Colorado Secure Savings Mandate – What you need to know

What business owners need to know about Colorado Secure Savings Act

 

In 2020 Colorado passed the Colorado Secure Savings Program. This law mandates that small business owners enroll in a state-run retirement savings plan. The pilot program is launching in October 2022 and employers throughout Colorado will be required to comply starting in 2023.

The purpose of this mandate is to increase access to retirement savings for workers in Colorado. The Colorado Secure Savings Act mandates that qualifying employers provide an employer sponsored individual plan. The cost of this program will be funded through auto payroll deductions.

In general, this seems like it will have positive benefits for employees. However, it may create additional burdens for employers and may in fact limit employees’ options. Here is what small business owners need to know about the Colorado Mandated Small Business Retirement Plan.

 

Who needs to comply:

 

The Colorado General Assembly states that you, as an employer,  will be required to implement this program if: 

  • You have five or more employees
  • Have been in business for two or more years
  • Don’t have an existing qualifying plan 

Companies already offering 401ks or other qualified savings plans are not required to use the Colorado Secure Savings Program. The law states that employers with less than 5 employees or who have not yet been in business for 2 years will not be required to participate. However, they will have the option to offer the program to their employees.

 

What needs to be done:

 

While there is limited guidance at the moment from the State of Colorado, employers will be required to offer auto enrollment and facilitate payroll deductions into the program. 

Upon enrollment, employees will opt into the default savings rate for Colorado Secure Savings, which is 5% of their gross pay. Beyond this, deferral rates may vary depending on how much you want to save each year. In addition, age, marital status, and income play a role in the amount that employees can contribute.

However, employees will be able to change their contribution amount or opt-out if desired.

As it is written so far, employers will have 14 days to send employees’ contributions to the program administrator. The program oversight will be done by the board of the Colorado Secure Savings Program. The board is currently chaired by the Colorado State Treasurer. This board will be making a process for withholding employees’ wages and remitting withheld amounts into their Colorado Secure Savings account. It’s not yet clear if the program will offer any integrations with payroll providers to facilitate the timely deposit of contributions.

 

Penalties for noncompliance:

 

Fines can be costly.  For non-compliance, fines will be $100.00 per employee per year and can ratchet up to $5000.00 annually. The compliance period is one year after implementation. 

However, they do state they plan to create a grant program to incentivize compliance. Yet no further details have been released.  The good news is it’s really easy to comply by setting up a 401k plan or another qualified plan in advance. Keep reading on to find out how.

 

General Concerns:

 

There is little to no guarantee of the level of quality or support that will be available to business owners from the state in implementing and managing the Colorado Secure Savings Program. The government has not released any real guidelines. There are some basics, but how is still very undefined. 

Further, if a company offers the state-run plan many of their higher income employees will be excluded. Employees with a Modified Adjusted Gross Income of more than $139,000 or $206,000 married filing jointly cannot participate.

As we wait for more details it’s not a bad idea to consider all the various plan options available to you and your company.

 

State Sponsored vs Employer Sponsored

 

There are a handful of states that currently have state mandated plans in place. California, Oregon, and New York are a few for instance. State sponsored plans have pros and cons, which business owners should carefully weigh. On one hand, government-mandated plans are generally a cheap solution with few fiduciary implications. On the other, these plans tend to be inflexible, one-size-fits-all. Plus they come with potential government penalties.

 

State sponsored retirement plans:

 

  • Roth IRA Investment structure (after-tax)
  • The state board selects investments
  • Annual Salary Deferral Limit $6,000 (Extra $1,000 catch-up if over 50) as of 2022
  • The plan will “travel with” people if they change jobs or leave the state
  • Excludes higher income employees
  • No employer contributions 
  • No federal tax credits for employers
  • Creates a significant burden for the employer

 

As an alternative, an employer sponsored 401k or other qualified plans may be a better option than having the state do it for you. A common misconception is that employer sponsored plans are expensive. However, that simply isn’t the case. Many plans are now being tailored for smaller companies. Plus, the IRS gives tax credits to firms with fewer than 100 employees for some ordinary and necessary costs of starting an employer sponsored plan. 

