Should I max out my 401k? Should I Invest My Bonus for Retirement?

Put simply, people work most of their lives to meet current expenses, obtain certain goals, and hopefully enjoy retirement. For some, retirement means kicking back more in their later years and spending time with loved ones. It may also look like helping children and grandchildren with educational endeavors or making sure loved ones are taken care of by leaving behind an inheritance. For others, it means seizing the newfound time off (ideally when you’re as young as possible) and traveling more or enjoying activities time never before allowed. Individuals need to make sure they have enough saved to achieve their goal lifestyle.

22% of Americans Have Less Than $5,000 For Retirement

The ideology that people need to work now to retire comfortably later is well-accepted. Individuals who spend all their income without saving for the future typically don’t have a retirement foundation to lean back on later in life. That’s why it is so alarming that as many as 22% of Americans have less than $5,000 saved for retirement. As saving for retirement is so crucial, employers often sponsor investment vehicles referred to as qualified retirement plans. These plans are voluntary investment plans with pre-tax contributions deferred from your paycheck. Nowadays, a typical vehicle chosen by employers is a 401k. You can learn more about the basics of 401k plans in our previous blog, ‘401(k) Plans: Learn the Basics (alleghenyfinancial.com)’. Even though these plans are common, how much you should contribute to these investment vehicles now to be able to retire comfortably later isn’t common knowledge.

When Can I Retire?

One of the most common questions a financial advisor faces is, “When can I retire?” The most popular answer financial advisors give is, “It depends.” What does it depend on? Some of the important details an advisor would evaluate to determine a contribution rate include;

• Your income
• When you want to retire
• How much (if any) retirement savings you have
• What type of lifestyle you’d like to live in retirement

What if you and your financial advisor develop a projection and decide on a percentage, and you can’t meet that percentage? On the flip side, what if meeting that amount is no problem at all? Do you contribute more?

How Much Should You Contribute to Your Retirement Fund?

There seems to be an accepted financial rule that you will have enough savings for retirement if you contribute 15% of your annual income throughout your career. Depending on your time horizon and goals, that may be a sufficient rate. Nonetheless, for the reasons stated above, retirement contributions are not one-size-fits-all.

In 2022, the IRS updated the maximum deferral for 401ks to $20,500. If the participant is over age 50, a catch-up contribution of $6,500 is also allowed. In other words, to contribute 15% and max out at the $20,500 limit this year, you need to be making at least $130,000. If you make $68,700 per year, which is the average American income, contributing the maximum limit would represent approximately 30% of your salary. A contribution rate that high isn’t often obtainable for most individuals; yet, it also isn’t necessary for most of them. Due to the time value of money and compounding interest, the more time you have until retirement and the more you already have saved, the less you may have to contribute at the moment. With the same logic, if you are closer to your goal without a good savings foundation, you will have to contribute more to put as much money to work as possible. These are common discussions an advisor has with their clients, balancing priorities and resources.

When Should You Max Out Your 401k Employer Match?

Often, employers will match employee contributions up to a certain amount. Traditional 401ks are not required to offer a match, even though most employers choose to. However, matching is mandatory with Safe Harbor 401ks. If you don’t contribute enough to receive the full employer match, you lose out on “free” money. For example, if your employer offers a 6% match, meaning if you contribute up to 6%, your employer will also contribute 6%. But, if you only contribute 4%, you are missing out on 2% of funds from your employer. Thus, if financially able, contributing enough to receive the employer match ensures you’re not leaving any money behind on the table.

On the other hand, maxing out on your contributions may not always be in your best interest. If you’re struggling to meet expenses, have other financial goals or retirement vehicles, or if your 401k doesn’t have great options, dumping as much money as possible into this vehicle may not align with your overall goals.

Financial Considerations To Ask Yourself Before Maxing Out Your 401(k):

1. Do you have a cash reserve of three to six months of basic living expenses to serve as an emergency fund?
   How much should you have in an emergency fund? Again, it depends. Part of this answer is mathematical, while the other part is behavioral. First, we will address the variables. Seasonality of work, security of work, and income variability are all factors that affect an individual’s cash reserve. If your income stream is seasonal, insecure, or variable, a higher cash reserve is necessary. On the other hand, if you are used to receiving the same paycheck every two weeks, a higher cash reserve is less crucial as you can anticipate and plan cash inflows and outflows. Often, three to six months’ worth of expenses is recommended.
   
