinking about it.
Example:
Let’s say Bob was earning $100,000 and received a 4% raise. He now earns a $104,000 salary. Congratulations!
Bob contributes 5% of his gross income to his pre-tax 401(k) to receive his company’s maximum match of 4%. Without any other changes, his pre-tax 401(k) contributions would rise $360 for the year.
Bob’s contributions +$200:
from $5,000, 5% of $100,000
to $5,200, 5% of $104,000
Matching contributions +$160:
from $4,000, 4% of $100,000
to $4,160, 4% of $104,000
Gain Without Pain
Raises are a great time to save more without it hurting.
Let’s say Bob bumped his pre-tax 401(k) contribution percentage from 5% to 7%. His 401(k) contributions would rise $2,440 for the year.
Bob’s contributions +$2,280
from $5,000, 5% of $100,000
to $7,280, 7% of $104,000
…plus his employer match increase of +$160.
The best thing is that Bob’s take-home pay might still rise. It could grow from $2,740 to $2,790 per biweekly paycheck.
That’s nearly $1,300 more a year to his checking account on top of $2,440 more to his 401(k). Taking home more while saving more is a win!
Easier to Max Out
Raises also make it easier to max contribution limits.
Bob is 40 years old and his employer offers a 401(k) plan. The most he can contribute to his 401(k) for 2024 is $23,000.
If he were were at least 50 years wise, he could make an extra $7,500 catch-up contribution for a total of $30,500. According to the IRS, those contributions limits are the same for 403(b) plans, most 457 plans, and the federal government’s Thrift Savings Plan. For simplicity, this article refers to 401(k) plans.
Bob’s 2023 contribution limit was a bit lower at $22,500. For him to max out, he would have needed to contribute 22.5% of his salary to the plan.
22.5% * $100,000 = $22,500
For 2024, he’d need to contribute about 22.1% to his 401(k):
22.1% * $104,000 = $23,000 (rounded)
Larger raises have an even bigger impact.
Bonus
Many companies just closed their books on a great year. Employees may receive sizable bonuses soon!
It’s important not to take bonuses for granted. An employer might pay a reduced bonus - or none at all - if things go poorly.
There’s good and bad news with bonuses:
Good - they provide significant income
Bad - they’re heavily taxed
Saving Options
There are thousands of saving options, including six tax-advantaged ones.
Company retirement plans may include:
Pre-tax 401(k)
Roth 401(k)
After-tax
Options beyond company retirement plans include:
Health Savings Account
Spousal IRA
Brokerage Account
Pre-Tax 401(k)
Saving some to a pre-tax 401(k) has three primary benefits:
reduces taxable income (and likely income tax)
gives investments more time to grow
reduces how much needs to be taken out of the biweekly paychecks to reach the annual contribution limit
Money added to a pre-tax 401(k) reduces taxable income for the year and grows tax-deferred until withdrawn. However, funds count as taxable income when distributed.
That may not be so bad! People often earn more when they work than they do in retirement. Because of the standard deduction and progressive tax brackets, it’s possible someone will pay less tax later than they would now.
A 10% penalty would apply if funds are withdrawn before the pre-tax account owner turns 59.5 - unless an exception applies.
These accounts are also subject to required minimum distributions later in life. The U.S. government essentially gets impatient. It gave a tax break when money was earned and wants the income tax before the worker passes. The current age for these minimum distributions is 73 and is projected to rise to 75 starting 2033.
Roth 401(k)
Another saving option is the Roth 401(k) - sometimes shortened to Roth(k).
The benefit of the Roth option is that someone pays income taxes now and - if withdrawals meet certain criteria - never again!
The Roth option might appeal to someone if they:
don’t need the money to fund their living expenses or high-interest debt payments,
anticipate their income will grow significantly in the future,
expect to continue to work until full retirement age, and/or
might move to a state with a higher income tax rate.