 

Employer Sponsored 401K plans:

 

  • Allow an employee to make contributions either before or after-tax, depending on plan options
  • Wide range of investments at various levels of risk chosen by the employer or by an advisor
  • Employee may direct their own investments
  • Higher Annual Salary Deferral Limit 
  • No employee income limits
  • Allows for employer contributions
  • Federal tax credits for the employer for start-up and admin costs and employee education

 

In addition, offering an employer sponsored plan to your employees may increase your company’s competitiveness in the job market. It could also help you retain valuable staff. Plus, you and other company leaders can participate. 

If you work with a payroll services provider, the software can easily and automatically transfer employees’ funds, making the procedure effortless. Additionally, private plans typically come with the support of financial advisors. Moreover, a financial advisor can help regarding plan types and how best to implement them for your business.

Clearly, adding a 401k or other qualified plans to your company’s benefits package has strategic advantages. Yet, by not providing your employees with a retirement plan, you risk having the state impose one. 

 

Do State-Run Plans Even Work?

 

Time will tell. However, Oregon, the first state to legally mandate a retirement plan, has pretty dismal enrollment numbers. Since its inception in 2018, only 114 thousand workers have enrolled out of a potential of over 1 million total. 

Using Oregon again as an example, there are a lot of restrictions. First, the percentage contribution is fixed. Second, the employee’s first $1,000 gets put into a stabilization fund that since its inception has earned 1.52% per annum, or basically 0%,  Or less after factoring in inflation. Finally,  if and when they have more than $1,000 invested, they must decide between a fund that is a mixture of stocks and bonds and one that is invested entirely with the State Street Equity 500 Index Fund. (03/31/2022

By comparison, in the private sector, there are multiple low-cost, exchange traded funds, most of which averaged an annual return of over 10% during the most recent 10 year period. Some would argue that directing employees away from these superior investment products arguably does a disservice to the employees.

 

Sample Administrative Duties

 

Further, Oregon has demonstrated what a significant burden the plan can be on employees. Here is a shortlist of employer duties that Colorado will likely have as well.

  • Submit an employee census annually
  • Track eligibility status for all employees
  • Provide enrollment packets to all employees 30 days after date of hire
  • Plus, track whether each employee has opted in or out
  • If an employee doesn’t opt out within 30 days,  set up 5% payroll deduction
  • Manually auto escalate all employees annually unless they’ve opted out
  • Repeat auto enroll process annually for all employees who have opted out
  • 6 month look-back for auto escalation:
    • Track if the employee has been participating for 6 months with no auto escalation
    • Provide 60-day notice  if they do not opt-out again
  • Hold open enrollment
  • Auto-enroll anybody who hasn’t been participating for at least 1 year

It’s too early to know whether state run programs work. After all, Saving for retirement is a marathon, not a sprint. As an employer, it is important to weigh all options. 

 

What Are Alternatives to the Colorado Secure Savings Program?

 

If you do not already have an existing plan, and you are skeptical about a government mandated plan, you can always make your own employer sponsored plan. Bonfire Financial has many 401k, Simple IRA, and SEP IRA options. We provide affordable, hassle-free solutions that will reduce the administrative burden. 

 

Colorado Secure Savings vs Retirement Plan with Bonfire Financial

State Run Retirement Plan vs 401k

How can my business establish its own retirement plan?

 

Above all, retirement plans don’t have to be expensive or difficult to manage. In light of Colorado’s rollout of the Secure Savings Plan, we are offering small business owners and employers a free, no obligation call with a CERTIFIED FINANCIAL PLANNER™ to help answer all your questions. We can help you create a better, more efficient retirement plan that is tailored to you and your employee’s specific needs. We are local in Colorado Springs and are here to help with all your retirement plan needs. 

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Small Changes, Big Differences in your Retirement plan

The Power of 1% 

  How Small Changes Can Make Big Differences in your Retirement Plan

We have all heard that something – something 1% more, or something-something 1% better every day will have a massive effect on your life over the long run. How small changes can make big differences. It makes sense, if you could mathematically make yourself 1% better or more each day, you will be significantly better than you were at the beginning of the month or beginning of the year. It is a worthy pursuit. But it is very hard to calculate unless you are talking about running miles or lifting weights.

