Free Money: Redefining “maxing out” and debunking retirement savings myths

First, to clear up a common misconception. “Maxing out” does not mean contributing enough to get the maximum company match. That’s a good start. But maxing out means contributing the maximum amount the IRS will allow for certain tax-advantaged retirement accounts. This article will focus on three types of accounts: 401k, Roth IRA, and Health Savings Accounts (HSA). Mr. Vine and I each max out all three of these accounts. But it wasn’t always this way. We fell victim to the fallacy that we didn’t need to max out these accounts and we had some excuses, too. Each of the accounts that we max out has certain eligibility requirements. The HSA in particular may not make sense depending on your family’s health care needs. As always, consider what will work based on your individual situation, but as a general, the more you can max out, the better off you’ll be.

The fallacy of saving “enough”

When Mr. Vine and I contributed just enough to capture our full employer match, we believed we were saving enough. Early retirement wasn’t on our radar at that point. Traditional retirement felt a long way off when our careers were just beginning. We were saving as much as, if not more than, our peers. It probably was true that we were saving enough for traditional retirement at the time, but our savings wasn’t keeping pace with our incomes and ages. This fallacy also assumes that we would be happy working until our sixties. It also assumed we’d be able to work until traditional retirement age. The truth is that we never know what the future holds. Although we’ve been fortunate to have our health so far, there’s no guarantee that will continue. More savings always creates more options. Always.

Excuse: “I can’t afford to save $18,000 per year”

The reason most people give this excuse is that they’ve allowed lifestyle inflation to consume their potential savings. Recently, a family member started a new job that came with a significant pay raise. This family member was already making a comfortable salary, so the increase wasn’t strictly necessary to pay the bills. This struck me as the perfect opportunity to increase retirement contributions. Assuming no high interest and consumer debt, taking full advantage of 401k and Roth retirement accounts can have an exponential effect on savings growth.

This excuse is based on the fear that saving more will affect lifestyle. Increasing 401k contributions are a great way to save more without feeling it quite as much. A 401k is pre-tax savings. This gives you a discount on the savings based on your tax rate. You’re putting away $18,000, but it only feels like $13,500 (assuming the 29% tax bracket). Another benefit to 401k savings is that it decreases taxable income. This can help you stay below the income limits so you can also contribute to a Roth IRA.

Mr. Vine and I, like our family member, felt like the IRS maximum was an impossibly large figure to save. So we comforted ourselves with the fallacy of saving enough and increased our contributions by 1% each year.

After I finished grad school and started working full time, Mr. Vine and I made an early commitment to  contribute the IRS maximum to our 401k plans as soon as we were eligible with our employers. It’s something I wish we had done much earlier. Because we made such a big savings increase at a time when our income made a huge jump, it didn’t feel like much of a lifestyle shift (hooray for beating lifestyle inflation!). This is precisely why a job change can be the best time to make this step.

Our family member is another example. She said this pay raise provides an extra $400-500 every month. If that’s her take home pay increase, the gross (pre tax) increase is probably higher. Putting an extra $600 per month, over and above the 401k contributions she was making at her previous job, would probably get her to the IRS maximum. Depending on what she was contributing before, she might not even be able to put her full pay increase into her new 401k. Once the tax savings are accounted for, she is now contributing the IRS maximum to her savings without any perceptible change to her lifestyle. She’s also capturing any available match dollars, too. This money won’t be missed, but it will make a huge difference as it grows and compounds over time.

If you’re not in the situation to have a big pay raise that comes along with a new job or adding an income, you can still get to the maximum through incremental change. We are terrible budgeters. But we are great at tightening the belt when we need to. Making a big increase in your 401k contributions can help reel in unnecessary spending. Because of the pre tax, payroll deducted nature of a 401k, it feels like a pay reduction that requires a reduction in spending.

We first tracked our spending and made a “budget”. Our budget was an average of what spent on fixed and variable expenses to identify the amount of our surplus. Once we knew the amount of the surplus, we knew how much we could contribute to savings. Increase 401k contributions by an amount roughly equivalent to that surplus.

If, like us, you know you’re spending too much on restaurants, will it help if you increase your 401k contributions and therefore reduce your available income? The key is to start today. Are you currently saving 6%? Make it 16%. The next quarter, bump it to 26%. Keep doing this until you reach the IRS limit. Incremental changes should be frequent and large enough to make a difference. Adding 1% of your income annually is not bad, but it’s not as helpful as adding 5-10% each quarter (or as frequently as your plan administrator allows changes). Incremental changes, coupled with adding any found money, such as bonuses and raises, decrease the discomfort of a sudden lifestyle adjustment.

Excuse: “I’m saving for my kids’ education”

The best gift a parent can give their children is not to become dependent on the children. There is financial aid for college, but there is no financial aid for retirement. And, as burdensome as student loans can be, they are taken on during the beginning of a career. At that time, we have the greatest control over our earning potential (and a high degree of choice about how much debt to assume). This is not true of retirement–which may come inadvertently and unexpectedly due to a layoff or illness.

Mr. Vine and I don’t have kids, but also contribute the IRS maximum to Roth IRA accounts. Whenever there is a limitation on how much you can put away in a savings plan, that’s the first clue it’s good for you. We use these programs to their maximum advantage. Just like an employer match to your 401k, the operative word in tax free savings is FREE! A Roth IRA is funded with post tax dollars, but all of the gains are tax free.

Because a Roth IRA is funded by post tax dollars, these contributions can be withdrawn, penalty free, at any time. Although not necessarily recommended, this money can serve as a true emergency fund or could pay for the kids’ education. If there is extra surplus leftover after fully funding these tax advantaged retirement accounts (401k and Roth IRA), then by all means, add another taxable account to your portfolio to cover the education.

Tax advantaged retirement savings accounts feel like one of the few ways the government helps a working person build wealth. The sad truth is that most working people are underutilizing this amazing benefit.

Health Savings Accounts

HSAs have eligibility requirements where the contributor must be enrolled in a high deductible health care plan. Mr. Vine and I are fortunate to be pretty healthy. We don’t spend a lot on health care and we don’t visit doctors often. The HSA as an early retirement vehicle is very attractive to us. It’s one more way we can reduce our tax liability and hedge against rising health care costs. We timed our contributions to these accounts to coincide with our annual raises and bonuses. Like a 401k, this is deducted from our paycheck, pre-tax. We each contribute the annual maximum, but haven’t experienced any noticeable reduction in pay. That’s because our post tax new salaries are pretty close to what our salaries were last year, without the HSA contributions.

The bottom line is to automate as much of your savings as possible. Time contribution increases to coincide with pay increases. It will be less painful than you think and the rewards will be abundant when you watch those account balances grow.

What are your excuses for not matching out tax advantaged retirement accounts? Have you overcome those excuses? How?

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