The Truth About Retirement Contributions: Debunking Common Misconceptions

As traditional pension plans become less and less available, employer-sponsored retirement plans that allow employees to contribute a portion of their earnings have become extremely popular. These include 401(k)s, 403(b)s, 457(b)s and 401(a)s. Employers have marketed these plans as an alternative to pensions, offering greater flexibility and control, but the plans have also become more complicated. 

When we meet with clients to figure out an ideal strategy for their student loans, we often discuss the benefits of contributing to their employer retirement plans. During these discussions, we often uncover common misconceptions that prevent many from understanding the full value of these retirement accounts. 

By understanding and avoiding these misconceptions, you can take advantage of your employer’s retirement plan to boost your retirement savings, lower your taxes and lower your student loan payments while still enjoying life today.

1. My employer doesn’t offer a match, so I don’t participate, or I only contribute up to my employer's match

As an incentive for employees to contribute to their retirement plans, many employers offer matching contributions. For instance, if they match up to 4% of your salary, and you contribute 4%, they will match your entire contribution, effectively doubling it. Because this is free money, employers place a lot of emphasis on the match to sell employees on participating. So it’s no wonder that many professionals see the employer match as the primary benefit of their retirement plans. 

Although an employer match is wonderful if offered, there is still much to gain from your employer retirement plan without it. Whether there’s a match or not, many of you will benefit from contributing, especially if you have student loans. This is because you’re allowed to make pre-tax contributions, which lowers your federal and state income tax owed. Once you invest your contributions, the investment growth will be tax-deferred, meaning you will not be taxed until you withdraw the investment earnings.

Related: What Physicians Should Do With Retirement Accounts From an Old Employer

Here’s how it works

Let’s say a pediatrician living in Illinois is making $200,000 a year, and she is married to a software engineer making $100,000 a year. They are in the 24% marginal federal income tax bracket, which means that every dollar they make above $190,751 is taxed at a rate of 24%. Illinois has a flat income tax rate of 4.95%. 

They are on an income-driven repayment plan for their federal student loans, with their annual payments equal to 10% of their income. Because 10% of their income is being paid to the federal government via their student loans, it is like they are in a 39% combined tax bracket, all in. 

So, if they each max out their retirement plans for a total of $45,000 contributed, they would save $45,000 x .39 = $17,550 in reduced taxes and student loan payments each year.  Let’s say their loans will be forgiven in 20 years, and they earn an average of 5% a year on their contributions. By the time their loans are forgiven, they will have $1.5 million in their retirement accounts, and they will have saved $351,000 in taxes and student loan payments. 

For higher-income borrowers living in higher-tax states, the savings are even greater. For example, suppose a surgeon living in California is making $450,000 a year, and his wife manages the home. They are in the 32% federal tax bracket and the 9% California tax bracket. Including the 10% of their income going to his student loan payments, it’s like they are in the 51% tax bracket! 

Although both of these couples will pay taxes on withdrawals from these retirement accounts when they are retired (the IRS still wants their money!), they will, in all likelihood, pay a much lower tax rate on that money than 39% or 51%, respectively, after they are no longer working.

2. My employer retirement account is the best savings vehicle for me, and I don’t need to save anywhere else

After understanding the immense value that employer retirement accounts have in helping you build wealth and reach financial independence, it might be easy to shift from undervaluing your employer plan to putting all your eggs in one basket. It’s important to understand the limitations of employer retirement accounts. 

Most employer retirement plans don’t allow you to access your funds before leaving your job unless you have an emergency financial situation. Even after you leave your job, any withdrawals before the age of 59 1/2 will be subject to a 10% early withdrawal penalty in addition to the normal taxes owed on all your withdrawals. 

Now, this may not be a problem if you save 39% to 51% in taxes and student loan payments on the way in, and you withdraw the funds during a low-income year. You could end up taking out money in a lower federal tax bracket, say 12%, and then eventually 22%. If your state tax rate is 5%, you’d pay a total of 12% + 5% + 10% = 27% in taxes on your initial withdrawals and then 22% + 5% + 10% = 37% on subsequent withdrawals. 

