Optimizing Your 401(k) for Retirement with Drew Jones

[00:03:59] Dean Barber: It’s very rare aside from teachers and government employees to have pensions. There are a handful of companies that still offer them. But for the most part, with the advent of the 401(k), most companies have gone to the idea that, “We’re going to provide a platform for you to save into. We’re going to make a match of your contributions to some fashion and then you decide how you want to invest.” In other words, the onus of getting it right goes right on to the individual, the employee.

[00:04:32] Drew Jones: Absolutely.

Dollar-Cost Averaging

[00:04:33] Dean Barber: It was sad back in 2008 when we had a market that fell by over 50%. The saying on the street was your 401(k) just turned into a 201(k) because it was cut in half. People didn’t understand the amount of risk that they had in there. If you’re a young person who is just starting to put money into a 401(k), you’re dollar-cost averaging, That means you’re buying it wherever the share price is on every time a deposit gets made into that 401(k). The ups and downs of the market early on shouldn’t really make a difference.

[00:05:05] Drew Jones: It’s more of a benefit to a younger person. They’re buying less when the market is high and buying more when it’s low to average it out.

[00:05:15] Dean Barber: Right. In long-term scenarios, dollar-cost averaging works. It’s been proven time and time again. If you don’t understand what dollar-cost averaging is, just Google it and check it out. That’s how you figure it out. There are a lot of great examples of what dollar-cost averaging is, but that’s not why we’re here today. Here’s the thing with the 401(k) for retirement, Drew. This will be the largest asset that most people ever accumulate but it’s almost impossible.

Optimizing a 401(k) for Retirement from a CERTIFIED FINANCIAL PLANNER™ Professional’s Perspective

There’s some technology that comes along that’s made it possible to a much higher degree but it’s been very difficult for a CERTIFIED FINANCIAL PLANNER™ professional to integrate the management of that 401(k) for retirement into a person’s overall financial picture. Let me just sort of paint a picture. From a CERTIFIED FINANCIAL PLANNER™ professional’s perspective, how do you approach this?

So, let’s say that we have somebody that wants to come in and talk about their overall financial plan. They want to get a plan put together so that they can get to retirement. They want to do things like buy a second home. The vast majority of their money is inside of their 401(k) plan, which is going to have limited investment choices and limited ability to trade or make changes without some significant restrictions most of the time. How do you address that in the overall plan?

Risk Assessments

[00:06:39] Drew Jones: Well, whenever you’re putting together this plan, it’s important in this stage to get a risk assessment on someone. Whenever I talk about a risk assessment, there are those kinds of questionnaires out there that talk more about kind of, “How did you feel when you’re investing in the market?”

We take a risk assessment and look at it from a dollars and cents standpoint. So, if I have this much money, what am I willing to potentially risk to gain? That’s kind of a starting point is to get somebody’s level of risk in their comfort level. I’ve seen quite a few times where somebody has a lower risk score, but whenever we plug the 401(k) holdings into that software, it’s saying something completely different.

Realizing How Much Risk You’re Taking in Your 401(k)

[00:07:30] Dean Barber: It happens all the time. I think that that’s where the disconnect is for a lot of people. They don’t know really how much risk they’re taking with inside their 401(k). And as that 401(k) gets larger and you get closer to retirement, you need to pay attention to that. But how do you integrate that into the plan? That’s the deal, right? Let’s say that somebody comes in and they’ve got $1 million, and $700,000 of it’s in the 401(k) and there’s $300,000 that the CERTIFIED FINANCIAL PLANNER™ professional can influence or manage.

There is technology that we’re using as we speak to help people manage those 401(k)s for retirement. The technology allows us to create the allocation models and do those types of things to actively go in and make the trades for them. But again, there’s limited choices. So, do you start with the limited choices that are within the 401(k)? Let’s go back to risk assessment to understand the ideal allocation for the individual. Then, we peer into what’s inside the 401(k) that we can utilize to fit that and then build the peace outside of it so that it goes around the 401(k). Is that kind of how you do it?

