Percentage of Pay vs Flat Dollar Amount

Retirement Contributions - Percentage of Pay vs Flat Dollar Amount

Enrolling in a company retirement plan is usually the first step employees take to join the plan and it is important that the enrollment process be straight forward.  There should also be a contact, i.e. an advisor (wink wink), who can guide the employees through the process if needed.  Even with the most efficient enrollment process, there is a lot of information employees must provide.  Along with basic personal information, employees will typically select investments, determine how much they’d like to contribute, and document who their beneficiaries will be.  This post will focus on one part of the contribution decision and hopefully make it easier when you are determining the appropriate way for you to save.

A common question you see on the investment commercials is “What’s Your Number”?  Essentially asking how much do you need to save to meet your retirement goals.  This post isn’t going to try and answer that.  The purpose of this post is to help you decide whether contributing a flat dollar amount or a percentage of your compensation is the better way for you to save.

As we look at each method, it may seem like I favor the percentage of compensation because that is what I use for my personal retirement account but that doesn’t mean it is the answer for everyone.  Using either method can get you to “Your Number” but there are some important considerations when making the choice for yourself.

Will You Increase Your Contribution As Your Salary Increases?

For most employees, as you start to earn more throughout your working career, you should probably save more as well.  Not only will you have more money coming in to save but people typically start spending more as their income rises.  It is difficult to change spending habits during retirement even if you do not have a paycheck anymore.  Therefore, to have a similar quality of life during retirement as when you were working, the amount you are saving should increase.

By contributing a flat dollar, the only way to increase the amount you are saving is if you make the effort to change your deferral amount.  If you do a percentage of compensation, the amount you save should automatically go up as you start to earn more without you having to do anything.

Below is an example of two people earning the same amount of money throughout their working career but one person keeps the same percentage of pay contribution and the other keeps the same flat dollar contribution.  The percentage of pay person contributes 5% per year and starts at $1,500 at 25.  The flat dollar person saves $2,000 per year starting at 25.

The percentage of pay person has almost $50,000 more in their account which may result in them being able to retire a full year or two earlier.

A lot of participants, especially those new to retirement plans, will choose the flat dollar amount because they know how much they are going to be contributing each pay period and how that will impact them financially.  That may be useful in the beginning but may harm someone over the long term if changes aren’t made to the amount they are contributing.  If you take the gross amount of your paycheck and multiply that amount by the percent you are thinking about contributing, that will give you close to, if not the exact, amount you will be contributing to the plan.  You may also be able to request your payroll department to run a quick projection to show the net impact on your paycheck.

There are a lot of factors to take into consideration to determine how much you need to be saving to meet your retirement goals.  Simply setting a percentage of pay and keeping it the same your entire working career may not get you all the way to your goal but it can at least help you save more.

Are You Maxing Out?

The IRS sets limits on how much you can contribute to retirement accounts each year and for most people who max out it is based on a dollar limit.  For 2018, the most a person under the age of 50 can defer into a 401(k) plan is $18,500.  If you plan to max out, the fixed dollar contribution may be easier to determine what you should contribute.  If you are paid weekly, you would contribute approximately $355.76 per pay period throughout the year.  If the IRS increases the limit in future years, you would increase the dollar amount each pay period accordingly. 

Company Match

A company match as it relates to retirement plans is when the company will contribute an amount to your retirement account as long as you are eligible and are contributing.  The formula on how the match is calculated can be very different from plan to plan but it is typically calculated based on a dollar amount or a percentage of pay.  The first “hurdle” to get over with a company match involved is to put in at least enough money out of your paycheck to receive the full match from the company.  Below is an example of a dollar match and a percent of pay match to show how it relates to calculating how much you should contribute.

Dollar for Dollar Match Example

The company will match 100% of the first $1,000 you contribute to your plan.  This means you will want to contribute at least $1,000 in the year to receive the full match from the company.  Whether you prefer contributing a flat dollar amount or percentage of compensation, below is how you calculate what you should contribute per pay period.

Flat Dollar – if you are paid weekly, you will want to contribute at least $19.23 ($1,000 / 52 weeks = $19.23).  Double that amount to $38.46 if you are paid bi-weekly.

Percentage of Pay – if you make $30,000 a year, you will want to contribute at least 3.33% ($1,000 / $30,000).

Percentage of Compensation Match Example

The company will match 100% of every dollar up to 3% of your compensation.

Flat Dollar – if you make $30,000 a year and are paid weekly, you will want to contribute at least $17.31 ($30,000 x 3% = $900 / 52 weeks = $17.31).  Double that amount to $34.62 if you are paid bi-weekly.

Percentage of Pay – no matter how much you make, you will want to contribute at least 3%.

