Your 401k plan is a lot more complex than most people realize. Many plans in the industry have sensitive rules around your employer match.
-If your employer only contributes their portion IF you’re making contributions, make sure you stretch your contributions throughout the entire year.
-Make sure you switch your contributions to after-tax after maxing out regular contributions.
-Baker Hughes 401k and other Oil & Gas companies have 401k plan rules that require you to actively monitor and change your contributions throughout the calendar year to maximize your employer’s match.
Internal Revenue Service Code Section 401(k).
That little blip in our tax law was, at its origins when Congress passed it in 1978, just that: a little blip.
In fact, when it was finally implemented into law in 1980, no one acted on it. This continued until Ted Benna, a Benefits Consultant from Pennsylvania, studied the new section in our tax code and suggested it to a client of his. The client rejected the idea, thinking it was crazy. In fact, when the Philadelphia Inquirer wrote about Benna’s findings, the newspaper received hundreds of calls from people claiming the strategy had to be illegal! You can learn more about it’s fascinating history here.
Benna eventually convinced his own company to adopt the plan. They did. The IRS soon clarified that it was perfectly legal and they allowed salary reductions to fund 401(k) plans.
Fast forward to today, and we have trillions of dollars invested in 401(k) plans. For the vast majority of Americans working white collar jobs, the 401(k) has become their greatest source of wealth and financial freedom.
The first few years of the vehicle was incredibly simple. You had a little bit of your paycheck sent to the 401(k) and maybe 2-3 investment options.
Well, that is not the case today. As a result, if you have a high income and significant matching from your employer, it’s essential to understand how to utilize your 401(k) best.
For some of you, making these simple changes could give you an extra $500,000 when you’re 60. How did I get there? Missing out on your full benefit could be costing some of you $12,000 per year (for some, that’s a low estimate). If you’re 40, and you want to retire at 60, $12,000/year earning 7% annualized for 20 years is over $500,000.
Let’s dive in.
Understanding today’s 401(k)
First, let’s understand the language we’re speaking. 401(k) plans, oddly enough, are not universal in their rules and structure. This is different than IRAs. If you have a Traditional IRA, the same rules govern it regardless of which investment firm you hold it at. 401(k) plans have most of their rules, investment options, etc. decided by the HR department of your company. In other words, it’s almost like there are 20,000 different 401(k) plans. What are your investment fund options? Can you take loans? Are you allowed to make Roth or after-tax contributions? This, and about 20 other questions, are decided by your company when they set up the plan.
In spite of this, there are still basic boundaries that the IRS stipulates that all 401(k) plans must operate inside of in regards to how they are funded. Let’s walk through them.
401(k) Funding Rules
-$19,500: Your contribution limit for 2020. The IRS refers to these dollars as “elective deferrals” because you are electing to defer your paycheck to the 401(k) and get to decide (in most plans at least) whether you do so on a pre-tax or Roth basis. As many of you know, this is not the total 401(k) limit. In fact, you can put almost 3x this amount in your 401k every year.
-$6,500: If you’re over 50, this is the “catch-up”
-Company match: If you’re reading this, you probably work at a large Oil company with a substantial match. Your company can go above and beyond the $19,500.
-After-tax: A lot of people miss this. After you max your first two options and receive your company match, you can still put in after-tax money. If your plan has separate accounts for Roth 401(k) and pre-tax 401(k), they likely allow you to convert this after-tax money to your Roth each year. Even if they don’t, you can roll it to a Roth IRA whenever you leave your employer and/or become eligible to do so.
–You can have a total of $57,000 ($63,500 if over 50) go into your 401(k) each year.
Here’s where your opportunity is
Many employer plans require you to keep track of and take action on your contributions to collect the full company match and utilize the after-tax option.
Take Baker Hughes, for example.
Let’s pretend you have a $225,000 salary with a $75,000 bonus paid in March. If you contribute 10% to your 401(k), you’re going to surpass the elective deferral limit of $19,500. Because your bonus pays in March, you’re going to hit the limit sooner than you think.
In Baker Hughes 401(k) bylaws, your contributions do not automatically switch to after-tax once you reach your pre-tax or Roth $19,500 limit. So, your contributions stop. Even worse, the company match does not pay out unless you are making some form of a contribution (pre-tax, Roth, or after-tax).
What’s the result? In this scenario, you might reach your $19,500 limit in July. For the last 12 paychecks of the year, you didn’t contribute anything to after-tax AND you missed out on ~$5,000 of free company match.
Apache is even more sensitive. The Apache plan does not allow any after-tax contributions, so you need to monitor your contribution rate and try to schedule your personal contributions to not max out until December. Similar to Baker Hughes, Apache doesn’t match if you’re not contributing.