[00:08:35] Drew Jones: Right. It’s going back to the plan, their goals, when that person wants to retire, and age of that person that determines some of the things that you might look at as an alternative to what stays in the 401(k) or if you’re eligible to roll the 401(k) out to an IRA.

How Do You Determine the Right Asset Allocation?

[00:08:57] Dean Barber: Some companies have what’s called an in-service distribution. That allows somebody to roll money out at a certain age even if they continue to work for that company. If they do that, they still get to make contributions. They’re still in the company match and all that. So, how do you determine the right asset allocation?

[00:09:16] Drew Jones: Great question. So, you’ll determine the wants, wishes, and needs of somebody’s plan and you’re marrying that with sources of income and the 401(k) and everything that they might have saved outside of that. It’s an important to do the risk tolerance questionnaire as well. But once you put all the puzzle pieces into this financial plan is whenever you can see what type of return you possibly need within the model to deliver the results or what you want to see happen in retirement.

[00:09:49] Dean Barber: So, based on the resources that an individual has and what their future goals are, you want to identify what the money need to do for them to accomplish those objectives.

[00:10:02] Drew Jones: Absolutely.

The Highest Probability of Success with the Least Amount of Possible Risk

[00:10:02] Dean Barber: Then, you can go in and build the asset allocation model that, from a historical perspective, gives them the highest probability of achieving that return with the least amount of risk possible.

[00:10:10] Drew Jones: Correct.

[00:10:11] Dean Barber: If somebody comes in and they’ve got a risk score that says, “Hey, I’m a moderately conservative investor,” yet you’re saying the moderately conservative portfolio isn’t going to get you the returns you need so we’re going to have to talk about some trade-offs, right? A, you got to save more or, b, you’re going to have to work longer.

[00:10:30] Drew Jones: Right.

[00:10:31] Dean Barber: Or, c, we increase the risk in the portfolio in an attempt to get a better rate of return. Once you can have those intelligent conversations with people and they can see what the difference is there, then they can start to make a better decision on how should the money be allocated inside that 401(k) for retirement.

The 401(k) Match

So, let’s talk a little bit about the match on the 401(k). It’s going to be different company-by-company depending upon what their plan document says. But most companies out there that offer a 401(k) have some sort of a matching element to that. So, explain the match.

[00:11:12] Drew Jones: So, the match is whenever you’re brought on board. It’s more of a perk to get employees. It’s an added benefit to working for the company. The match is basically saying you contribute so much and we’ll kick in a certain percentage of what you’re saving as well. It kind of ties you with the company. They’re kind of going back to our analogy of the three-legged stool where you had the pension, Social Security, and what you saved. You’re saving for retirement now, but the company is kind of helping you get there, too.

The Math Behind the Match

[00:11:46] Dean Barber: Right. So, A company might say, “Look, we’ll match you 50 cents on the dollar for the first 6% that you contribute. That’s pretty simple math. If you could put 6% into your 401(k), there’s going to be a total of 9% of whatever your compensation is that’s going to go into the 401(k) because the company is going to match 50 cents on the dollar.

There are some more generous companies out there that do a dollar-for-dollar match up to 4%. Some of them do a dollar-for-dollar match up to 6%. Those are very generous matching contributions. In the matching contribution side of that, you can identify it on your 401(k) statement. They’ll say, “Here are your contributions, the company’s matching contributions, and the value of each one of those.” That’s designed to get people to understand that the company has done more for them than just providing a job. They’re actually helping to fund their retirement.

Roth vs. Traditional 401(k)s

I want to switch gears a little bit and discuss the different types of 401(k)s. Most people have an option between doing the traditional 401(k) and Roth 401(k). There’s a big difference between the two. There are times when people should be doing the Roth 401(k) and there are times when people should be doing the traditional 401(k). So, first, I want you to explain what’s the difference between the traditional 401(k) and the Roth 401(k).

