Understand if the Traditional 401(k) plan is the best for your situation
First of all, pump the brakes on using the Traditional 401(k). Depending on your income/tax situation it might not be the best place for you to save for retirement. The reason for this is how money is saved to various retirement plans. If you use a Traditional 401(k) plan, then the money you save avoids taxation when you contribute to the account, and is only taxed when you remove it from the plan. Your original contributions and the amount it’s grown to become subject to taxation at current income tax rates – similar to how your income is taxed now.
But if your effective personal tax rate (ETR)* is below 15%, I would not be using the Traditional 401(k) plan – I would use the Roth 401(k) plan. The Roth 401(k) has you paying taxes on your contributions now and then you do not pay taxes on any withdrawals you make in retirement.
* To calculate your ETR, pull up your recent tax return. Find out how much tax you paid, and divide it by the amount of taxable income you had. This will give you percentage, or your Effective Tax Rate. It shows you how much tax you pay per dollar you earn. For example, if you pay $15,000 in taxes and earn $100,000, your ETR is 15%.
I maxed out my contributions, should I keep making after-tax contributions?
If you find yourself in a situation where you’ve maxed out your contributions in your Abbie 401(k) mid-way through the year, you now have a choice:
- Keep making after-tax contributions to the AbbVie 401(k). It won’t have a tax benefit but you keep saving to the account.
- Take the money home in your paycheck and save it / spend it / give it elsewhere.
Whatever decision you make here depends on your financial goals. If you have other goals you want to achieve, then I would take the money home and spend it on achieving them. If you want to build up a non-retirement savings account, then take it home and do so. However, if you’re just looking for a convenient place to save money without opening up another account, then saving to the Abbie 401(k) would be a good option.
One great feature of continuing to save to the 401(k) plan in an after-tax manner is that you can convert the after-tax contributions to the Roth 401(k) plan once you are eligible to make a withdrawal from the plan. This time period is typically when you leave the company at age 55 or after 59½. Any after-tax contributions can be seamlessly converted to a Roth account, and no penalties or taxes are assessed. This makes it an ideal way to put money into a Roth account at a later stage even you if don’t meet the income requirements at this current time.
What income limits are there on saving to the AbbVie 401(k) plan?
There are a couple of limits that the IRS and AbbVie place on the 401(k) plan:
- You can defer between 2-50% of your income to the 401(k) plan, but this stops once you hit the annual limit, plus the catch-up amount if you’re eligible.
- If you want to keep contributing using after-tax contributions, 2-10% of your income is eligible to be saved.
- The after-tax contribution is not subject to the annual contribution limit, but is subject to a maximum funding limit to a retirement account. In 2020, this number is $57,000 (not including over age 50 catch-up) but includes pre-tax, company matching and after-tax contributions.
I’ve been told I’m a “Highly Compensated Employee”, what does that mean and how does it affect my contributions?
There is a disadvantage to earning too much money – and this affects how much you can save to your AbbVie 401(k) and how much you receive in matching contributions. Each company has to follow certain IRS rules with its 401(k) plan and the salaries of their participants can determine if the plan meets certain guidelines.
For 2020, if you earn over $285,000, AbbVie cannot provide a match on your salary over-and-above that. For example, let’s say you’re 48, earning $350,000 and maxing out the Traditional portion of your 401(k). If AbbVie was to match 5% of your income, they’d contribute $17,500 to the plan. The IRS wants to keep 401(k) matching fair for employees of all income levels, so sets the 2020 limit to $285,000. Now, AbbVie is only allowed to contribute a maximum of $14,250 to your plan. With your $19,500 contribution, and no after-tax savings, you can expect to see $33,750 of savings into your account this year.
There are a lot of investment choices in the plan, which do I choose?
You have a choice in the plan – do you build your own portfolio or do you use the State Street Target Retirement funds? If you are unsure of your investing knowledge and skills, then use the Target Retirement funds. Choose a date close to when you want to retire and use that one fund. You’ll need to change investments once you retire to produce income for yourself, but this fund will work to accumulate your wealth.
What if you want to build a portfolio? The next question to ask is if you want to have an “active” or “passive” portfolio. At Retirement Matters, we subscribe to using 100% passive funds (ones that track a certain portion of the stock market, and don’t try to time market movements with help of a manager).
If you’re building a portfolio, understand what split between equity and fixed income exposure you need, and then diversify amongst asset classes as you build this. I would stick to Vanguard funds as much as you can.
I can invest in AbbVie and Abbott stock in my 401(k). Is this the account I should be using to invest in my company stock?
One word for you: Enron.
Company employees of Enron not only lost their income, but also their retirement savings if they invested heavily in Enron stock. Also, if you are taking part in the Cash Profit Sharing (CPS) plan, AbbVie Incentive Plan (AIP) or the Long-Term Incentive Plan (LTI), you’re receiving compensation – either cash or stock – with a cash benefit to you based on the success of the company.
The rule of thumb is not to hold more than 10% of your investments in one stock. This is also important – and 10% may be too high – if you’re also earning your income from that company as well. I suggest that clients hold no more than 5% of their investment portfolio in AbbVie stock if they are also earning their income from this company as well. While in the good times, it can be really good financially, but in the bad times, it can get really, really bad.
I’m nearing retirement. I have a large amount of AbbVie stock in my 401(k) that I purchased a long time ago. Do I have to pay income taxes on this as I take it out?
Here’s where it pays to understand how a 401(k) typically works, so you can understand how cool the nuances can be.
Anything that you purchase in your 401(k) as an investment grows tax-deferred. However, when that investment in withdrawn from the account for living expenses, the amount taken out is taxed as though it were income, and is subject to income tax rates.
But company stock holdings inside of a tax-deferred account have their own special rule, called Net Unrealized Appreciation, or NUA for short. Let’s use an example to explain it:
Let’s say I made a $1,000 contribution to my ABC 401(k) and purchased ABC stock at $1/share. I now own 1,000 shares of ABC stock. Time goes by and I look to retire. ABC stock has gone up to $100/share. Each share that I own has grown by $99, and my original $1,000 is now worth $100,000. If I wanted to withdraw the entire position, I would be paying income taxes on $99,000.
But in using NUA, I can bring down my tax bill substantially, especially if I find myself in high Federal and State tax brackets. By electing to use NUA, I would withdraw the ABC stock out of the 401(k) and pay income tax on the amount of stock that I purchased ($1,000) versus the $100,000 value. If I needed the cash now, I could then liquidate the entire position and pay capital gains rates on the $99,000 remaining position.
Instead of paying income taxes of up to 40% on the $100,000 position, I’ve only paid that on $1,000, and then paid 15-20% on the remaining amount.
NUA is a powerful tool when the situation warrants it, and can provide a HUGE tax savings when done right.
What do I do now?
If you’re contributing to the AbbVie 401(k) at this time, this article should have given you some pointers on some things to improve upon. If you’re looking for customized advice for your situation, let’s chat. You can make an appointment on my calendar for a free 30-minute phone call here. No sales, no obligations, just conversation.