Empowering Clients: The Importance of Investing Beyond the 401(k)

For most people, there’s little to think about when it comes to making contributions to their 401k plans. They enjoy reduced current taxes, deferred taxes on account earnings, and, for most, a matching contribution from their employer. That’s a huge incentive to contribute as much of their earnings as possible—up to $23,000 in 2024, and those over 50 can add $7,000 in annual catch-up contributions.

But is maxing out 401k contributions really the best retirement savings strategy for your clients?

While deferred taxation in a 401k is great for capital accumulation, they will owe ordinary income taxes on their withdrawals, impacting their cash flow in a critical life stage. Many retirees are shocked by the amount of taxes they owe on their retirement income.

If the objective is to maximize cash flow in retirement, they can reduce their tax liability by spreading their retirement savings between pre-tax retirement plans (401k and IRA) that trigger ordinary income taxes and post-tax accounts, such as a Roth IRA and taxable brokerage account. Income from a Roth IRA is not taxed, and capital gains and dividend income from a brokerage account are taxed at more favorable rates.

You play a crucial role in helping your clients understand the importance of investing beyond their 401(k) for retirement. Here’s the approach you can use:

#1. Highlight the Limitations of a 401(k)

Limited investment options:

Explain that 401(k)s typically offer a limited selection of mutual funds and target-date funds, which may not align perfectly with an individual’s risk tolerance and investment goals.

Contribution limits:

Point out that the annual contribution limit for 401(k)s ($23,000 in 2024, with an additional $7,000 catch-up for those over 50) may not be enough for everyone to reach their desired retirement income, especially for high earners.

Early withdrawal penalties:

Remind clients that withdrawing money from a 401(k) before age 59.5 (except for certain exceptions) incurs a 10% penalty and income taxes, hindering accessibility for emergencies or unexpected needs.

Required minimum distributions (RMDs):

The tax code requires retirees to start taking withdrawals from their 401(k) regardless of whether they need the income, which can push them into a higher tax bracket.

Social Security tax:

Income from a 401(k) is included in the Social Security tax calculation, which can result in up to 85% of your benefit becoming taxable. Income from alternative vehicles such as a Roth IRA or annuity is not.

#2. Emphasize the Benefits of Diversification

Greater control and choice:

Explain that investing outside a 401(k) allows access to a broader range of asset classes, such as individual stocks, bonds, and real estate, potentially leading to higher returns and a more customized portfolio.

Reduced risk:

Diversifying investments across different accounts and asset classes helps mitigate overall portfolio risk, making the financial plan more resilient to market fluctuations.

Flexibility and accessibility:

Investments outside a 401(k) may offer more flexibility regarding access and liquidity, potentially providing funds for emergencies, down payments, or other financial goals.

Tax diversification in retirement:

Withdrawals from a 401(k) are taxed as ordinary income, whereas income from other vehicles is not taxed (Roth IRA) or taxed at more favorable rates (capital gains and dividends from a brokerage account). If the goal is to maximize cash flow in retirement, tax diversification can reduce the amount of taxes owed on retirement income.

The Advisor’s Role in Client Education

Personalize the conversation:

Assess each client’s risk tolerance, time horizon, retirement goals, and current financial circumstances to recommend suitable investment strategies beyond the 401(k).

Highlight the potential impact:

Use financial planning software to create personalized cash flow simulations comparing the potential taxation outcome of investing solely in a 401(k) and a diversified approach using multiple vehicles.

Provide educational resources:

Share informative articles, online resources, and investment calculators to empower clients to learn more about different investment options. You can also conduct educational workshops or webinars on the importance of diversified investing and various investment vehicles available outside a 401(k).

Address concerns and build trust:

Acknowledge clients’ doubts and answer their questions patiently, building confidence and ensuring they feel comfortable with their investment decisions.

A layered retirement savings strategy can increase after-tax income and reduce the required minimum distributions (RMDs), further reducing their tax liability. With a multiple retirement vehicle strategy, you and your clients will have much more flexibility in devising a retirement income strategy that best suits their situation when they reach retirement.

By effectively educating your clients about the limitations of 401(k)s and the benefits of diversified investing, you can help clients understand the importance of looking beyond their 401(k) and building a well-diversified investment portfolio for a secure and fulfilling retirement.

Related: Balancing Politics and Portfolios: Navigating Client Political Opinions in Investment Decisions