[00:13:16] Drew Jones: The Roth 401(k) is after-tax dollars going into the Roth portion. The employer match will still go to a traditional 401(k), whereas if you’re just doing all traditional 401(k), all that money is going in pretax. That money going in pretax has never been taxed. So, once you start to take that money out is whenever you will pay that tax.

The Roth Is Tax-Free Income in Retirement

[00:13:48] Dean Barber: How does the Roth work?

[00:13:50] Drew Jones: Whenever you’re putting that money in after-tax, it’s sitting there growing. When you retire, though, and pull that money out, there is no tax paid on it.

[00:14:01] Dean Barber: So, your Roth 401(k) becomes a totally tax-free source of income in retirement, while your traditional 401(k) will become a fully taxable source of income in retirement.

[00:14:14] Drew Jones: Right. When we’re talking about Roth 401(k)s and the importance of them versus the traditional 401(k), I use a simple analogy. In retirement, when you have that money in a Roth 401(k) and pull that money out, you pull a dollar out and you’re going to get that dollar assuming that you meet all the specific requirements. But with the pretax or using traditional 401(k), when you take that dollar out, you’re probably going to net $0.70, $0.75 on that dollar by the time you pay those taxes.

How Social Security Comes into Play

[00:14:45] Dean Barber: Right. And there’s another a distinct advantage to the Roth 401(k) that revolves around how money is taxed in retirement. One of the things that helps us make a decision on whether a person should be doing Roth or traditional is understanding how much their Social Security is going to be and when they plan on claiming that Social Security. Distributions from a Roth IRA don’t count as provisional income when it comes to determining how much of your Social Security is going to be taxable.

In other words, let’s say that somebody had $50,000 of combined Social Security and they’ve got $100,000 in withdrawals coming in from the Roth IRAs. How much tax will that person pay?

[00:15:35] Drew Jones: Zero.

How Will the Distributions Play Out?

[00:15:36] Dean Barber: Zero. Because Social Security by itself is not taxable and Roth 401(k) distributions are not taxable. Roth 401(k)s don’t show up as part of the formula that determines if any of your Social Security should become taxable. So, there’s a huge benefit there. When people are comparing whether to do traditional versus Roth, they can’t just look at traditional versus Roth. They need to look at how the Roth or traditional distributions are going to play out. How are they going to play with all the other sources of income that a person might have in retirement?

[00:16:12] Drew Jones: Absolutely. And That goes back to the importance of having that overall plan in place. If you just do a Google search for, “Should I do Roth 401(k) versus traditional 401(k)?” the most basic answer that you’re going to get is like, “Try to predict where you think you might be tax-wise in the future.” Well, that’s really no help to anybody because that very basic information doesn’t know the specific person that’s sitting in front of a computer typing it in.

Two Hypothetical Scenarios with Choosing Between Traditional and Roth

[00:16:39] Dean Barber: Right. I’ll give you two examples of deciding between traditional and Roth.

Someone Right Out of College

Let’s take somebody that’s fresh out of school, gainfully employed, and signing up for a 401(k) to get on track for retirement. We’re not going to use one of these funds where they get to pick your investments. We’re going to teach you how to pick the right investments. When you’re first in that job for the first eight to 10 years, you’re probably going to be in the lowest tax bracket you’re ever going to be in your life. So, the tax deduction for the traditional 401(k) doesn’t make any sense at that point in time. They should be putting 100% of their contributions into the Roth portion of that 401(k) to give that tax-free growth decades to compound.

Someone in Their Peak Earning Years

And you flip that around and you’ve got somebody that’s 55 years old. They’re in their peak earning years. Let’s say the combined family income is now $125,000. Well, they’re up in one of the higher tax brackets out there. Let’s also further assume that this couple has done a good job of saving some money outside the 401(k). Their house is going to be paid for when they go into retirement and their living expenses are going to be far less when they go into retirement because they will have no debt.