Below is a quick comparison of the Roth and pre-tax 401(k):
After-Tax
An option many employers have added recently is after-tax contributions. It’s especially helpful for higher earners looking to save on top of pre-tax contributions like:
401(k) and
Health Savings Account.
According to the IRS, the 2024 contribution limits are:
$23,000 for employee deferrals like the pre-tax 401(k)
$69,000 in total defined benefits
The company match also counts toward the $69,000 limit.
Example:
Jen is a 45 year-old who earns a $200,000 salary and a $50,000 annual bonus. Congratulations!
Jen maxes her pre-tax 401(k) contributions at $23,000. Her employer also matches $10,000 (4% of $250,000).
That leaves her $36,000 to contribute to her after-tax account:
$69,000 total defined benefits limit
less $23,000 employee contribution
less $10,000 company match
Mega Roth
Jen’s employer also allows her to move money out of her after-tax account while still employed. (The fancy term is an in-service distribution.) She can sweep those funds to a Roth IRA.
If she uses her bonus check, she may only have to do the transfer once a year. She may also set funds to be automatically transferred (converted) to her Roth IRA with a call to her company’s plan administrator (custodian).
This is known as a Mega Roth. It’s sometimes referred to as a Mega Backdoor Roth. Don’t worry! Congress blessed it.
Health Savings Account
A Health Savings Account (HSA) is a portable way for employees to save for their future healthcare expenses. If they leave the company, they can take the HSA with them! The funds aren’t “use it or lose it” like other healthcare accounts.
In addition, the contributions are triple tax advantaged:
Avoids tax on the front end
Grows tax free
Can be withdrawn tax free for qualified medical expenses
HSA funds can build over time and even be invested. Most custodians require some cash - maybe $2,000. Anything above that limit can usually be invested.
The list of qualifying medical expenses is long. It even includes premiums for:
long-term care
COBRA
Medicare
Medical expenses need not be reimbursed right away. Someone could pay out of pocket, carefully save their receipts, and submit for reimbursement much later.
The biggest drawback is that a Health Savings Account requires someone to be on a High Deductible Healthcare Plan (HDHP). If someone has significant medical expenses, they’d likely need to pay more out of pocket.
Also, the contribution limits set by the IRS are relatively small. In 2024, they’re:
$4,150 for a covered individual
$8,300 for a covered family
Spousal IRA
Another retirement plan falls outside employers altogether.
A spousal Individual Retirement Arrangement (IRA) is an account a spouse can contribute to despite earning little or no income.
If the couple is married and files a joint tax return, they may be able to:
contribute to the spouse’s account,
invest it for long-term growth, and
reduce their tax bill.
Here’s the best part: a 2023 contribution can be made until 4/15/2024! A February bonus may be the perfect time for a last-minute retirement plan contribution.
Whether it would lower taxable income depends on:
whether the spouse was covered by a retirement plan at work and
how much the couple earned in 2023.
Here’s a quick decision tree with the income limits:
Brokerage Account
Finally, it’s easy to overlook a regular brokerage account!
Funds there can be accessed right away - without penalty. They also receive tax benefits like:
Long-term capital gain for investments owned over a year
Lower tax rates for qualified dividends
Step up in basis when the account owner passes
That last point is worth a double-click.
Example
Let’s say Mike passes with $2 million - all of it in a taxable brokerage account. His estate is small enough that it avoids both federal and state estate taxes - even in Washington.
Let’s say his account was invested in stocks that did well like Microsoft, Amazon, Costco, and T-Mobile. He paid only $200,000 to buy the shares and held them for decades.
His daughter, Marie, inherits Mike’s brokerage account. Again, it’s worth $2 million and he only invested $200,000.
Marie could now sell all $2 million and pay no taxes. The $1.8 million gain would avoid tax altogether!
I hope this helped.
If you’re interested in a review of your specific situation…
Disclaimer
In addition to the usual disclaimers, neither this post nor these images include any financial, tax, or legal advice.