   Now, we address the behavior component. The point of holding a cash reserve or emergency fund is to offer investors a safety net and peace of mind. So, what amount are you comfortable having on the sidelines for yourself? With the current economy and higher interest rates, having an abundance of money sitting in cash isn’t smart. Checking and savings accounts earn around 0.01%, while inflation is sitting around 7.5%. Thus, your money is losing 7.49% sitting in the bank. However, if you have a cash need within the next 1-2 years or if you have an emergency fund, then the cash serves a purpose in your overall plan and portfolio. Any excess cash should be invested to earn a better rate of return and outpace inflation.
2. What do your financial liabilities look like? Do you have any loans?
   Car loans, student loans and other personal loans are all liabilities that need to be accounted for. Especially if your liabilities have high-interest rates, you do not want to sacrifice liability payments, which would impact your credit score, in order to max out on 401k payments.
3. What milestones are you looking to meet in the meantime? Would you like to buy a house? Get married? Have kids? Help fund their education?
   Retiring early isn’t very appealing if you are putting life on hold until then. Nevertheless, like most areas in finance and life, there is a balance. Referring back to the time value of money, you do not want to conquer all of your immediate goals than worry about saving for retirement later. You can take a loan out for education, homes, and most other shorter-term personal goals, but you can’t take a loan out for retirement.
4. Do you have insurance for your loved ones?
   In the unfortunate case you pass away young while you still have a lifestyle of expenses you are responsible for, insurance may be more valuable to your loved ones than a retirement vehicle. At death, the beneficiaries of your 401k are responsible for distribution taxes, just as the original owner would have been. An insurance death benefit is tax-free.
5. Does your 401k plan have attractive options and fees?
   It’s important that you understand what fees may be assessed on your 401k so you can make a fully educated decision. Check out the articles from Investopedia or the Department of Labor to learn more about how fees can affect your 401k: The Hidden Fees in 401(k)s (investopedia.com) or A Look at 401(k) Plan Fees (dol.gov).
6. Do you have outside retirement accounts you contribute to? Do you have a pension available to you?
   If you’re planning for retirement in other ways, maxing out your plan may be overkill. Instead, it’s about finding the amount to save that will allow you to live your desired lifestyle in retirement without having to scrape pennies and eat cans of tuna until then. An employee-sponsored plan is often not the only retirement vehicle individuals utilize. Some other common retirement vehicles include IRAs, Roth IRAs/401ks, SIMPLE IRAs, SEP IRAs, annuities, and pensions.
   

What Should I do with my Bonus?

Congratulations, you’ve earned a bonus! Suppose that your bonus isn’t calculated into your daily financial lifestyle. You may be asking yourself, “What should I do with my bonus?” First, refer to the above list. If you’re satisfied with your answers to the above, then you could use these funds to pay down loans or save for long-term goals. One of those long-term goals may be retirement.

A benefit of investing your bonus wages in a pre-tax retirement plan is potential tax reduction. How your employer chooses to pay out the bonus will affect your taxes. If your employer selects the percentage method, that means taxes are withheld at a flat rate of 22%. If the aggregate method is used, your employer issues your bonus with your regular salary. When bonuses are added onto standard wages, taxes are withheld at a higher rate as the additional money is now included in your income level. If your tax bracket shifts above 22%, you do not necessarily pay more in overall taxes. You will most likely see a larger refund when you file your taxes but would be walking away with less income (or bonus money) in your pocket. Further, your bonus may also be subject to state taxes; the withholding rate varies depending per state.

Final Thoughts

If your financial advisor is conducting comprehensive financial planning with you, they will be interested in your three types of capital. First is your Real Capital. This includes real estate, personal property, collectibles. Next is your Investment Capital. This is your savings, tax-qualified accounts like a 401k, IRA, or Roth IRA, and non-qualified accounts, including bonds, stocks, and mutual funds. Finally, your Intellectual Capital. This is important because it drives your earning power or your ability to add to your Investment and Real Capital in order to achieve your goals. For example, suppose we can understand and even support your education and career development in some way. In that case, we can help you increase your earning power, thereby helping qualify you for bonuses to apply towards your financial well-being.

Remember, while this article offers general principles to follow, your financial situation is independent to you and should be tailored to your goals. In other words, be sure to consult a CERTIFIED FINANCIAL PLANNER^TM practitioner to turn the “It depends” answer into “Here is a plan for you.”

Author: MaryKate Tobin | Planning Associate

Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered broker/dealer. Member FINRA/SIPC.