Now, that individual should pile it all into the traditional 401(k) because the tax deduction that you’ll get today at the high tax brackets that you’re in will be substantial. And then once you retire, we roll that to a 401(k), and we’ll do methodical year-by-year Roth conversions, staying in on a 12% to 22% bracket. If we could defer it in a 32% bracket and then convert it to a Roth IRA in a 12% bracket for the first five to eight years of retirement, suddenly you’ve won that game. You got money into the Roth at a much lower tax rate.

Gaining Clarity and Confidence through the Guided Retirement System™

[00:18:50] Drew Jones: Absolutely. That’s why it’s important to have that plan in place and run those simulations. Some of the neat stuff about some of the software that I use is you can see the impacts of staying under those brackets. What does it do whenever I compare it versus doing nothing at all? How much more do I pay in tax by not doing the Roth conversions?

[00:19:11] Dean Barber: When you’re creating a financial plan for somebody using our Guided Retirement System™, you can show the difference in the future results if you save into a Roth versus if you save into a traditional, and then it’s right there in black and white.

[00:19:30] Drew Jones: Absolutely. Yeah.

[00:19:32] Dean Barber: And it’s like, “This is a no-brainer.” We can back it up with data that says why you should be doing the traditional or the Roth. Yet the vast majority of people are guessing. It’s hard to fathom the lack of education when it comes to what a person should be doing. Most people working in H.R. are like, “I don’t know. You choose. It’s not my decision.”

What Your Friend or Coworker Does with Their 401(k) for Retirement Might Not Work Best for You

[00:20:02] Drew Jones: Yeah. A lot of people that may be coming in for the first time might be getting advice from the person in the cubicle next to them. I’m sure that coworker is a great person, but that’s not the person you want to take the advice from. That’s why you want to have a complete picture of what you’re doing for yourself.

[00:20:21] Dean Barber: We put together a really interesting piece called the 401(k) Survival Guide. It talks about a lot of those ins and outs of the Roth versus traditional and all of that. I would encourage anybody to get a copy of it.

I don’t think there’s a rule of thumb on how much should you contribute, whether you should do traditional or Roth, and what your asset allocation should be. There’s always been that rule of just owning your age in bonds. Well, that doesn’t make any sense. It’s like treating us all like cattle, and we’re not. We all have our unique financial situations that need to be looked at. And they need to be looked at by professional that understands what are the future implications of what you’re doing today.

Legacy Plays a Large Role

[00:21:16] Drew Jones: That’s something else that we also talk about a lot. With Roth conversions, it’s understanding the person’s wants, wishes, and needs. Oftentimes, legacy is important to people. There are all kinds of more reasons to open up a discussion about how important Roths can be with the SECURE Act. I also have a lot of conversations with clients where maybe the legacy to the kids isn’t that important. But what would happen if something were to happen to the spouse?

[00:21:49] Dean Barber: That’s a big deal. I don’t think a lot of people take that into consideration. But that’s one of the stress tests we do in the plan to see what happens if there’s an early demise of one of the spouses. How is that surviving spouse’s tax bracket going to change? That can then give us a lot of insight into whether we should be doing traditional or Roth. You can run stress tests on all kinds of different what-if scenarios to help you make the right decision on traditional or Roth.

Maximizing the Match

The minimum amount that you should be contributing to that 401(k) for retirement is the amount up to which that company will match. If that company will match up to the first 5%, the minimum amount you should contribute is 5%. If that company will match up to 8%, the minimum amount you should be contributing is 8% because it’s free money that the company is willing to give you. You just have to put some of your own in first.

[00:22:49] Drew Jones: This kind of speaks to the younger people or the people watching that have kids or grandkids, and that would be to start early.

[00:22:56] Dean Barber: Absolutely. The day you start your first job, get in and sign up for the 401(k) to get yourself on track for retirement. Understand how much the match is and make sure that you’re contributing up to that match. Then, as you get raises, decide which portion of that raise you want to go into that 401(k) as well. The people that start saving early will wind up accumulating a heck of a lot more money because they have time on their side.

