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How to Make the Best of Your 401(k) Plan

TOP - May 2015, Vol 8, No 2 - Financial/Insurance Information
Lawrence B. Keller, CFP, CLU, ChFC, RHU, LUTCF
Founder of Physician Financial Services.
W. Ben Utley, CFP
Lead Advisor, Physician Family Financial Advisors.

We see a number of changes you might make to improve your financial security, but one item is usually beyond your control: your 401(k) plan. Unless you are self-employed, there is practically nothing you can do if your 401(k) has limited investment options, low contribution limits, or tax consequences.

If your 401(k) is your main (or maybe your only) investment vehicle for retirement, we have good news for you: It is possible to work around your 401(k) plan’s limitations so you can get on track toward retirement.

1. Low Limits

You may be operating under the mistaken belief that, if you max out your 401(k) plan contributions, you will be all set for retirement. Pharmacists, nurse practitioners, and physician assistants should strive to save 20% of their gross income toward retirement—starting the day they begin working. For example, a pharmacist earning $100,000 should strive to save $20,000 annually. But did you know that the maximum amount of money you can elect to defer into your 401(k) this year is only $17,500 ($23,000 if you will be aged 50 years or older by December 31)?

Although it is true that if you start early, you can save less, saving 20% provides flexibility for years where you may not be able to save as much, to allow for poor investment returns, or for a personal or financial catastrophe such as divorce or disability. If all goes well and none of these scenarios materialize, then you will be left with a wonderful choice: retire earlier or retire wealthier.

Using the Rule of 72, it is easy to calculate approximately how long it is going to take for your money to double. You just take the number 72 and divide it by the interest rate you hope to earn on your investment. Therefore, assuming a 6% rate of return on your investment, your money will double in 12 years.

Another rule of thumb often used by financial planners is that you can safely withdraw about 4% of your nest egg each year of retirement. This rule says, in essence, that you must save about 25 times your annual expenses, or that you can withdraw approximately 4% of your portfolio in the first year of retirement and then adjust that amount for inflation each year, with little chance of running out over a 30-year retirement.

To improve your odds of reaching your retirement goal, you can save outside your 401(k) plan. Even if you cannot deduct the contributions you make to a traditional IRA, you can still contribute $5500 this year ($6500 if you will be aged 50 years or older by December 31), and if you max out your own IRA, your spouse can also contribute up to $5500 to his or her IRA ($6500 if he or she will be aged 50 years or older by December 31) even if he or she is not earning an income.

Depending upon your tax situation, it might also make sense to convert these contributions to a Roth IRA, doing what is known as a “backdoor” Roth IRA contribution. Once the money is in a Roth IRA, it can grow tax-free for the rest of your life. Of course, this still might not be enough to allow you to retire comfortably, so you should consider investments outside of your 401(k) plan and IRAs.

2. Limited Options

You probably haven’t read the fine print behind your 401(k) plan, but you are betting that your employer or human resources department has carefully vetted both your 401(k) plan provider and the investments offered inside your plan. Don’t rely on it!

If your plan charges more than 50 basis points (0.50%) on top of mutual fund operating expenses, your plan’s costs are draining an unfair share of your retirement savings. To get this under control, you need to review your plan carefully.

It’s more common to see an investment lineup consisting mostly, if not entirely, of actively managed mutual funds. At a time when most prudent investors recognize that passively managed index funds have been shown to have delivered better results at a lower cost than the average actively managed fund, there’s no good reason that your plan should continue to limit you to subpar investment options.

To work around these issues, look at your retirement investments holistically. Think about your 401(k) plan, your traditional IRAs, and your after-tax accounts (mutual funds and brokerage accounts), as if they were all 1 “retirement portfolio.” Then use the best investment options available in your 401(k) and pair them with the best options available within other accounts that make up the balance of your portfolio.

3. Tax Time Bomb

You already know that you pay more than your fair share of taxes. But did you know that you are probably setting yourself up to pay more taxes on your 401(k) than you really should? That’s right. There’s a perverse little wrinkle in the tax code that can turn your 401(k) plan into a tax time bomb.

To understand this trap, you need to know a little bit about how investments are taxed. Withdrawals from your 401(k) plan will be taxed at your marginal income tax rate, which may be as high as 39.6% for federal income tax. At the same time, capital gains and qualified dividends from mutual funds held in taxable accounts outside your 401(k) plan are taxed at a maximum federal rate of 23.8% (which is 20% plus the new 3.8% Medicare surtax).

This means that your 401(k) nearly doubles the tax rate you pay on capital gains and qualified income by effectively converting these tax-favored returns into tax-trapped ordinary income. Consider holding equity mutual funds in a taxable account, or better yet, own them in your Roth IRA or the Roth subaccount of your 401(k), if you have one.

If your 401(k) is a lousy place to stash your stock funds, what should you hold there instead? Consider low-growth, income-producing investments, including bond funds and stable value funds. If you have an appetite for more aggressive fare, consider high-yield (“junk”) bond funds or emerging market bond funds. Outside your 401(k) plan, these investments may be taxed at your highest marginal rate, so it’s a good idea to protect their income by keeping it inside the tax shelter of your 401(k) plan.

Again, the best workaround for this tax trap is to view your entire retirement portfolio—including your 401(k) plan, your IRAs, and your other accounts that are earmarked for retirement—as 1 portfolio. Choose to own the best investments in the accounts that make the most sense from the standpoint of expense, risk, return, and taxation.


Even if your 401(k) plan has limitations, you can still make the best of the situation. All you have to do is take a look at the big picture, think outside the box, and make smart moves to put yourself on track for a solid retirement. Since there are many variables that need to be taken into consideration, you may even want to consult with a Certified Public Accountant and/or financial advisor to help you make decisions based on your specific situation.

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Last modified: July 22, 2021