Finances

401(k): Why It’s Your Most Profitable “Employee” & How to Optimize It

By Ken Krivacic, OD, MBA

Sept. 15, 2021

If you read the title, and wonder why I equate an employee with a 401(k), I’ll explain. First let’s discuss the basics of a 401(k) plan. Most of us reading this article probably have and know what a 401(k) plan is, but let’s review a brief history.

What is a 401(k)?
Named after a section of the Internal Revenue Code, 401(k)s are employer-sponsored defined-contribution plans that give workers a tax-advantaged way to save for retirement. The 401(k) plan was started when Congress passed the Revenue Act of 1978, which included a provision that was added to the Internal Revenue Code – Section 401 – that allowed employees to avoid being taxed on deferred compensation. Employee funding comes directly off their paycheck and may be matched by the employer.i

What are the Advantages of a 401K?
• You can deduct your 401(k) contributions from your tax return in the year that you make them.
Perhaps the biggest advantage of a 401(k) is the ability to defer taxes on your contributions into the 401(k) plan. Taxes on investment earnings are also tax deferred. For most people this is helpful because the tax rate we will have at retirement should be lower than the current rate as an employee.

How does this work in the real world? Let’s say as an employed optometrist, either by another entity or your own company, you are paid $100,000 and you defer the $19,500 that is the current maximum allowed in 2021, your taxable income is then reduced to $80,5000 for the year. Your income would put you in the 22-24 percent tax bracket depending on whether you are filing single or married and would result in a savings of $4,290 single or $4,680 married. Also, if you are at least 50 years old at any time during the year, you are now allowed additional pre-tax “catch up” contributions of up to $6,500 which would save an additional $1,320 to $1,440 in taxes.

• A 401(k)-employer match can help you grow your account even faster.
Some employers offer a company match to the amount you contribute. Essentially this is free money and should be taken advantage of. The matches are usually a percentage of your salary with a dollar-for-dollar match up to a certain amount. A common example is a 50 percent match up to the first 6 percent you contribute to the 401(k). It is the model we used in our office. Let’s say, as to our previous example, our doctor has a $100,000 salary. If the doctor contributes 6 percent of their annual earnings ($6,000) to the 401(k), the employer would contribute an additional 50 percent of that amount. That’s $3,000 of free money. Take advantage of that.

• High contribution limits
You can save much more each year in a 401(k) than in an IRA. For 2021, the 401(k) contribution limits are $19,500 and $26,000 (includes a $6,500 catch-up for those age 50 and older), respectively.
Your employer can contribute, too. In 2021, the contribution limit goes up to $58,000, or (with the $6,500 catch-up) $64,500.

• Contributions after age 72
If you are not working after you turn 70 then you must begin making distributions from your accounts by April 1 of the calendar year after turning age 70+1⁄2 or April 1 of the calendar year after retiring, whichever is later. For individuals who turn age 70+1⁄2 after December 31, 2019, distributions are required by April 1 of the calendar year after turning age 72 or April 1 of the calendar year after retiring, whichever is later.

If you decide to work past age 72 then there are benefits to the 401(k) plan that are not available with other retirement accounts. You can continue to contribute to these for as long you’re still working. Even better, while you’re working, you’re spared from taking mandatory distributions from the plan provided you own less than 5 percent of the business that employs you. If you like working, at that age and with the amount of funds that should in your account, your balance will grow faster than earlier. This is due to the large amount already invested and provided your earnings remain constant.

• 401(k)s offer protection from creditors, including the IRS, in some cases.

• Roth 410(k)s are ideal for high earners who aren’t eligible to contribute to a Roth IRA and for people who expect to be in a higher tax bracket in retirement. Keep in mind that Roth 401(k)s are still subjected to required minimum distributions (RMDs) post age 70½ or 72. To avoid RMDs on Roth dollars, it’s best to transfer those assets into a Roth IRA before RMD age.

So, back to my original statement, how it is a 401(k) plan like a good employee? A good employee comes in to work every day and makes the practice successful by generating more income than they are paid in salary. Also, a good employee will stick with you in the lean times and the good times. Finally, a good employee wants to make you happy. If used properly, your 401(k) plan will do all those things.