Beneficiary Designations

So, let’s go back and discuss a piece that gets messed up a lot. I’m talking about the beneficiary designation on the 401(k). How should the beneficiary designation be chosen and how should it be completed?

[00:23:41] Drew Jones: I guess we have to talk about what time in our life are we at.

[00:23:45] Dean Barber: Let’s just say that it’s the young person that’s getting ready to start. They’re starting their job. Go with them first.

[00:23:53] Drew Jones: For a young person who isn’t married yet is going to want to put siblings or parents as their primary beneficiary. If anything were to happen to you, who do you want 100% of this money to go to?

Don’t Just Put Your Estate as the Beneficiary

[00:24:12] Dean Barber: And it can go in percentages. If you have five siblings, you can split it between them at 20% each. I’ve seen a lot of scenarios over my 35 years in this industry where people will just put the estate of Drew Jones. Well, what does that do? Suddenly, the estate of Drew Jones doesn’t have a life expectancy. That’s not even a real thing.

All the money has to come out of that 401(k) immediately and it becomes taxable. And then who decides where the money goes? Probate courts. Don’t ever do that. Don’t ever put the estate of yourself as the beneficiary. Your beneficiary forms on your 401(k) should be reviewed those at least once a year to make sure that it is exactly what you want.

Having a Trust as a Beneficiary

Now, let’s say you want to have a trust as a beneficiary. You’re older and trying to control the wealth distribution down to children and grandchildren, and so you might want a trust to do that. So, you need to make sure that your trust qualifies as a see-through trust. Can it receive those 401(k) dollars and then distribute them amongst the ultimate beneficiaries? If it doesn’t qualify as a see-through trust and that trust is the beneficiary, that trust has no life expectancy and all distributions of IRAs and 401(k)s are based on life expectancy. That could cause the entire amount to be taxable immediately. If you get divorced and remarried, these things require you to go back and address that beneficiary form as well.

[00:25:53] Drew Jones: Yeah. I’ve seen situations like that where we’ve been doing reviews of outside accounts and maybe there’s just a fresh divorce. Sometimes you will still see the ex-spouse as the primary beneficiary even though they may have remarried or not together at that point. So, that’s a big issue to your point of reviewing every year to make sure that you keep that as clean as possible.

Keep Your Beneficiaries Up to Date …

[00:26:17] Dean Barber: Here’s another caveat. This is an area that you’re not going to get from your 401(k) administrator or H.R. department. This example will be familiar to those who have listened to a court case that happened and people that have listened to The Guided Retirement Show episodes with Ed Slott. He’s considered America’s IRA expert. I’ve studied with him for over 15 years and sat on his advisory board for a number of years.

One of the court cases that we were going through maybe four years ago involved an individual whose spouse had passed away. He did the right thing when the spouse passed away by putting his three adult children as a third, a third, a third, as primary beneficiaries on the 401(k).

… Or Things Could Get Messy

But about five years later, he met a new woman and got remarried. Six months after he was remarried, he dropped dead of a sudden heart attack. The children were still named as primary beneficiaries on the 401(k). It’s what he wanted. However, the new spouse of six months wound up getting 100% of the 401(k) because for the children to be named as primary beneficiaries, there has to be spousal consent. This was a new spouse that didn’t consent to the children being primary beneficiaries. So, by law, all the money in the 401(k) went to the new spouse of six months.

[00:28:21] Dean Barber: And he wouldn’t have known that. He wouldn’t even have thought to ask his H.R. department, but this was a huge one. We see this getting missed more than I want to mention, but this scenario went all the way to the California Supreme Court. The kids were fighting to try to get the money, and the court just basically said the rule is simple. Their dad didn’t follow the rules of the law. So, the surviving spouse of six months got all the money and didn’t care to share it with the three kids.

[00:28:58] Drew Jones: Oh, man.

Determining the Targeted Return You Need

[00:29:00] Dean Barber: Yeah. Money can do crazy things, but that beneficiary form is critical. You need to make sure that it’s done right.