The concept is that a small change over a long period of time will have a massive impact on you and your life if done for a long time. This can be applied to so many things. Even an aircraft that is 1 degree off will land in a very different location than what was scheduled. But today I want to apply it to your financial life. Specifically, your 401k or retirement plan.

The “Power of 1%” is a motivational abstraction, why would I want this idea applied to a boring, old 401k plan? Because just 1% could make a massive difference in your life. These small changes can make big differences in your retirement plan. This one concept could make your retirement and life unimaginably better, and totally change the way you grow your wealth. Just 1% can be the difference between barely scraping by, to being a comfortable millionaire.

 

Power of 1%

 

The true key is to simply increase your 401k contribution by 1% at the beginning of the year, each year.

 

Let’s talk about how.

 

You have a 401k retirement plan and let’s say you are saving a decent amount of your money at 5% of your income, and your employer is either matching your contribution or putting in a percentage of your salary, depending on where you work.

Let’s take three pilots for this example, each in different stages in their career. 1. Rookie 2. Senior FO 3. Fully Tenured Captain that was flying bi-planes back in the day (joking). Pay will remain the same for easy math.

The Rookie makes $100,000 per year and is deferring 3% of his salary each year. In 5 years he would have put away $15,000 into his 401k. 3% seems like a lot, but over 5 years, that is only $15,000 for his retirement. Now let us see what would happen if he increases his deferral by just 1% each year. If he starts at 3% and increases each year by 1%, he will be at 7% (Year 1 was 3%) and over that time he would have contributed a total of $25,000! That is an extra $10,000 or 67% more than what he was normally doing.

Small Changes Big Differences in your Retirement plan

The Senior FO makes $250,000 per year and is deferring 5% into his 401k each year. When he retires in 10 years, he would have contributed $125,000 into his 401k. Not bad! But if he plans to retire, he should definitely do more. If he increased his contribution just 1% each year for 10 years, He would add $216,500 over his time, almost twice as much if he stuck with the 5% rate. Remember, you can only max out your side of the 401k contributions up to $19,500 each year, plus another $6,500 if you’re 50 or more, which is the case here. But you can always take that money and put it somewhere else. (Hint, hint Backdoor Roth Conversions) Here is the example:

Small Changes Big Differences in your Retirement plan

The last person is a Captain that will be retiring in 3 years. He has 3 years to put away as much money as possible. His salary is $350,000. He will need to put away 8% of his salary in order to meet his max of $26,000. Since he doesn’t have a lot of time to scale up every percent, he should just try to contribute as much as possible before he retires. If he maxes out, he will have $78,000 over 3 years! The more you can contribute to your 401k the better life will be.

 

The Tale of Two Pilots

 

Now let’s look at another example of how small changes can mean big differences in your retirement plan.

David and Susan both went to Metro State University to be pilots. They both were very good students, graduated from school, both worked for a regional liner and they just started flying for the same major airline. David loves to snowboard, vacation around the world, and party. He says  “As long as I’m covering my financial bases, I can do the things I enjoy.”

Susan loves to ski, read books, and spend time with her family. Living a comfortable life is important for her and she wants to make sure she can do the things she enjoys in the future. 

On their first day, they sit down with HR, and they are asked how much they want to start deferring in their retirement plan. David, whose friend told him to defer as much as he can, announces he will start with 5% of his $150,000 salary going to his 401k. When Susan sits down with HR, she says she can’t defer any dollars into her 401k because she wants to finish paying her student loans first. But she promises next year she will start with 1% of her $150,000. And the next year, 2% and so on. 

At Year 10, they both start getting paid $250,000. And at Year 20, they are making $300,000.

25 years later, after they both have amazing and fulfilling careers, they bump into each other at the DIA breakroom! “Wow!” They say for they haven’t seen each other for a long time. After a while of catching up, they talk about their retirement accounts. 

