A few days I ago, an article I contributed to by the Simple Dollar was published.  This one’s provides tips on how couples can take advantage of having 401(k)s with different features.

Click here to read the article.

Below are my full thoughts on the topic.  Many of the tips apply to single people as well.

Often times, spouses cannot afford to maximize their 401(k) contributions—in these cases its worth exploring the risks and benefits of titling contributions towards the more favorable 401(k) or retirement plan.

Some of these benefits include:

  • Maximizing Matching Contributions: One spouses 401(k) may provide a better matching contribution. Retirement plan participants should at the very least seek to contribute enough to maximize their employer’s matching contribution.
  • Roth 401(k): Some 401(k)s allow employees and employers to make after-tax Roth contributions. Qualified distributions from Roth IRAs or Roth 401(k)’s are tax-free.  These types of contributions usually make sense if a plan participant expects to be in a higher tax-bracket in retirement, than they are today. Note that roth and pre-tax 401(k) employee contributions cannot together exceed the $19,000 annual contribution limit.
  • After-tax 401(k): Some 401(k)s allow individuals to contribute after-tax contributions. These are different than Roth contributions. For individuals who have trouble building an after-tax savings, because the money burns a hole in their pocket, an after-tax 401(k) can be a way to build taxable savings, while creating some barriers to accessing their money. At retirement, the after-tax contributions can be rolled over into a Roth IRA.  The after-tax (non-Roth) funds may also be accessed without tax penalties—though some 401(k) plans restrict after-tax contributions for a period of time, usually 6 months, after a distribution of after-tax money.
  • Investment Options: One spouse’s 401(k) may have investment options with better performance and risk characteristics. Some 401(k)s allow participants to choose among thousands of mutual funds in a self-directed portfolio.
  • Protection from Creditors: In bankruptcy proceedings, 401(k)s and other qualified retirement plans are usually fully-protected from creditor claims.  However, if one spouse has an IRA, the IRA is only protected up to $1,283,025.
  • Employer Stock:  Some 401(k) allow for contributions of company stock and the potential for dividends and growth. But not all employer stock is worth purchasing—as the employee, participants may have the best insight into whether their company makes a great investment.  

The main downside of titling contributions towards one spouse’s 401(k) occurs for individuals living in equitable distribution states.  In the 9 community property states (Arizona, California, Idaho, Louisiana, Nevada, Texas, Utah, Washington and Wisconsin), 401(k) contributions and earnings made during marriage are 50-50 property between spouses. In the other states, called equitable distribution states, the division of 401(k) assets must be fair, as determined by a judge; fair does not always mean equal with these types of divisions.

Upon divorce, if one spouse has a significantly higher retirement account value, either retirement plan assets or other assets (i.e. real estate, taxable portfolio, etc) can be used to provide for a more equitable division of assets. A major mistake spouses make, when dividing retirement plan assets, is treating pre-tax assets the same as taxable assets.  Distributions from pre-tax assets, like 401(k)s, are taxable at high ordinary income tax rates, versus distributions from taxable accounts, which are subject to more favorable capital gains tax rates.

 

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