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Common Mistakes People Make When Saving For Retirement

Doug Carey, CFA

Key Points: 

  • Saving to a 401(k) plan or IRA is the best way to boost your investments for retirement.
  • For the self-employed, the solo 401(k) plan is starting to take the place of a SEP IRA due to its higher contribution limits.
  • Many people contribute to a 529 plan while still having the ability to contribute to a 401(k) plan. Many times this is a mistake. 

Most people know by now that the easiest way to save enough money for retirement is to save as much as possible to a 401(k) plan. The 401(k) plan’s current limit for individual contributions is $19,000 per year if under age 50. For those 50 and older, the limit is $25,000 per year. Add to that the possibility of company matching and you can see how quickly this amount of savings can add up. 

Even though millions of people contribute as much as they can to their 401(k) plans, there are still people leaving a lot of money on the table by contributing to less tax-friendly accounts or not getting the full match from their employer. 

Company Matching

If I told you that there is an investment with a guaranteed 100% rate of return for the first year, you would jump at it right? Well, this is exactly what dollar-for-dollar company matching is. If your company will match you dollar-for-dollar on, say, your first $8,000 in 401(k) plan contributions, then your first $8,000 earns a 100% rate of return for that year immediately! Not only that, it’s tax-deferred. You won’t pay any taxes until you withdraw the money. 

Unfortunately, some people don’t even contribute enough to get the full matching from their employer. Over time, this is a lot of money left on the table. Let’s take a look at an example. I used our WealthTrace Financial & Retirement Planner to run the following scenarios. We have a 30 year old who only contributes $2,000 a year to his 401(k) plan. His company is willing to match dollar-for-dollar up to $8,000. Therefore, he is leaving $6,000 of matching on the table. Let’s say his 401(k) investments will earn 7% per year for the next 20 years. If he only contributes $2,000 per year, he will have about $85,000 (in today’s dollar terms) in his 401(k) plan when he is 50 years old. 

So what if he cut back his spending by just $6,000 a year and instead contributed that to his 401(k) plan? The total increased contributions would actually be $12,000 due to the company match. 

401(k) balance if saving $2,000 per year

401(k) balance if saving $14,000 per year

If he does this he will have nearly $458,000 when he is 50 years old! That is the power of compounding at work. For just an extra $6,000 a year he will have $373,000 more when he’s 50. 

Retirement Plans For The Self-Employed

The SEP IRA was once the go-to retirement savings vehicle for most self-employed people and small business owners with few or no employees. But many of these people have low reportable W-2 incomes, which severely limits how much they can contribute. The rules state that SEP IRA owners can contribute up to 25% of their W-2 reported income for the year with a maximum of $56,000 in 2019. But if income is low or the business owner takes his or her profits in a different way, such as dividend income for an S-Corporation, then the contributions to the SEP IRA can be very limited. 

This is where a Solo 401(k) plan can be a much better choice. For small business owners or self-employed people with no employees (besides a spouse), the Solo 401(k) plan has similar contribution limits to a regular 401(k) plan and it is not tied to W-2 income like a SEP IRA is. The contribution limit is currently $19,000 per year if under age 50 and $25,000 per year if 50 or older. In addition to this, a profit sharing contribution can also be made and it can be large. The profit sharing contribution can be up to 25% of compensation or 20% of earned income. The total contribution limit for Solo 401(k) plans in 2019 is $56,000. For those 50 or older, the limit is $61,000. 

Contributing To A 529 Plan Vs. A Retirement Plan

I have seen this mistake being made many times. A couple wants to prepare for a child’s future and therefore responsibly starts saving to a 529 plan early on. But in order to save to the 529 plan they reduce their savings to their 401(k) plans. 

Let’s say we have a couple that is currently 43 years old and they have two children who are 2 years old and 1 year old.  They reduced their 401(k) savings by $10,000 a year and are instead going to use that money to contribute to 529 plans for the next 16 years. 

This is a mistake by this couple. By the time their children are going to college, they will be older than 59 ½ and will therefore be able to tap their retirement savings for whatever they want. This means they can use their 401(k) money to pay for their children’s college. The benefits of using the 401(k) plans over the 529 plan is that the contribution to the 401(k) is deducted from their income for federal and state income tax purposes, whereas the 529 contribution only gets a state income tax break. Let’s say their marginal federal income tax rate is 25%. This means that by saving the $10,000 a year to the 401(k) rather than the 529 they will be able to save an extra $2,500 a year (25% * 10,000). 

I ran these two scenarios in WealthTrace and found that if they follow the strategy of saving only to their 401(k) plans they will have an extra $75,000 saved when their first child starts college. This is due to the fact that they save on taxes and get to in turn save those savings to their 401(k) plans and let it compound over time. It’s amazing to think that a simple decision like this can lead to an extra $75,000, but this happens more than people think. 

Some people might be asking, “But what if this couple is younger than 43 and won’t be able to tap their 401(k) plans for college funds?”  In this case it comes down to whether or not they have other sources of taxable money to fund their children’s college education. If they do then they should save to the 401(k) plan. If they don’t then they should indeed save to the 529 plan since they will have to have some way to pay for their children’s college and they won’t be able to use their 401(k) money without paying steep fees and taxes. 

Don’t Leave Money On The Table

Seemingly small decisions can lead to huge changes in wealth over time. Paying high fees, contributing to the wrong types of accounts, or not getting the full company match can mean the difference between retiring early with enough money or working well into your 70s. 

Do you want to see how your investments and retirement plan would hold up under a variety of what-if scenarios? Sign up for a free trial of WealthTrace to find out. 

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Doug Carey, CFA