So, I want to go back to really quickly your idea of helping people in their 401(k) to understand what kind of a targeted return do we need to get. And the only way you do that is by creating your well-thought-out written plan. The Guided Retirement System™ basically says, “Here are all the resources I have. Here’s my ability to save and what I want to have happen in the future. Based on all that, what’s the rate of return?”

And then you can come in as the CERTIFIED FINANCIAL PLANNER™ professional and say, “Based on the choices that you have with inside your 401(k), these are the allocations that are going to help you get that return with the least amount of risk possible.”

[00:29:50] Drew Jones: It’s obviously seeing what they have and knowing that asset allocation, what’s that rate of return, the risk in that rate of return, and then utilizing the asset allocation as it is.

Getting Your Questions Answered

[00:30:04] Dean Barber: When someones schedules a complimentary consultation with one of our CERTIFIED FINANCIAL PLANNER™ Professionals, they get to ask you questions. And you get to ask them questions and have them think about things that maybe they didn’t think about before. It’s a way for them to understand what would it be like to get a chance to work with a CERTIFIED FINANCIAL PLANNER™ professional. All those questions can be answered in that complimentary consultation. So, talk a little bit about what that experience would feel like for a person.

[00:30:50] Drew Jones: Yeah. So, what we do is we walk through what we offer and how we do it here at Modern Wealth Management. We talk about the series of meetings, the way that we prioritize your goals, and we put people through a pretty fun exercise. We get a lot of information from people going through this priority exercise. When I say we marry what you have with what you want, this whole process helps in doing that.

Marrying Your Life with Your Money by Optimizing Your 401(k) for Retirement

[00:31:22] Dean Barber: I think of us marrying your life with your money and for a lot of times the very first time ever. Optimizing your 401(k) for retirement is a big part of it.

[00:31:27] Drew Jones: Right. Then, we’ll talk about the process and how we go through it. Again, we talk about the series of appointments so you know how we’re doing everything ahead of time.

[00:31:40] Dean Barber: And do you give them a look at what would the relationship look like in the future if they decided to engage with you?

Checking All the Boxes of Retirement

[00:31:46] Drew Jones: Correct. Yeah. We run through the reviews that we do and what we’re going to look at in each review. So, you know that checkbox is getting marked every year. It may be things like what we were talking about with looking at the beneficiaries—if you have got trust or estate plan in place, we’ll review that. Obviously, looking at the asset allocation in the plan is important, but just as important is the tax planning that we’ll look at year in and year out for clients.

[00:32:13] Dean Barber: Yeah. And in that complimentary consultation, would you do a risk assessment for somebody and then plug their stuff in to see if they match?

[00:32:21] Drew Jones: Exactly. That’s one of the things that we like to know is what’s your risk assessment? Like I said before, once we see their 401(k)s and can plug their 401(k) into the software, it’s saying something completely different. To your point of people that are getting closer to retirement, that is their biggest nest egg. So, you want to make sure that you are trying to get a good rate of return, all while taking the least amount of risk that you have to take to achieve all those wants, wishes, and needs.

The 401(k) Is a Complex Beast … Let Us Help You Understand How to Optimize Your 401(k) for Retirement

[00:32:54] Dean Barber: Absolutely. Well, Drew, thanks so much for joining me here on The Guided Retirement Show. The 401(k) is a complex beast. It does become one of the largest assets that people have and it’s really critical that they pay attention to all aspects of the 401(k) for retirement.

[00:33:06] Drew Jones: It truly is. Thank you so much for having me. I appreciate it.

[CLOSING]

[00:33:09] Dean Barber: I had a great time talking with Drew. There are so many questions that need to be answered. With your 401(k) being one of your largest assets, this is not something to leave to chance or to guesswork. So, schedule a complimentary consultation with one of my CERTIFIED FINANCIAL PLANNER™ professionals. Make sure that your 401(k) is getting all the attention that it needs so that one of these days, you can let your money work for you. That’s what I call financial independence.

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