Tax-Exempt Retirement Contributions and the Bucket Analogy

Here, I am continuing my prior post and other writings. Even though I am financially competent, tax-exempt retirement accounts are complex and I have only just discovered that Roth 401(k)s, which have only been available since 2006, actually have different contribution limits from Roth individual retirement accounts (IRAs; which have been available since 1997). Before, I had incorrectly thought that the combined limits between the two were $5500. Actually, the limit for a Roth IRA is $5500 per year (under Age 50) and for a Roth 401(k), an additional $18,000 (under Age 50; increasing to $18,500 in 2018). For Americans Age 50 and above, the limits are $6500 and $24,000 (the latter increases to $24,500 in 2018), respectively. Although I work for a university on a stipend (not fellowship) consisting of earned income via an assistantship (graduate teaching associate), I did not discover until recently I can contribute to a 403(b), the non-profit equivalent of a 401(k), in addition to a Roth IRA.

For the uninitiated, Roth accounts require you to have earned income for which you pay income tax now, but in retirement (above Age 59.5), all capital gains taxes are waived. There are also a few other situations such as medical expenses, education expenses, and first-time home-buying that allow you to make withdraws with waived capital gains taxes before Age 59.5. Depending on your tax bracket when the withdraws are made, under the new 2018 tax laws, your capital gains tax (which would be long-term due to investments being held over one year) could be 0%, 15%, or 20% depending on your income, but most likely 15%.

Roth 401(k)s can only be contributed to via employee contributions, which come out of your paycheck. Notably, your contribution is tax-exempt while any employer matching funds are tax-deferred like with a traditional 401(k). Employers usually have retirement programs with companies such as Fidelity whereby employees can pick a percentage of their pay to contribute. Roth accounts are especially applicable to low-income workers (i.e., in the 12% tax bracket) because they might be in a higher tax bracket at Age 59.5+, so tax exemption benefits them more. However, even for those with higher incomes, capital gains can far outstrip the initial contribution over many decades. Furthermore, anyone who has cashed out a U.S. savings bond knows the IRS gives no consideration to inflation when calculating the unearned interest income derived forthwith. Monetary inflation is also not considered for capital gains, which is a reason tax-exempt accounts are especially valuable.

Roth IRAs can only be contributed to via a person with earned income setting up one on his/her own, such as with Vanguard. Employers cannot offer Roth IRAs. Those with earned income can contribute up to $5500 per year to Roth IRAs, tax exempt, in addition to contributing up to $18,000 to a Roth 401(k) if their employer offers one.

Both traditional and Roth retirement accounts are wrappers for other types of investments. You could put your money in a money market account or certificate of deposit, bonds, or equities. Over long time periods (e.g., 15+ years), stocks are the best of these three types of investments. You can change how your retirement fund is invested at any time. Many financial advisers advocate for putting most of your money in an index fund of the S&P 500 or whole U.S. stock market while young, with a transition toward bonds as you near retirement, which offer less risk of loss but less potential for gains.

Sadly, both traditional and Roth retirement accounts grossly favor the wealthy and well-informed, perpetuating wealth inequality. Most Americans cannot being to approach the $18,000 annual limits on 401(k) contributions. Many do not even have an emergency fund. Wages are too low and expenses too high for them to contribute anywhere near $5500 per year to an IRA, as well. Nonetheless, every year that goes by is a missed opportunity to contribute, because there is no “catching up” on prior years’ annual contribution limits (besides being allowed to contribute for a prior year up until tax day—even after you have filed your taxes for Roth IRAs).

The ideal way to build wealth would be to contribute annually to your IRA as follows, and to your 401(k) too if you have the funds available:

Full annual contributions

However, even financially savvy Americans do not typically have enough money available to put $5500 in their IRAs nor $18,000 in their 401(k)s per year. If they are above-average, their contributions might look like this:

Varying partial annual contributions

However, the rules to withdraw retirement monies are complex and fraught with taxes and penalties. Most Americans cannot say with assuredness that they won’t “need” thousands of dollars until Age 59.5+. Contributing to a retirement account only to cash it out a few years later is common, often with penalties. Even without penalties, such behavior harshly perpetuates wealth inequality because there is no way to put the piggy bank back together after hammering it open (i.e., one cannot withdraw money and then make up for this later, and taking a loan from your retirement account comes with unsavory fees). Consequently, the statistical mode for American retirement contributions is as follows:

No annual contributions

Stocks go up and down. When we look at this S&P 500 chart from Wikipedia, it is clear that one could invest at a market peak and be upside-down for many years:

66-year S&P 500 chart

However, being invested over a long duration of time results in a near-guarantee of returns that exceed money market accounts, certificates of deposits, or bonds. Without thinking about tax-advantaged retirement accounts, one would think that late-bloomers to retirement saving can simply catch up by putting in a lot of money now. However, the annual contribution limits for these accounts, shown through the imagery of buckets, prevent late bloomers from catching up. Although one can contribute the maximum per year starting now, there is no way to go back and contribute for prior years—even at current market levels. Therefore, the typical American suffers the double whammy of missing out on tax-exempt or tax-deferred retirement savings and market gains. This situation is insufferable.

Updated 2018-01-30 to note graduate assistants can contribute to a 403(b) and to note $500 increase to 401(k) annual contribution limits in 2018.

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