David smiles and boasts “I’ve been saving 5% of my salary since the first day I got here, and now I have saved $282,500 of my salary” as he calculates in his Excel spreadsheet:

“Very impressive!” Says Susan, as she tabulates how much she has saved. She started saving with nothing, but she promised she would increase her contribution by just 1% each year. After she does some math, she shows David how much she has saved. Smug David leans forward and stares, mouth open, at the numbers from Susan’s tablet…

“You saved $439,500?! Wow! I thought you said you were doing none, how did you beat me? That’s almost twice as much as I’ve saved, and I’ve been doing 5% my entire career!”

“Slow and steady wins the race” Susan smiled. 

Just a small change can make a huge difference in your retirement plan. And just because you start off slow doesn’t mean you’re out. Don’t get discouraged, just try to be 1% better. Like Susan!

 

What’s Next?

 

If you are just starting out or in your mid-career, increasing your retirement plan contributions by just 1% this year will have a huge impact on your retirement accounts and life. This doesn’t even factor in the potential increased growth that your account could receive. Lastly, your salary regularly increases with inflation, usually around 2% to 3% each year. If you just took 1% from that, you would hardly notice the change in your cash flow. 

This strategy is something relatively new but is gaining more traction among plan sponsors and large companies. Many of them are automatically enrolling employees into automatically increasing their deferral, or at least strongly encouraging that their employees increase their 401k contribution each year. Hopefully, these examples have made it clear the importance of growth for your retirement. 

Do you have a financial plan? Please reach out for a complimentary discovery meeting with our CERTIFIED FINANCIAL PLANNERS™ to help give you a clear path to a successful story. Susan would 🙂

 

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United Airline Layoffs. What to do if you are laid off.

United Airline Layoffs

 

Economic downturns often hit the airline industry harder than most. Once again, the airline industry has been grounded by the pandemic and the corresponding economic conditions. As such, layoffs are looming.  United Airlines announced it will be laying off thousands of employees, estimated to be 36,000 by October 1, 2020. Additionally, United Airlines said the jobs of more than 14,000 employees are at risk when federal aid expires in the spring of 2021. These layoffs could affect everyone from customer service employees, flight attendants, to pilots. Many other airliners may follow suit.

The fallout from 9/11 and the impact of the 2008 Financial Crisis took the airline industry roughly 2-3 years to recover. It is hard to say how long the coronavirus impact will last or how it will all turn out.

If you are worried you might be one of the airline employees to be laid off or already have been, there are many concerns you may have.  From how to pay bills, to how long will this last, to how to keep medical insurance and benefits… the list goes on.

 

What should I do if I am laid off?

 

We have put together some tips, ideas, and strategies to help you get through this tough situation. 

 

Covering your living expenses

 

Being able to cover your living is by far the most important question and concern.  There are a number of strategies to help navigate this and there are also some new provisions from the CARES ACT that can help if you are a United Airline employee who has had to face the layoffs. 

 

Your emergency fund

 

An emergency fund is a savings account or separate account that is set aside for when the unexpected happens, like being laid off.  We recommend that our clients have 3-6 months of their monthly expenses saved in this kind of account. The goal is to use this money to pay for your mortgage, food, etc.  It is designed to help you bridge the gap of unemployment to your next job or getting rehired when things recover.  

One often-overlooked task is once you are employed again to refill your emergency fund. This account can help you in a tough situation but be sure to replenish it to ensure it is there for the next time something unexpected comes up. 

If you do not have an emergency fund in place, read on for some other ideas that can help. 

 

Claiming unemployment

 

If you received a WARN, it is important to start planning ahead now. You can now qualify for weekly unemployment payments from the state in which you worked.  Many people fly out of a hub that is different from the state that they live in. When applying for unemployment, use the state that you work out of. Selecting reason for unemployment: “Coronavirus” can streamline the paperwork process. A quick Google search of your state and unemployment will land you on the right page. Look for “.gov” in the address. The CARES Act is adding $600 per week into unemployment checks but is set to end on July 31st. This may be extended as the impact of the virus continues. 

