When Not To Make Pretax 401K/Retirement Contributions

Patrick Cote |

BY: PATRICK R. COTE CFA, CFP®

The general investment advice is to contribute the maximum amount to a pretax 401K every year in order to save for a more comfortable retirement. 
However, there are three situations in which investors are better off using other savings tools instead, such as a Roth IRA, a Roth 401K or even a taxable brokerage account in a given year.  These situations typically occur when the tax rate today is lower than what the investor is likely to pay in the future:

  • Business owners with household income around $364K coming from pass-through entities (e.g., LLCs and S corporations) – often service professionals, such as physicians or attorneys.  The goal is to maximize the QBI (qualified business income) deduction of 20%, also known as the 199A, which only applies to pass-through income.  Getting the QBI deduction at an income of $364K brings their top IRS marginal income tax rate down to only 19.2% today, which is very low by historical standards.  If business owners make additional pretax contributions now to further lower their income below the $364K level, it might cost them more in the long run if they withdraw their retirement money in the future at a time with much higher tax rates.
  • High earners with an unusually low-income year.  This can include people leaving the workforce to go to graduate school, workers taking a sabbatical or others taking time off between jobs.  If your income is much lower in a given calendar year, a Roth conversion should also be considered.
  • Workers expecting to receive Social Security and 401K/IRA RMDs (required minimum distributions) soon.  While each person’s calculations are different, many people who continue working into their 70s can see a significant boost in taxable income from Social Security and the RMDs from all of their pretax retirement accounts.  In their late 60s, some folks are better off not continuing to increase their pretax 401K or cash balance/defined benefit plans, because they may end up paying a higher tax rate later in retirement!

 

While in the situations above, we show how some folks will be better off using other vehicles beyond pretax retirement accounts to save for their future, the bottom line is that saving for retirement is encouraged for everyone.  

If you have any questions about your own particular situation, please feel free to reach out to us.