Taxable brokerage account

For any money you might need before age 59 1/2, it might be better to contribute to a taxable brokerage account. You’ll owe taxes each year for any interest or dividends earned, as well as capital gains taxes as your holdings go up in value, but you can access your funds at any time for any reason. 

What if you’d like to retire well before age 59 1/2? What if you want to take extended time off and spend more time with your family while your kids are young before returning to work? A taxable brokerage account could make these goals possible so you can wait to tap into your retirement account until after the 10% penalty goes away.

Roth IRA

You also might want to contribute to a Roth IRA. Roth IRAs have the opposite benefit of your employer retirement account. You don’t get any tax savings on the front end when you contribute, but all investment earnings are tax-free. Along with the taxes saved, having a tax-free source of retirement income provides a hedge in case tax rates increase in the future. 

You can contribute up to $6,500 a year (as of 2023) to a Roth IRA. If you make more than $153,000 as a single person or $228,000 as a married couple, you are not allowed to contribute to Roth IRAs. To get around this limitation, you would need to utilize the Backdoor Roth strategy. 

Some employers allow Roth contributions to your 401(k) or 403(b) as well. Not only do other investment accounts outside of your employer offer their own unique advantages, but they also allow you to save more than the $22,500 employer account annual max contribution. This might be necessary for many of you to enjoy your desired standard of living in retirement, given your higher potential life expectancy and the uncertainty around Social Security benefits.

3. I’m contributing to my 401k, but I want to start investing my money

When people say this, I have to tell them they’re already investing in their employer retirement account. It may be that people don’t consider their employer accounts to be investing in the same way they would if they opened their own accounts elsewhere because they’re limited to the investments chosen by the plan administrator. 

It is true that employer retirement accounts usually don’t give you access to speculative investments like individual stocks, individual real estate properties and private equity. But they offer traditional stock market and bond mutual funds that provide diversification across the market. Although not as sexy, a passively managed, broadly diversified portfolio will likely outperform stock picking over time. 

Due to the lack of track record, buying trendy investments like crypto or NFTs is pretty much the same as gambling. That’s not to say you should never purchase these speculative investments, but your employer retirement plan likely offers quality investment options that provide a foundation for a prudent long-term investment strategy. In fact, many employers offer a self-directed brokerage account option that allows you to purchase any retail investment offered by the plan’s custodian (Fidelity, Vanguard etc.), including individual stocks.

4. Retirement accounts are risky, and I can lose my money, so I shouldn’t contribute

Some people who realize that employer retirement accounts are for investing may shy away from them because they're concerned about losing their money. It doesn't mean that you must invest in the stock market through your retirement account just because you can. 

If you want to keep your money in safer investments like bonds and money market accounts, you can invest in those within your employer retirement account but still benefit from the tax and student loan savings from your contributions. 

However, if you don’t need the money for a long time, you should consider taking on some risk in the stock market. Although you’re likely to experience volatility and market crashes over shorter periods of time, stocks tend to outperform safer assets over longer periods. This is because the stock market is made up of companies that raise money from investors and are committed to using that money to grow and increase profits. 

If many of these companies continue to innovate and become more profitable, there’s a good chance that economic booms will outweigh economic busts over long periods of time, and that will reflect in their share prices. 

A diversified portfolio of mutual funds allows you to invest in hundreds or even thousands of these companies, so you’re betting on the U.S. economy overall without picking winners and losers. As long as you don’t need to pull your money out during an economic downturn, you can hope to ride out the dips and make money over the long term.

Bringing it all together

In a world where retirement savings can seem daunting, employer-sponsored retirement plans offer a beacon of hope — it’s an important but sometimes underappreciated aspect of your benefits package.

By understanding and avoiding these misconceptions, you can take advantage of your employer's retirement plan to boost retirement savings, lower taxes and student loan payments, and still enjoy your desired standard of living in retirement.