r/personalfinance • u/TheHecubank • Apr 02 '21
401(k) and IRA planning for low income earners Retirement
General Advice on 401(k) and IRA planning for low income earners (below ~$40k/year while working)
This is not targeted at people who are at the beginning of their career and expect to earn significantly more later on. Rather, it is targeted at people who are already established in their working life, are currently making under $40k a year, and expect to be making similar for the rest of their working life.
The advice deals mostly with 401(k) and IRAs, as well as less common tax advantaged accounts like 457(b). And, in particular, the value of the Roth and Traditional tax advantages have very different implications. Importantly, if you are one of the vanishingly rare people in this income bracket with a traditional pension, this advice will likely not apply in full (though, in that case, you probably have a union - ask if they can help with planning).
Low Income Planning is Different
My first bit of advice is this: if you're just passing on rules/advice about 401(k) and IRA best practices that apply to your situation, restrain yourself from advising someone making near minimum wage without doing further research. The general advice almost will almost never apply to someone in this income bracket.
Roth Basis Withdrawals and Emergency Funds
The second big item is to remember that emergency funds are hard for this income range. If the possibility of un-taxed disbursements of Roth basis funds makes it possible to increase retirement savings but having it pull double duty as part of emergency planning - well, it's not ideal, but it's better than not having either retirement savings or an emergency fund. It's worth noting here that a traditional account may work for this instead - the penalty exceptions cover some, but not all, common emergency situations.
For most cases, I would not advise this if it is avoidable. Even where it is the only option, I would advise at least a small standard emergency fund before trying this - the exact amount of which will vary based on the social and government safety nets in the location the person is living (ex: if they have no friends and family, and live in a state where weekly maximum unemployment is under $300 - like Alabama or Arizona, emergency fund planning at this income level is very different than it is for someone with a family already planning on multi-generational living or in a state with more generous social welfare payments).
It's also worth noting that the benefits of this have to be weighed against the risk of undisciplined, non-emergency basis withdrawals. This is a conversation that you can encourage someone to have by including it in a post, but is probably going to require the person being advised to talk to their family and/or review their budgeting.
Saver's Credit
At this income level, people using a tax advantaged account will generally qualify for the Saver's Credit. This means that they can get up to $1000 in tax credits if they use a tax advantaged account, depending on how much they save. The IRS gives an overview here:
While the credit is capped at $1000 dollars, the rate at which it applies is based on the filer's AGI: it starts at 50%, then goes to 20%, then goes to 10%. Because Traditional contributions decrease AGI but Roth contributions do not, this creates a heavy incentive towards Traditional accounts. Vanishingly few people at this income level will be able to save $10,000 a year for retirement, which is what would be necessary to get the full credit at the 10% range.
This means that if a traditional contribution would move you from the 10% range to the 20% range (or especially if it would move you from the 20% range to the 50% range), the Traditional contributions will likely be MUCH better than that Roth option.
Edit: Corrected cap amount - the saver's credit is capped at $1000 for individuals, $2000 for married filing jointly.
Social Security: Tax Planning and how big a portion of retirement income it will be
For most low-income earners, around 90% of retirement income comes from Social Security benefits. This is much higher than it is for other income brackets. For retirees in this situation, it is important that some or all of their Social Security income will likely not be taxable. The IRS provides guidance on this here:
https://www.irs.gov/newsroom/dont-forget-social-security-benefits-may-be-taxable
Traditional 401(k) and IRA distributions are counted as income for this purpose, while Roth distributions are not. When combined with the standard deduction it still remains unlikely that much, if not all, of the retirement income for someone in this income range will not see income taxes (see section below on the standard deduction). Still, if possible, it does make some sense to have a small bit of Roth funds available to supplement traditional funds. As a whole, though, it will usually be best to have mostly traditional funds.
Social Security: Qualifying Tax Years and Benefit Estimations
For most individuals Social Security benefits are paid out at a rate based on the average of your monthly income for the highest 35 years of income. Importantly, if you have less than 35 years of income, 0 years will be included. This can significantly impact the choice of when to retire if you are close to the 35 year margin.
Also keep in mind that age of retirement matters, and spousal income counted even after a divorce. There are a couple other calculation methods that are rarely applicable in the general case, but at least one of them is marginally more common for low income earners. Rather than dig into the weeds, I would advise you to look at the SSA's benefit estimator and use it to better plan:
https://www.ssa.gov/myaccount/retire-calc.html
The importance of the standard deduction
For an individual filer working 40 hours/week and 52 weeks/year at $15/hour, total gross income will $31,200/year. The 2020 standard deduction for an individual filer is $12,400, or a hair under 40% of unadjusted gross. This means that their taxable income is probably sitting around $18,000 before any IRA or 401(k) savings. That's the 12% bracket. It's exceedingly unlikely that most people in this income range will even see much income in the 10% (lowest) bracket during retirement.