 

Mortgage Forbearance

 

Mortgage Forbearance means you can postpone your mortgage payment temporarily. For 180 days you can request a forbearance from your mortgage lender. If granted it means you will not have to pay your mortgage for about 6 months.  However, this is not mortgage forgiveness. You still owe the full amount and interest still accrues on the months you do not pay.  You will need to work out the details and repayment plan with your lender as each situation is different.  Per the CARES Act, no additional fees or penalties will be applied if you require forbearance.

 

Retirement Account Withdrawals

 

Taking a distribution or withdrawal from your 401(k) should be a last resort. The money in your 401(k) is meant for your retirement. However, with the intensity and impact of the United Airline layoffs caused by COVID-19, the CARES Act has set up many relief options.

Traditionally, you could not access your retirement account before the age of 59 1/2 without having to pay a 10% penalty and income tax.  The CARES Act has waived this 10% penalty.  Since all retirement accounts (Roths excluded) are funded with pre-tax dollars and the income tax is normally due in the year of a distribution. 

The CARES act has allowed distribution in 2020 up to $100,000 be taken out and the taxes are due over the next 3 years. For example, if you take out $90,000 from your retirement account, you will have to pay tax on $30,000 in 2020, $30,000 in 2021, and $30,000 in 2022. That is much better than having to pay all $90,000 in 2020. The money will come out of your account’s investments pro-rata, so if you have half your money in large-cap stocks and half in small-cap stocks, the money will be sold in them equally to fund the distribution.

Reach out to your 401(k) provider Charles Schwab or Fidelity for details.

 

401(k) Loan

 

Taking a loan from your 401(k) is not a good idea because you will be taxed on the distribution, and you will have to repay the loan. There could potentially be many more downsides to taking a loan rather than just distributing the money.  If you are furloughed or leave the plan, you will be subjected to a faster repayment schedule.

If you take out a loan, you will be taxed on the loan amount, plus you will have to use after-tax dollars to pay back the loan. In the grand scheme of things, once you repay the 401(k) loan, you will still be subjected to income tax when you take the money out when you retire. So you will be taxed TWICE on the money, instead of just at the distribution.

 

Miscellaneous Items

 

Many car manufacturers are offering payment deferrals during this time. If you are unable to make payments comfortably on your car, be sure to reach out to your car’s manufacturer finance department to discuss payment options. Many newer cars (2018 or newer) will have more generous payment options than older vehicles.

Also, a voluntary separation could be a good idea if you are close to retirement. The benefits of the United Airlines Retirement Health Account (RHA) can help you pay for medical insurance. 

 

What about my  Benefits if I am laid off??

 

United Airline layoffs are hard enough, luckily you can retain certain benefits. For instance, health insurance, RHA, and you’re retirement accounts can still provide you benefits.

 

Health Insurance

 

COBRA is a government bill that lets you keep your medical insurance with your company for up to 3 years. You will have the same coverage and plan, except you will have to pay 100% of the premium (plus a 2% premium for administration costs for a total of 102%) Look at your most recent pay stub to see how much you and your employer were paying for medical insurance.

 

Retirement Health Account

 

Your Retirement Health Account (RHA) is a unique account granted directly to United from a private letter ruling with the IRS. The RHA is used to pay for out-of-pocket medical expenses and health insurance premiums when retired, furloughed, or separated from service. The RHA can also be used to pay for your COBRA premiums. Click here for more details on how to use your RHA.

 

401(k) and Retirement Investments

 

There are some options you can choose to do with your 401(k) when you have faced a layoff.

  1. You can keep it with the company.  Nothing will change as you will have the same investment options and access.
  2. You can withdraw the money, as we mentioned above.  However, this is not the best action to take if it can be avoided.
  3. You can roll your money into an IRA.  There are no taxes on this move, and it can give you more investment options and control of your money.

Our preference is to roll your 401(k) over into an IRA so that you have better access to your account while avoiding the administration and investment fees from United, Fidelity, or Charles Schwab. We can build you a custom portfolio based on your needs and our custom investment research for a fee typically lower than your Fidelity and Charles Schwab 401(k) options.

Our expertise is working with pilots and aircrew in providing them the best investments through our relationship with Charles Schwab. Leveraging our partnership with Charles Schwab we can build you a custom portfolio in your PCRA.

 

What’s Next?

