I consider it an inevitable misfortune that conversations about investing begin and end with “what should I invest in?” An unsophisticated questioner might mean “what stocks do you think will go up?” while a sophisticated one means “what should my allocation be to low-cost stock and bond ETF’s?” but both questions skip over the much more important question: how much are you saving?
Pre-tax savings are cheap
You can pay a financial advisor to game out different tax regimes and withdrawal scenarios, but there’s nothing complicated about calculating your tax savings when you make traditional 401(k) and IRA contributions: every dollar you save reduces your taxes by your marginal federal and state income tax rate, and this is true in every marginal income tax bracket.
In the 10% income tax bracket, putting $6,000 into a traditional IRA saves you $600 to do with as you please. You can then save the $600, if you like, but you don’t have to: you can use it to pay down credit card debt, pay rent, buy a Nintendo Switch, whatever you please!
When I talk to people about their 401(k) or 403(b) contributions, they often balk when I say they need to set their contribution to $1,625 per month in order to maximize their annual contribution. How are they going to get by with $1,625 less per month in salary? They’re going to get by because a $1,625 contribution doesn’t cost them anything close to that much. In the 22% federal income tax bracket and with a 10% state income tax, it barely costs them $1100.
And, to return to the point, this is true regardless of what they invest in.
There is no such thing as a catch-up contribution
I detest imprecision in speech, which is why I call the Retirement Savings Contribution Credit the RSCC and not the Saver’s Credit and why I call the Earned Income Credit the EIC and not the EITC. The way I see it, imprecision in speech usually reflects imprecision in thought.
One of the most offensive such imprecisions is the conceit of the “catch-up contribution.” In 2020, people over the age of 50 enrolled in either employer-sponsored or individual 401(k) plans can contribute an additional $6,500 per year in employee contributions, for a total of up to $26,000, and an additional $1,000 to IRA’s for a total of up to $7,000. If able, they should certainly do so.
This bonus pre-tax savings capacity for over-50’s is referred to universally as a “catch-up contribution,” on the premise that those who failed to save enough earlier in life should be given a chance to make up their missed savings opportunities.
But this is absurd, since the amount of the “catch-up” contribution has no relationship to the amount by which a saver has “fallen behind.” For those wealthy enough to save the maximum amount in pre-tax accounts throughout their working life, it’s a windfall, while those who struggled to save anything at all are unlikely to find an extra $7,500 per year in income to defer in their last few years before retirement.
Use it or lose it
Personal finance gurus love to talk about giving your investments as much time as possible to compound, with their smoothly rising charts that inevitably look silly in the midst of capitalism’s periodic crises.
Forget all that for a moment: the reason to contribute as much as possible each year to retirement accounts is that once that year’s contribution deadline has passed, you have permanently lost the ability to shield that year’s contribution from taxes.
If you don’t know what to invest in, save anyway
In recent years there has been a half-hearted movement to channel savers into simplified, lower-cost investing vehicles. I don’t hold this movement in very high esteem, but it has certainly had some successes: allowing auto-enrollment into 401(k) plans, allowing automatic increases in contributions, and allowing automatic allocation into so-called “target retirement date” mutual funds.
But fortunately, it doesn’t matter very much. In constant-dollar terms (i.e., removing annual inflation adjustments), someone saving $19,500 per year between age 22 and 50, and $26,000 per year between age 50 and 67, will have accumulated $988,000 in savings even if their savings do not earn any interest at all.
Conclusion: hitch the savings horse before the investment cart
At the end of the day, investing for high-income, white-collar professionals is pretty boring: the only question is, how rich do you want to be when you die? If you want to be really rich, you can take on a riskier investment portfolio, and if you’re content with being only somewhat rich, you can happily dial back your risk. The stakes are essentially non-existent.
My point is that even poor, low-income people like me, with no advice whatsoever, and taking no risk whatsoever, can also die rich, not by maximizing their investment performance, but by maximizing their savings performance. Invested entirely in cash (not an allocation I would recommend!), a pre-tax saver will still see their 401(k) and IRA balances steadily rise over the course of their working life, while happily taking advantage of both an annual tax deduction and, for low-income savers, the RSCC.
I agree – the key is savings, much more important than the nuts and bolts of investing.
Re: imprecision in language, consider using “high income” rather than “wealthy” in the sentence “For those wealthy enough to save …” I live in a world with many high income, not wealthy people. I would argue that savings is what turns people into wealthy people, and I agree completely that savings is much more painless when one is high income.
You may be surprised to see how many “high income” people do NOT max their contributions early, and actually use the “catch up” literally to catch up. Also, there are “middle income” people who don’t max contributions early, who panic at age 50 when they realize they have missed an opportunity and also start “catching up” (but agree – this is often too little too late.)
I’m curious to hear your perspective on the “nudge” of auto enrolling workers and why you have little respect for it. For the military, it has improved savings rates and account balances, and can be adjusted by those who don’t want to participate.
ArmyDoc,
I’ve worked with a lot of high-income people, and a lot of wealthy people, which is why I expressed myself the way I did: high-income people are not particularly good at saving, and in fact in my experience it’s almost impossible to convince them to do so. Wealthy people are great at saving and don’t require much encouragement at all (although they are typically terrible at picking their investments and advisors). The principle function of tax-advantaged retirement accounts is and has always been to allow wealthy people to move their taxable investments into tax-shielded accounts.
My point about “catching up” is simply that it is not true: you are entitled to make so-called “catch-up” contributions whether or not you made contributions before age 50, and the amount of your “catch-up” contribution isn’t linked to the amount by which you fell short earlier in life. If everyone gets an identical increase in maximum contribution, the increase by definition isn’t linked to the amount by which one “fell short” or needs to “catch up” later in life, so that’s an absurd and inaccurate way to describe the increased contribution cap.
Re: “nudges,” I simply don’t think voluntary workplace-based savings vehicles are a realistic method of ensuring a dignified retirement. I don’t have any objection to people saving money, but universal social insurance programs are the only method ever conceived that has actually reduced elder poverty, and they’ve been phenomenally successful. The more we attempt to shunt earnings into investment vehicles, the more precarious retirement income will become, however effective those attempts are, because it makes income in retirement contingent on one’s personal saving rate and investment decisions, and no one’s dignity in retirement should be contingent on their personal saving rate and investment decisions, because people are terrible at saving and investing!
—Indy
The money shot really is “when I say they need to set their contribution to $1,625 per month in order to maximize their annual contribution…. it barely costs them $1100”
If program like TurboTax/Mint.com would help show the estimated (or last year’s) tradeoff, I think more people save. It’s nice to see what my marginal rate of taxation is, but making that information meaningful and actionable makes a lot of … cents.