Where are you saving for retirement? For many Americans, there's only one answer: in a workplace-sponsored 401(k). These tax-advantaged retirement accounts hold some $6 trillion in U.S. retirement assets. They offer savers a range of benefits, including automatic, pre-tax payroll contributions, tax-deferred earnings growth, and, often, employer-funded contributions.
Unfortunately, the tax perks associated with 401(k) saving may lose their luster in coming years. Here's why: When you take distributions from your 401(k) in retirement, those amounts are fully taxable as regular income, just like a paycheck would be. You accept that future liability as a trade-off for tax-free contributions today and tax-deferred earnings over time. That trade-off makes sense, because most savers expect their effective tax rate in retirement to be lower than it is today.
The problem? The coronavirus crisis and the resulting unemployment means lower income tax revenue for federal and state governments. States are additionally feeling the sting of lower sales tax revenue since so many businesses were shuttered in March and April of this year. Plus, the federal government will end up spending trillions on coronavirus stimulus programs. The CARES Act alone has an estimated cost of $1.8 trillion.
The logical resolution for governments facing budget deficits is to raise taxes. And when taxes are poised to rise, deferring them in a 401(k) puts you at risk of paying more later.
Don't give up on your 401(k)
While prospect of higher taxes isn't great news for 401(k) savers, it's not reason enough to ditch your workplace plan entirely. Many 401(k)s are still funding employer match contributions, and you should take full advantage of those. Matching contributions can expedite your wealth production significantly. Say you make $70,000 annually and you're contributing 10%. Your employer matches up to 3%. After 10 years of investing at a growth rate of 7%, you'd have about $132,000 -- with about $30,000 coming directly from your employer match. You don't want to turn away that kind of cash.
Funds in your 401(k) are also protected from liens and creditors, which is a big advantage over taxable brokerage accounts.
Create nontaxable income streams
You can hedge against future tax increases by taking steps now to build nontaxable streams of retirement income. Do that by saving to a Roth account or a taxable brokerage account. Contributions to designated Roth accounts and Roth IRAs are not tax-deductible, but earnings grow tax-free and distributions in retirement are tax-free. Taxable brokerage accounts offer no tax perks. But if you pay taxes annually on realized gains, dividends, and interest, you can withdraw cash without tax implications.
For most savers, the best option is contributing to a designated Roth account if your 401(k) offers that feature. Check with your plan administrator. The designated Roth account is basically a subset of your 401(k); you'd elect to make after-tax contributions there, and then the funds are available for tax-free withdrawals later.
Your Roth deposits do count against the 2020 401(k) contribution cap of $19,500, or $26,000 if you're 50 or older. But there are no income limitations on these contributions.
If you don't have a designated Roth account, you can funnel cash into a Roth IRA as long as you meet the income requirements. Normally, IRA contributions are capped at $6,000, or $7,000 if you're 50 or older. But those caps start phasing out when your modified Adjusted Gross Income (AGI) is higher than $196,000 for married filers or $124,000 for single filers.
The last option is a taxable brokerage account, which does incur taxes year to year, but has no caps, restrictions, or withdrawal limitations.
Save in and outside your 401(k)
Even with the potential for rising taxes, keep saving in your 401(k) and earning your free employer match. But also protect yourself against future tax changes by building up your tax-free sources of retirement income. Having taxable and nontaxable income at the ready gives you flexibility to manage through any tax hikes that might come your way.