 

We can help you navigate one of the most difficult times the airline industry has ever faced, and that is really saying a lot! We work with many pilots, crew members, and their families and help them prepare for a successful retirement and reach their financial and life goals.

Bonfire Financial is a fiduciary, fee-only,  financial advisor.  We have a staff of Certified Financial Planners™ that specialize in helping United Airline Employees and Pilots.

As a United Airline or major airline employee, we would like to offer you a free consultation to help answer any questions you may have and help you get a game plan in place. Scheduled your call now. 

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Roth 401k or Traditional 401k?

Roth 401k or Traditional 401k? 

 

The 401k plan is the cornerstone to retirement. Gone are the days of big company and school district annual pensions and generous social security benefits. It’s now up to the individual to plan and save for their entire retirement. In addition to all the expenses that go with it. Luckily, a Roth 401k or Traditional 401k is a fantastic tool. One of the best that you can use to save for your retirement and goals. However, there is a lot to understand about how they work and how to use the 401k for your best outcome.

 

A little background

 

The purpose of the 401k plan is to save for retirement. Currently (as of 2019), an employee can contribute $19,000 of their own money to their account and an additional $6,000 if they are over 50 years old per year. Your company can match or add to the 401k plans. The total plan can add up to $56,000 or $62,000 (if 50) per year in 2019. Some plans also allow for you to contribute to a Roth 401k. Many people wonder if this may be a better option for them. We’ll explore the key differences between a Roth 401k or Traditional 401k so you can make a confident decision.

 

The Roth 401k

 

The Roth 401k is a relatively new concept. It was introduced in 2001 for the purpose of allowing employees to take taxes now and forever shield the gains from tax. Many people see the benefits of contributing to the Roth 401k. However, some are hesitant as to whether the traditional tax-deferred 401k will still be better for them because of its favorable tax deferral. When you elect to contribute to the Roth 401k, you can use your entire employee contribution of $19,000 (plus $6,000 if over 50) to your account each year.

The money you add to the Roth is still considered income. You will be taxed on that amount. Once your savings in the account have been taxed at your regular income level, it will grow tax-free. Then, when you take money out of it, that will also be tax-free.

This is a great option if you do not want to pay extra tax in your retirement. Also, good if you are in a lower tax bracket than you expect to be in the future.

 

Example

 

As an example, if you contribute $25,000 to your Roth 401k at the 22% tax bracket, you will still pay $5,500 as a part of your tax bill. Let’s say if you contribute $25,000 annually for 10 years at a rate of 8%, you would be the owner of an account that has $362,164 completely tax-free! The benefit of having a Roth IRA is that you will never pay taxes on the gains that you make in the account. If your account is still around for your heirs, they will not have to pay any tax either!

Having this option will allow you to grow your money . Addtionally, you will not have to worry about paying extra taxes. It is important to note that your employer does NOT match your contribution on a Roth basis if you do. They will continue to match your contribution, but it will only be in traditional tax-deferred dollars.

Let’s say your company matches you 3% of your salary. If you are in the plan and make $100,000, you will be contributing $3,000 each year into your Roth 401k. Plus, your company will contribute $3,000 to the traditional 401k. They will be in the same account but will be accounted for separately by the administrator of the company 401k plan. When you are deciding, if you can afford to do the Roth 401k, you absolutely should.

 

The Traditional 401k

 

The traditional 401k allows an employee to defer their income of what they contribute. That means if you made $100,000 and decided to contribute $25,000 to your 401k, you will only have to report $75,000 to the IRS. This is because you “deferred” your income into the account. Once you retire and withdraw that money, you will have to pay the income that you “realized” at the tax rate you are at when you withdraw.

The advantage of the traditional 401k is that you get to defer your income and save it while it grows in your account. When you retire, you may move your traditional 401k to an IRA. As an example, you made $170,000 as a married couple. At $170,000, you are pushed into the 24% tax bracket (over $168,450 Married Filing Jointly). But because you understand the 401k can defer your income, you decide to defer $15,000 into the account, dropping you out of the 24% bracket and into the 22% bracket, which saves you money!

