I was working with an older gentleman who was going to be turning 68 later this year, and begin working next month, so he came to me with questions about enrolling in the 401k plan. He was curious as to what the contribution limits were, investment choices, and so on. So, I explained how the plan works, and that he can contribute up to $20,500 this year since he is over 50(the 401k limit 2013 is higher now), that there was a 5% employer match on contributions with a 3 year vesting period.
He seemed quite interested, and he said he would certainly contribute the maximum for the next few years, and planned on working more than 3 years so he would also vest the matching funds. But, before he could commit to anything, he wanted to check with his accountant, which is perfectly normal.
The Accountant Says No
He called back and said his accountant said he should not enroll because he is only a few years away from turning 71 1/2 and being required to take required minimum distributions. Wait a second, let’s back the truck up. This is the first red flag. For one, active employees can delay their RMD from their current employer’s qualified plan. So, as long as he was still working, he would not have to take an RMD from the 401k.
Using the RMD as a basis for this decision, the accountant also said it would create an unnecessary tax burden. Well, that could be true if you took a lump sum distribution, but an RMD for each year would be just a small amount based on life expectancy. This relatively small distribution would result in a small tax burden. But again, it is a moot point since he wouldn’t have to take the RMD until finally retiring for good.
What He Could Have Gained by Enrolling
From what I knew of his situation, he planned on maxing out the plan this year and for the next 4 or 5 years while still working. He is also at the highest tax rate. So, assuming contribution limits remained the same for the next five years, he would have contributed $102,500 on a pre-tax basis over the next five years. That would mean saving nearly $36,000 in taxes over the same period.
And just to factor in a few years of modest returns on the investment, let’s assume he kept the money in something conservative that made 4% annual returns over the same period. That would bring his account value to around $115,500 after five years. That is another $13,000 in interest/gains. And let’s not forget the company match, which would easily be a few thousand each year, probably giving him somewhere around $10,000 in free match money.
When you combine the tax savings and returns on the money, he is essentially missing out on nearly $60,000. While this may not seem like much to someone who is making $400k a year, it is still throwing money away for no reason.
Even if the RMD Applied
Assuming the RMD did apply to the situation, he would still have 3 years of contributions to make before needing the RMD. So, in those 3 years he would have still saved over $20,000 in taxes during those years. Then when the RMD kicked in, the first RMD based on this account value alone, would only be a little over $3,000 the first year. Taxed at the 35% rate, that is about $1,000 in taxes. So, his accountant basically told him that it is better to give up tens of thousands just to save a couple thousand in taxes that the RMD (which really doesn’t even apply) would cause.
Would You Find a New Accountant?
I have informed the person about the issue with the RMD, and I’m not sure if he will take that back to his accountant or not and change his mind. Even without the RMD issue, it still seems like with just three years of maximium contributions, he could have still delayed a large tax burden into the future when it is likely he would possibly be in a lower tax bracket (although depending on how the election turns out, who knows). Based on all of this, would you find a new accountant?
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