If the match is based on a percentage of pay, not only is it easier to determine what you should contribute by doing a percent of pay yourself, you also do not have to make changes to your contribution amount if your salary increases.  If the match is up to 3% and you are contributing at least 3% as a percentage of pay, you know you should receive the full match no matter what your salary is.

If you do a flat dollar amount to get the 3% the first year, when your salary increases you will no longer be contributing 3%.  For example, if I set up my contributions to contribute $900 a year, at a salary of $30,000 I am contributing 3% of my compensation (900 / 30,000) but at a salary of $35,000 I am only contributing 2.6% (900 / 35,000) and therefore not receiving the full match.

Note:   Even though in these examples you are receiving the full match, it doesn’t mean it is always enough to meet your retirement goals, it is just a start.

In summary, either the flat dollar or percentage of pay can be effective in getting you to your retirement goal but knowing what that goal is and what you should be saving to get there is key.

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.

Lower Your Tax Bill By Directing Your Mandatory IRA Distributions To Charity

When you turn 70 1/2, you will have the option to process Qualified Charitable Distributions (QCD) which are distribution from your pre-tax IRA directly to a chartable organization.  Even though the SECURE Act in 2019 changed the RMD start age from 70 1/2 to age 72, your are still eligible to make these QCDs beginning the calendar year that you turn age 70 1/2.   At age 72, you must begin taking required minimum distributions (RMD) from your pre-tax IRA’s and unless you are still working, your employer sponsored retirement plans as well.  The IRS forces you to take these distributions whether you need them or not.  Why is that?  They want to begin collecting income taxes on your tax deferred retirement assets.

Some retirees find themselves in the fortunate situation of not needing this additional income so the RMD’s just create additional tax liability.  If you are charitably inclined and would prefer to avoid the additional tax liability, you can make a charitable contribution directly from your IRA and avoid all or a portion of the tax liability generated by the required minimum distribution requirement.

It Does Not Work For 401(k)’s

You can only make “qualified charitable contributions” from an IRA.  This option is not available for 401(k), 403(b), and other qualified retirement plans. If you wish to execute this strategy, you would have to process a direct rollover of your FULL 401(k) balance to a rollover IRA and then process the distribution from your IRA to charity.

The reason why I emphases the word “full” for your 401(k) rollover is due to the IRS “aggregation rule”.  Assuming that you no longer work for the company that sponsors your 401(k) account, you are age 72 or older, and you have both a 401(k) account and a separate IRA account, you will need to take an RMD from both the 401(k) account and the IRA separately.  The IRS allows you to aggregate your IRA’s together for purposes of taking RMD’s.  If you have 10 separate IRA’s, you can total up the required distribution amounts for each IRA, and then take that amount from a single IRA account.   The IRS does not allow you to aggregate 401(k) accounts for purposes of satisfying your RMD requirement.  Thus, if it’s your intention to completely avoid taxes on your RMD requirement, you will have to make sure all of your retirement accounts have been moved into an IRA.

Contributions Must Be Made Directly To Charity

Another important rule. At no point can the IRA distribution ever hit your checking account.  To complete the qualified charitable contribution, the money must go directly from your IRA to the charity or not-for-profit organization.   Typically this is completed by issuing a “third party check” from your IRA.  You provide your IRA provider with payment instructions for the check and the mailing address of the charitable organization. If at any point during this process you take receipt of the distribution from your IRA, the full amount will be taxable to you and the qualified charitable contribution will be void.

Tax Lesson

For many retirees, their income is lower in the retirement years and they have less itemized deductions since the kids are out of the house and the mortgage is paid off.  Given this set of circumstances, it may make sense to change from itemizing to taking the standard deduction when preparing your taxes.  Charitable contributions are an itemized deduction. Thus, if you take the standard deduction for your taxes, you no longer receive the tax benefit of your contributions to charity. By making IRA distributions directly to a charity, you are able to take the standard deduction but still capture the tax benefit of making a charitable contribution because you avoid tax on an IRA distribution that otherwise would have been taxable income to you.

Example: Church Offering

Instead of putting cash or personal checks in the offering each Sunday, you may consider directing all or a portion of your required minimum distribution from your IRA directly to the church or religious organization.  Usually having a conversation with your church or religious organization about your new “offering structure” helps to ease the awkward feeling of passing the offering basket without making a contribution each week.

Example: Annual Contributions To Charity

In this example, let’s assume that each year I typically issue a personal check of $2,000 to my favorite charity, Big Brother Big Sisters,  a not-for-profit organization.   I’m turning 70½ this year and my accountant tells me that it would be more beneficial to take the standard deduction instead of itemizing.  My RMD for the year is $5,000.  I can contact my IRA provider, have them issuing a check directly to the charity for $2,000 and issue me a check for the remaining $3,000.  I will only have to pay taxes on the $3,000 that I received as opposed to the full $5,000.  I win, the charity wins, and the IRS kind of loses.  I’m ok with that situation.