The traditional 401k is best if your cash flow is tight. It is extremely important to save for your retirement. You should always save 10% or more of your salary as a rule of thumb. When you save on taxes, you will be saving yourself money.

 

Example

 

Here is an example that will illustrate how your contributions of $20,000 affect your cash flow.

 

Roth 401(k) or Traditional 401(k)

 

Here we can see with a salary of $100,000 we cannot defer any money from taxes if we contribute $20,000 into the Roth 401k. Our total taxes at 24% will be $24,000 for the year. If we contribute $20,000 to the traditional 401k, we will defer that money from taxes, so only $80,000 will be taxed at 24%. At the end of the year, using the traditional will save us $4,400, which is $367 per month. If that money is needed for your cash flow, do the traditional. If you can take the hit now on taxes, you should do the Roth 401k.

 

Which one is best for me?

 

You are weighing now versus later. If you are just starting out in your career and are in the lower tax brackets you should contribute to the Roth 401k. At the end of the year, you will have a bigger tax bill from Uncle Sam because you recognized all of your Roth contributions. Have no fear! Your Roth retirement account will grow tax-free all the way up until you retire. Plus, all the gains that you have made throughout those years will be tax-free as well!

If you have a good handle on your cash flow, you should contribute to the Roth 401k. If cash flow is an issue you can use the traditional 401k to lower your tax bill. You get to defer that income and save it in a tax-deferred account that will grow. Once you take money out of the account, you will have to pay income tax on it. This can be quite advantageous if you are at the top of your career and at the higher tax brackets. If you believe that you will be in a lower bracket when you retire, the traditional is your best bet.

 

The Backdoor Roth IRA

 

People want to enjoy deferring their income to save on taxes but also want the ability to have a Roth account that they can draw from tax-free in retirement. Many people close to retirement are looking at all the taxes they have saved in their accounts and now see a huge dollar sign going to the government every time they take money out for their retirement expenses.

The Backdoor Roth IRA allows a person to continue to defer their income through their 401k, but also contribute $6,000 (plus $1,000 if over 50) per spouse into a Roth IRA. A married couple can contribute up to $14,000 each year to Roth IRAs. If this planning technique is done for 5 – 10 years before retiring, this would give a retiring couple a substantial tax-free account.

 

Example

 

As an example, if a married couple were to contribute the max amount of $14,000 for 10 years. Assuming a yearly return of 8%, they would have $202,811.87 of assets that would never be taxed again! The benefit of a Roth is also that there are no Required Minimum Distributions as there are with a traditional account. If a married couple paired the backdoor Roth IRA with the 401k plan, they would have an effective diversification of their tax accounts, which would be very helpful in retirement.

This is a complex planning strategy. It is important to work with a financial advisor that understands your objectives and will help you leverage your current situation to help you meet your expectations.

 

The Bottom Line

 

If you can stomach the tighter cash flow and you are suspecting that you may be in a higher tax bracket, the 401k Roth is best for you. If you are tight on cash flow and could use the extra money while also saving for your retirement, the traditional 401k is for you. Also, if you suspect to be in a lower tax bracket in the future when you take out money, the traditional 401k is what you should choose.

The Backdoor Roth IRA is great for people that wish to save in a traditional 401k to take advantage of the tax deduction, but also want to grow a Roth IRA that will never be taxed. Using this mechanism, a single person could add $62,000 into a traditional 401k and $7,000 into a Roth IRA.

 

What’s next?

 

Interested in learning about the differences between an IRA and a 401k? Read up on that here.  Still have questions? Please feel free to contact us!  719-394-3900- We offer free 30 minute consultations that can help answer many of your questions.

Differences Between an IRA and 401k

IRA vs 401k: What’s the Difference:

 

There are some common misconceptions about the difference between an IRA (Individual retirement account) and a 401k plan. While these two are very similar there are some distinct differences that make each unique.

Before we tackle the difference between an IRA and a 401k it’s important to note that these are not investments.  They are simply accounts.  Just because you have an account open does not mean you have an investment that will grow and help fund your retirement.  Much the same way that just because you own a refrigerator doesn’t mean you actually have any food in it. You have to add to it.