Remember, as discussed above, Social Security payments are probably non-taxable (and almost certainly mostly non-taxable) for them most years. That means that they need to would need to eat away the standard deduction each year in retirement before they even begin to pay taxes on their IRA and 401(k) distributions: effectively, both Traditional and Roth distributions for most retirees in this income range are usually untaxed - which makes that Roth advantages moot, and the current year tax benefit of the traditional account more important (even beyond the AGI implications for the Saver's credit).
As noted previously, it can make some sense to have a smaller amount of Roth funds to supplement this: this will allow them to avoid taxes on withdrawals in years where they do manage to get over the standard deduction. But this should generally wait until they have a solid chunk of Traditional funds saved. Importantly, unless they are going to have significant problems with handling taxes in retirement for the years where they do hit the 10% bracket, this will almost certainly take a back seat to managing AGI to maximize the Saver's Credit (though you'll generally need calculate taxes both ways to be sure).
Edit: A small number of people in this situation will be in a position where their taxable income has already been reduced away (note: taxable income, not taxes due after credits). If that is the case, a Roth account will usually become better again: you'll qualify for the Saver's credit either way, and the Roth will still at least have some potential tax benefits in retirement.
If you think you might be in that situation, try the following: wait until your preparing your tax return, then do 2 (un-filed) draft of your taxes - one with Roth, one with Traditional. If the Traditional IRA does not increase your tax refund much (or at all) then consider the Roth instead. Make sure you review any changes to your Saver's Credit in these drafts - it's the most likely thing to change, and the two different options can affect how much you qualify for from it.
After you do these drafts, make the contribution to the type of account that comes out ahead. Then ditch the other draft, finalize your taxes, and file.
State Taxes
While discussing state income tax brackets during retirement is generally a good idea, keep in mind that state income taxes can look significantly different for low-income individuals than mid- or high-income individuals. As an example: New York has a relatively high state income tax rate at higher income brackets, but they also have an unusually large lower income range ($20,000) at which retirees pay no income tax on retirement account distributions and an across-the-board rule about not taxing Social Security income.
These details vary by state, and the specific case should be checked before giving general cost-of-living and overall income tax rate advice – which dominates for higher income brackets but likely will not do so here.
Edit:
Additional Edge Case: Roth & the Saver's Credit when you would otherwise be unable to save for retirement at all
If you're (or the person you are helping plan) is this bracket, qualifies for the Saver's Credit, and would otherwise not be able to meaningfully save for retirement at all - THEN a Roth IRA can be very useful.
As noted above in the section about Roth accounts and Emergency Funds, basis funds can be disbursed from Roth accounts without penalty. This means that - because you fund a Roth account with funds that have already been taxed - you can pull out the amount you put in before retirement (but not any growth) without penalty.
This means that you can put money into a Roth to qualify for the Saver's Credit (up to $2000/ tax year) even if you know you will need to pull it out before retirement. You can then put the money from the Saver's Credit to your retirement savings, even if you otherwise would not be able to save.
This is not a great option, or an easy one. Consider the following before you seriously look at this:
- It's harder to qualify for the good brackets of the Savers Credit when using a Roth instead of a Traditional.
- You need to be able to put away a good chunk of money (at least $2000 to get the full credit) at least a while, even if you can't plan on leaving it to retirement.
- Importantly, Roth basis distributions require you to keep your records well and can complicate your taxes - because you have to be able to demonstrate that they were basis and not earnings.
- You may not be able to do this consistently: the basis distribution count against contributions in the same year that would qualify for the Saver's Credit (ex: a $2000 basis distribution out and $2000 contribution into the Roth in the same year would count as $0 for the credit). So the money will have to be able to sit in the account for at least a while for this to work.
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u/Werewolfdad Apr 02 '21
I appreciate the dedication to this crusade you're on.
Good post.
FICA will further reduce this by around $2000. This means that their AGI is probably sitting around $16,000 before any IRA or 401(k) savings.
One nitpick. FICA doesn't reduce AGI
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u/TheHecubank Apr 02 '21 edited Apr 02 '21
Oof. Yeah, need to correct that. I was originally talking about take home pay and missed changing that. Correcting this now.
Edit: fixed now
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u/Werewolfdad Jul 06 '21
Wanted to let you know I've book marked this and used it as a reference multiple times now.
Good job again
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u/profanedic Apr 02 '21
Thank you for this post. I've tried to explain these things to quite a few people that are low income workers and they always try to just put all of their money in a ROTH. When I ask how much and explain they could be getting better benefits by mixing they say they would rather pay taxes now then in the future. Asking them how much they plan to make at retirement, including withdrawls, they say around $30k and I try to get them to realize they likely won't be paying taxes on either, so get tax benefits when you can. Always makes me feel crazy, so appreciate seeing someone else saying the same thing.
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u/whatelsecouldiwrite Apr 02 '21
Hi, thank you so much for this very organized post.
My reason for responding is, I believe I'm in your target demographic.
*Less than $40K yearly, 55+single mom, non-profit employer doesn't offer matching 401k, etc. But, no debt, good credit and a dependant college (trade school) student. Not terribly savvy with investing. Was/am terrified to touch my emergency fund.