Don’t Accept Anything From The Charity In Return

This is a very important rule.  Sometimes when you make a charitable contribution, as a sign of gratitude, the charity will send you a coffee mug, gift basket, etc.  When this happens, you will typically get a letter from the charity confirming your contribution but the amount listed in the letter will be slightly lower than the actual dollar amount contributed.  The charity will often reduce the contribution by the amount of the gift that was given.  If this happens, the total amount of the charitable contribution fails the “qualified charitable contribution” requirement and you will be taxed on the full amount.  Plus, you already gave the money to charity so you have spend the funds that you could use to pay the taxes.  Not good

Limits

While this will not be an issue for many of us, there is a $100,000 per person limit for these qualified charitable contributions from IRA’s.

Summary

While there are a number of rules to follow when making these qualified charitable contributions from IRA’s, it can be a great strategy that allows retirees to continue contributing to their favorite charities, religious organizations, and/or not-for-profit organizations, while reducing their overall tax liability. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Secret: Spousal IRAs

Spousal IRA’s are one of the top tax tricks used by financial planners to help married couples reduce their tax bill.  Here is how it works:

In most cases you need “earned income” to be eligible to make a contribution to an Individual Retirement Account (“IRA”).  The contribution limits for 2021 is the lesser of 100% of your AGI or $6,000 for individuals under the age of 50.  If you are age 50 or older, you are eligible for the $1,000 catch-up making your limit $7,000.

There is an exception for “Spousal IRAs” and there are two cases where this strategy works very well.

Case 1:  One spouse works and the other spouse does not.  The employed spouse is currently maxing out their contributions to their employer sponsored retirement plan and they are looking for other ways to reduce their income tax liability.

If the AGI (adjusted gross income) for that couple is below $198,000 in 2021, the employed spouse can make a contribution to a Spousal Traditional IRA up to the $6,000/$7,000 limit even though their spouse had no “earned income”.    It should also be noted that a contribution can be made to either a Traditional IRA or Roth IRA but the contributions to the Roth IRA do not reduce the tax liability because they are made with after tax dollars.

Case 2:  One spouse is over the age of 70 ½ and still working (part time or full time) while the other spouse is retired.  IRA rules state that once you are age 70½ or older you can no longer make contributions to a traditional IRA.  However, if you are age 70½ or older BUT your spouse is under the age of 70½, you still can make a pre-tax contribution to a traditional IRA for your spouse.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Traditional vs. Roth IRA’s: Differences, Pros, and Cons

Individual Retirement Accounts (IRA’s) are one of the most popular retirement vehicles available for savers and the purpose of this article is to give a general idea of how IRA’s work, explain the differences between Traditional and Roth IRA’s, and provide some pros and cons of each.  In January 2015, The Investment Company Institute put out a research report with some interesting statistics regarding IRA’s which can be found at the following link, ICI Research Perspective.  The article states, “In mid-2014, 41.5 million, or 33.7 percent of U.S. households owned at least one type of IRA”.  At first I was slightly shocked and asked myself the following question: “If IRA’s are the most important investment vehicle and source of income for most retirees, how do only one third of U.S. households own one?”  Then when I took a step back and considered how money gets deposited into these retirement vehicles this figure begins making more sense.

Yes, a lot of American’s will contribute to IRA’s throughout their lifetime whether it is to save for retirement throughout one’s lifetime or each year when the CPA gives you the tax bill and you ask “What can I do to pay less?”  When thinking about IRA’s in this way, one third of American’s owning IRA’s is a scary figure and leads one to believe more than half the country is not saving for retirement. This is not necessarily the case.  401(k) plans and other employer sponsored defined contribution plans have become very popular over the last 20 years and rather than individuals opening their own personal IRA’s, they are saving for retirement through their employer sponsored plan.

Employees with access to these employer plans save throughout their working years and then, when they retire, the money in the company retirement account will be rolled into IRA’s.  If the money is rolled directly from the company sponsored plan into an IRA, there is likely no tax or penalty as it is going from one retirement account to another.  People roll the balance into IRA’s for a number of reasons.  These reasons include the point that there is likely more flexibility with IRA’s regarding distributions compared to the company plan, more investment options available, and the retiree would like the money to be managed by an advisor.  The IRA’s allow people to draw on their savings to pay for expenses throughout retirement in a way to supplement income that they are no longer receiving through a paycheck.

The process may seem simple but there are important strategies and decisions involved with IRA’s.  One of those items is deciding whether a Traditional, Roth or both types of IRA’s are best for you.  In this article we will breakdown Traditional and Roth IRA’s which should illustrate why deciding the appropriate vehicle to use can be a very important piece of retirement planning.