I’m in my mid-sixties and did not start contributing to a 401(k) plan until I was in my mid-thirties. There have been larger gains in the account over the past 10 years than the first 10 years. This is due to the magic of compound interest. You can also see that in the example below. In the example below, the first 10 years shows a gain from $0 to $307,780 yet the last 10 years shows again from $$1,233,356 to $2,695,619 for a total of $1,462,263. This large gain is again the magic of compound interest.
See the chart below:

Age Salary Balance Interest Yearly savings Desired retirement income Pension income Year ending balance
30 $100,000 $0 $0 $19,500 $0 $0 $19,500
31 $100,000 $19,500 $1,365 $19,500 $0 $0 $40,365
32 $100,000 $40,365 $2,826 $19,500 $0 $0 $62,691
33 $100,000 $62,691 $4,388 $19,500 $0 $0 $86,579
34 $100,000 $86,579 $6,061 $19,500 $0 $0 $112,139
35 $100,000 $112,139 $7,850 $19,500 $0 $0 $139,489
36 $100,000 $139,489 $9,764 $19,500 $0 $0 $168,753
37 $100,000 $168,753 $11,813 $19,500 $0 $0 $200,066
38 $100,000 $200,066 $14,005 $19,500 $0 $0 $233,571
39 $100,000 $233,571 $16,350 $19,500 $0 $0 $269,421
40 $100,000 $269,421 $18,859 $19,500 $0 $0 $307,780
41 $100,000 $307,780 $21,545 $19,500 $0 $0 $348,825
42 $100,000 $348,825 $24,418 $19,500 $0 $0 $392,743
43 $100,000 $392,743 $27,492 $19,500 $0 $0 $439,735
44 $100,000 $439,735 $30,781 $19,500 $0 $0 $490,016
45 $100,000 $490,016 $34,301 $19,500 $0 $0 $543,817
46 $100,000 $543,817 $38,067 $19,500 $0 $0 $601,384
47 $100,000 $601,384 $42,097 $19,500 $0 $0 $662,981
48 $100,000 $662,981 $46,409 $19,500 $0 $0 $728,890
49 $100,000 $728,890 $51,022 $19,500 $0 $0 $799,412
50 $100,000 $799,412 $55,959 $19,500 $0 $0 $874,871
51 $100,000 $874,871 $61,241 $19,500 $0 $0 $955,612
52 $100,000 $955,612 $66,893 $19,500 $0 $0 $1,042,005
53 $100,000 $1,042,005 $72,940 $19,500 $0 $0 $1,134,445
54 $100,000 $1,134,445 $79,411 $19,500 $0 $0 $1,233,356
55 $100,000 $1,233,356 $86,335 $19,500 $0 $0 $1,339,191
56 $100,000 $1,339,191 $93,743 $19,500 $0 $0 $1,452,435
57 $100,000 $1,452,435 $101,670 $19,500 $0 $0 $1,573,605
58 $100,000 $1,573,605 $110,152 $19,500 $0 $0 $1,703,257
59 $100,000 $1,703,257 $119,228 $19,500 $0 $0 $1,841,985
60 $100,000 $1,841,985 $128,939 $19,500 $0 $0 $1,990,424
61 $100,000 $1,990,424 $139,330 $19,500 $0 $0 $2,149,254
62 $100,000 $2,149,254 $150,448 $19,500 $0 $0 $2,319,202
63 $100,000 $2,319,202 $162,344 $19,500 $0 $0 $2,501,046
64 $100,000 $2,501,046 $175,073 $19,500 $0 $0 $2,695,619

In the chart we assume several things:

1) You contribute consistently every year

2) No matches were included. Had matches been included, the final amount would be much larger

3) No fees were included. Had the fees been included, the amount would have been lower.

4) A 30-year 7 percent yearly return. How do I arrive at that figure? The stock market since 1926 has averaged a 10 percent per year gain. If we look at the years 1957 to present, that average is 8 percent. Yes, you may have some bad years in there, but 30 years being a long time tends to average out the gains.

Final Thoughts
• Consistent saving is key to a successful retirement plan.
• Always be sure to contribute enough to a 401(k) to qualify for matching contributions from your employer.
• Be wary of the underlying costs and fees of the various investments within your retirement plans.
• No matter where you are in your career – start saving now.

References
i. Wikipedia

Ken Krivacic, OD, MBA, practices at Las Colinas Vision Center in Irving, Texas. To contact him: kkrivacic@aol.com.

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