Chevron has an ideal structure. The company allows pre-tax, Roth, and after-tax contribution. They break down your contributions into basic and supplemental. A basic contribution is 2% of your paycheck in any from (pre-tax, Roth, after). A supplemental is anything above 2%. Chevron matches 4% on your first 1% and 8% on your entire basic contribution of 2%. More importantly, when you reach your contribution limits, Chevron will automatically adjust your contribution to a basic 2% after-tax contribution to ensure you receive the company match. Ultra high-income employees may want to be careful not to contribute too much to ensure they reach the full IRS limit later in the year and get as much company match as they can. Employees making under 200k may want to monitor when they max out their elective deferrals to potentially contribute more than 2% after-tax.
Solution: Monitor your plan throughout the year. If you max out the $19,500 elective deferral, manually login or call the plan’s 800# and switch your contributions to after-tax. Make sure you’re not contributing too much too early and max out the entire plan in October with $57,000. If you put too much of your own money in, then the company isn’t able to contribute theirs. In other words, our hypothetical example should not contribute 20% of their income because they’ll hit the $57,000 max way too early and lose out on free company dollars. However, if we amend my previous example (~$300,000 income) to $120,000, but this person also has a spouse with a similar income, you may want to save 20%-25% of your income, max it out, and do as many after-tax contributions as possible.
Simply put, make sure you or your advisor understands the bylaws within your 401k plan. If you’re missing out on part of the company match and your after-tax opportunity, you are leaving money on the table.
Where does your 401k fall in order of the most important places to save?
Well, because of the free money (company match), maybe it’s #1, but let’s take a nuanced look at it. Before ranking your potential places to save and invest, I’m a big fan of paying off consumer debt and building an emergency fund. I’m also writing this in April of 2020 and I run a wealth management firm tailored to Oil & Gas professionals. So, 6-12 months of an emergency fund can be necessary with the volatility this industry faces. Ok, now to the point–here’s where you should save.
HSA. Your HSA gets the same tax advantage as your pre-tax 401k (it lowers your taxable income immediately). But wait! There’s more! Your HSA grows tax-deferred and, as long as your future distributions pay eligible medical expenses, you get to take it out tax-free. So, max out your HSA, do not spend it on your current medical expenses, and invest it for the long-term.
401k elective deferrals ($19,500). If you (& your spouse if you file a joint tax return) have a substantial income, you probably need to choose pre-tax and lower your income now. There are situations where you may want to choose Roth if you’re in the 24% bracket (for example, you’re 55, already have a 1.5M pension and 1.5M in your 401k, and you make $275,000/year). In that case, you have substantial pre-tax assets already, and it may be worth building some future tax diversification and choosing Roth contributions. However, if you’re in the 32% tax bracket (my 275k example is still in the 24% bracket if he/she is married), it’s very likely that pre-tax is in your best interests. Remember, we can always build a Roth conversion plan in the early years of your retirement when your income is lower.
Roth IRA/Backdoor Roth IRA. At this point, you have maxed out all of your pre-tax savings vehicles. For many in Oil & Gas, you have a higher income than most and/or your spouse works as well. So, after you’ve alleviated your current tax problem as much as possible with pre-tax vehicles, the Roth IRA is where you want to focus next. If you make more than $193,000 (married joint), you’ll have to utilize a backdoor Roth contribution.
After-tax 401k. For #4, we go back to the 401k. You’ve already maxed out your pre-tax or Roth contributions in step #2. Now, you want to utilize the after-tax contribution. Why is this so valuable? In some 401k plans, you can actually convert your after-tax contribution to Roth every year (Anadarko’s 401k allowed you to do this). Many plans don’t have this yet, but I would not be surprised if they add it in the near future. Even if they don’t, storing up after-tax 401k funds can be valuable because whenever you leave your company, you can roll them to a Roth IRA. This is why I refer to this step as a “mega backdoor Roth” contribution.
After-tax brokerage account. If you have some goals you’re saving for in the near-term, #5 may be higher on the list. Be careful how you invest in your taxable brokerage accounts as they do not have a tax shelter. So, you want to focus on low turnover funds without a substantial tax impact.
529 College Plan. This is not #6 for many. I put it last with a caveat–this fits in somewhere between #3-#5 depending on how many kids you have and how much you want to contribute towards their education. College savings should not happen unless you are on track with your own investments. College can be funded with a loan. If you’re 62 and your company decides they want to lay you off, your living expenses cannot be funded in the same manner.
To wrap it up, your 401k is more complicated than you realize. For many in Oil & Gas and Petrochemicals, you should be maxing it out. But, it’s critical to have an advisor that understands your particular plan and how to maximize your investments, your future tax situation, and the employer match.
If you’d like to learn more about how the various employer-specific 401k rules apply to your employer and situation, you can schedule a time for a conversation here.