Why are they used?

Both Traditional and Roth IRA’s have multiple uses but the most common for each is retirement savings.  People will save throughout their lifetime with the goal of having enough money to last in retirement.  These savings are what people are referring to when they ask questions like “What is my number?”  Savers will contribute to retirement accounts with the intent to earn money through investing.  Tax benefits and potential growth is why people will use retirement accounts over regular savings accounts.  Retirees have to cover expenses in retirement which are likely greater than the social security checks they receive.  Money is pulled from retirement accounts to cover the expenses above what is covered by social security.  People are living longer than they have in the past which means the answer to “What is my number?” is becoming larger since the money must last over a greater period.

How much can I contribute?

For both Traditional and Roth IRA’s, the limit in 2021 for individuals under 50 is the lesser of $6,000 or 100% of MAGI and those 50 or older is the lesser of $7,000 or 100% of MAGI. More limit information can be found on the IRS website Retirement Topics - IRA Contribution Limits

What are the important differences between Traditional and Roth?

Taxation

Traditional (Pre-Tax) IRA:  Typically people are more familiar with Traditional IRA’s as they’ve been around longer and allow individuals to take income off the table and lower their tax bill while saving.  Each year a person contributes to a Pre-Tax IRA, they deduct the contribution amount from the income they received in that tax year.  The IRS allows this because they want to encourage people to save for retirement.  Not only are people decreasing their tax bill in the year they make the contribution, the earnings of Pre-Tax IRA’s are not taxed until the money is withdrawn from the account.  This allows the account to earn more as money is not being taken out for taxes during the accumulation phase.  For example, if I have $100 in my account and the account earns 10% this year, I will have $10 of earnings.  Since that money is not taxed, my account value will be $110.  That $110 will increase more in the following year if the account grows another 10% compared to if taxes were taken out of the gain.  When the money is used during retirement, the individual will be taxed on the amount distributed at ordinary income tax rates because the money was never taxed before.  A person’s tax rate during retirement is likely to be lower than while they are working because total income for the year will most likely be less.  If the account owner takes a distribution prior to 59 ½ (normal retirement age), there will be penalties assessed.

Roth (After-Tax) IRA:  The Roth IRA was established by the Taxpayer Relief Act of 1997.  Unlike the Traditional IRA, contributions to a Roth IRA are made with money that has already been subject to income tax.  The money gets placed in these accounts with the intent of earning interest and then when the money is taken during retirement, there is no taxes due as long as the account has met certain requirements (i.e. has been established for at least 5 years).  These accounts are very beneficial to people who are younger or will not need the money for a significant number of years because no tax is paid on all the earnings that the account generates.  For example, if I contribute $100 to a Roth IRA and the account becomes $200 in 15 years, I will never pay taxes on the $100 gain the account generated.  If the account owner takes a distribution prior to 59 ½ (normal retirement age), there will be penalties assessed on the earnings taken.

Eligibility

Traditional IRA:  Due to the benefits the IRS allows with Traditional IRA’s, there are restrictions on who can contribute and receive the tax benefit for these accounts.  Below is a chart that shows who is eligible to deduct contributions to a Traditional IRA:

There are also Required Minimum Distributions (RMD’s) associated with Pre-Tax dollars in IRA’s and therefore people cannot contribute to these accounts after the age of 70 ½.  Once the account owner turns 70 ½, the IRS forces the individual to start taking distributions each year because the money has never been taxed and the government needs to start receiving revenue from the account.  If RMD’s are not taken timely, there will be penalties assessed.

Roth IRA:  As long as an individual has earned income, there are only income limitations on who can contribute to Roth IRA’s.  The limitations for 2021 are as follows:

There are a number of strategies to get money into Roth IRA’s as a financial planning strategy.  This method is explained in our article Backdoor Roth IRA Contribution Strategy.

Investment Strategies

Investment strategies are different for everyone as individuals have different risk tolerances, time horizons, and purposes for these accounts.

That being said, Roth IRA’s are often times invested more aggressively because they are likely the last investment someone touches during retirement or passes on to heirs.  A longer time horizon allows one to be more aggressive if the circumstances permit.  Accounts that are more aggressive will likely generate higher returns over longer periods.  Remember, Roth accounts are meant to generate income that will never be taxed, so in most cases that account should be working for the saver as long as possible.  If money is passed onto heirs, the Roth accounts are incredibly valuable as the individual who inherits the account can continue earning interest tax free.

Choosing the correct IRA is an important decision and is often times more complex than people think.  Even if you are 30 years from retiring, it is important to consider the benefits of each and consult with a professional for advice. 

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.