To continue with this analogy…  in your fridge, you can have a variety of different types of food (juice, pickles, eggs, beer, and anchovies- if you’re into that sort of a thing). In an IRA and 401k you can have different investments too.  Such as stocks, bonds, mutual funds, ETFs, commodities, real estate, and more. You can also change or “throw out” the investments in your IRA or 401k if you’ve left them in the back of the fridge for too long. You know like that 3lb. jar of mayo you bought for that party that one time.

Now that you are hungry, let’s get to the dive-in.

 

Overview of an IRA vs. 401K:

 

You probably know fundamentally that saving for retirement is one of the single best things you can do financially. You don’t want to rely on social security, you don’t want to run out of money, you don’t want to be a financial burden to your children, and you want to enjoy your golden years. All great reasons to have a retirement plan! So which retirement plan is best for you?

Both IRAs and 401Ks have tax benefits and are among the most common defined contribution plans. The good news is that you don’t have to choose one over the other. To maximize your retirement savings, you can and should, if possible, contribute to both an IRA and 401k.

The key to note is that a 401k, named for the section of the tax code that discusses it, is an employer-based plan and an IRA is an individual retirement plan. Got it?

First up let’s look at how a 401K and IRA are alike.

 

The Similarities:

 

  • Both allow you to put money in on a tax-deferred basis. Meaning that taxes are not due at the time when you add money. For example, if you make $50,000 and decide to invest $2,000 of it into your IRA or 401k, the $2,000 is not going to be part of your taxable income.
  • Your money within an IRA or 401k can be invested in a variety of ways.
  • The money that is invested is allowed to grow tax-deferred. You do not have to pay taxes on the gains from your investments until you take the money out.  If you make $1,000 off of your $2,000 investment, you now have $3,000 in your account and you will not have to pay taxes on that gain until you withdrawal the money.
  • When you do withdrawal the money for whatever amount it will be considered part of your taxable income. You will own taxes on the withdrawal amount. Let’s say you withdrawal the $2,000 and your current annual income is $50,000 after the withdrawal your taxable income will be $52,000.
  • Since an IRA and 401k are designed for retirement the money that you invest is not supposed to withdraw until after the age of 59 ½. You read that correctly -the government added in a half, well, because your inner 6-year-old knows it’s that important. If you withdraw the money prior to 59 ½ you will pay a 10% penalty on the money plus the amount withdrawn is now part of your taxable income.
  • Also, the government mandates that at age 71 ½ (again the half) you have to take out a Required Minimum Distribution (RMD).  Basically, they tell you the amount that you must pay taxes on.  Quick note, if you are still employed at age 71 ½ and not the owner you can delay your RMDs.

 

The Differences:

 

While an IRA and a 401k have many similarities, they do differ is a few very key areas.  The main one being that an IRA is Individual Retirement Account, so it is yours and yours alone. Anyone can have one. A 401k is company-sponsored, so you can only participate in it if your employer offers one.   Some other key differences are:

  • Since a 401k is employer sponsored typically the employer will match a percentage of their employees’ contributions up to a certain limit or percentage. There is no option for  this in an IRA.
  • Consequentiallybecause a 401K is employer-sponsored your investment options are limited to what the employer offers. Whereas an IRA will allow you to have more variety in terms of stocks, bonds, real estate, etc.
  • Loan or hardship withdrawals are available for 401ks. However, IRAs generally do not permit loans or early
  • withdrawals.
  • An IRA has certain income limts and a 401k does not.
  • Finally, the contribution limits are different and change from year to year. Check with your financial advisor or go here to learn about the current years’ limits.

 

Difference Between an IRA and 401k- A Venn Diagram

Differences between an IRA and a 401k

Which is Right For You?

 

It depends really. If you have the option of putting your money into an employer-sponsored 401k or an IRA you should do both. Max them out if possible. We recommend prioritizing the 401k first especially if your employer offers a match and then adding to an IRA if you are within the income limits.

This hopefully gives you a good overview of the differences between an IRA and a 401k. While there are many factors to consider, the most important thing to remember is that both are great tools to use to help achieve your retirement goals.

Are you interested in learning about a Roth?  We’ve got a great article here for you.

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