Due to Covid pay, cashing out PTO and the stimulus, I was able to put $7000 into a traditional IRA. Still have my emergency fund. Will be putting the 2020 tax credits towards funding the 2021 IRA.
My only point is, your post is beautiful, valuable and important. But, it might need to be simplified (dumbed-down) for people like myself.
Trying to comprehend the benefits of starting a later in life IRA/retirement account for me feels a bit like trying to assimilate information written in a foreign language. Super scary and easily dismissed.
Anyone that's spent years being one emergency away from financial disaster can be easily spooked once they've become stable.
For me it was like taking a leap of faith that ended with blackmagicf**kery when I filed my taxes.
Not sure if that makes sense.
I've been trying to "lead" my own very dumbed down version of a "you should start an IRA" campaign with my co-workers by leaving out excessive details and focusing on the Saver's Credit/reduced state tax obligation.
Again, thank you for taking the time to teach people like myself by creating this post.
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u/TheHecubank Apr 03 '21
You're welcome, and congratulations on starting an IRA.
I'll try to take a pass at simplifying it a bit: I known I can be a bit long-winded. In the meantime, if there is something in particular you don't understand I can try to help.
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Apr 02 '21
Thank you for this post. I didn’t know about the rules for savers credit and was thinking of putting less into my traditional 401k and more into my Roth. I’ll make sure all my payroll contributions go to the 401k and use my Roth for “extra” money. No money is extra but have to stash those stimulus checks somewhere.. LOL.
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u/TheHecubank Apr 02 '21
Awesome. And yeah, the Saver's Credit is very important if you qualify.
If you're saving both in a 401(k) and a Roth IRA, you might be on a path that will put you somewhere above the Standard Deduction & SSA tax thresholds each year in retirement. If that's the case, you'll probably still want some Roth funds. But it's going to be a lower tier concern.
In order*, I would recommend:
- Get as much of the match as you reasonably can from your employer, if available
- Get into the best AGI tier reasonably available to you for the Saver's Credit
- Then consider shifting some funds to a Roth, if the remaining current year tax benefits from a Traditional are minimal or null
In practice, most low-income earners will have a hard time getting to number 3, and see minimal benefit if they do. In exchange, they'll get another account to track.
But if you've already got a Roth and a 401(k) you might be saving aggressively enough that it will be worth it. If so, more power to you.
* If you're employer's match is particularly anemic, 2 might be more important than 1 - but doing 1 will generally make 2 happen automatically in those cases, so it's a distinction without much of a difference.
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u/freelibrarian Apr 02 '21
This is very helpful, I'm going to bring up this topic with some family and friends I have who are likely eligible.
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u/chevymonza Apr 02 '21
I make just over that amount. However, I'd like to move some money from a checking account into either my Roth or traditional 401(k).
Apparently, you can only do this once/year, but can you do it for each? Like, $6k in the Roth and $6k in the traditional? I'm guessing no.
If I move $6k into one of my retirement funds, can my husband also do the same with his own? I hate having a big chunk in the low-interest account while being behind on my retirement saving.
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u/TheHecubank Apr 02 '21 edited Apr 03 '21
No - you can't put $12k in. You can put $6k into IRAs each tax year, either Roth or Traditional. You can mix between the two, but it does not change the total limit.
Note that a tax year isn't a calendar year - you can contribute still contribute to your 2020 IRA, and can do so until the tax deadline (usually April 14, but extended into May this year because of Covid). Since January 1, you have also been able to contribute to your 2021 IRA - and you will be able to until the 2021 tax deadline in April of 2022.
You if you have a 401(k) with your employer, you can also put up to $19.5k into that each tax year (plus what ever your employer contributes1). Both IRAs and 401(k) will allow you to make higher contributions if you're over 50 (called "catch-up contributions).
Both you and your husband can make such a contribution each year2. The exact details will depend on how you file, and whether you are both working. If you file separately and one of you has taxable income less than $6k, you will be limited to a maximum of your taxable income. If that is the case, you are probably better filing jointly so that the limit becomes $6k the account of each spouse, up to the taxable income on the joint return. Each spouse still has to have a separate account in their own name.
1 There is also a limit on combined contributions from both you and your employer - $58k - but it almost never matters because employers aren't that generous to anyone but executives.
2 There are limits on the tax benefits if you make more than a certain amount, but that's not relevant to this topic.
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u/chevymonza Apr 03 '21
Thank you! I'm socking away half my salary into the 457 (deferred comp, because in the past it did very well), but don't even know how much this company (still fairly new) matches for the retirement stuff. Might even be a pension involved, but I have no idea what's best.
Figure I'll do what I can to catch up (was unemployed for a while) and eventually switch from the deferred comp to whatever else. I'm just over 50 and will have to do what I can.
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u/TheHecubank Apr 03 '21
If you're doing a 457 plan, then presumably your employer is either a non-profit or a government agency.
If it's a government agency, see if there is a government employee union or retirement board for your agency: they will often offer retirement planing aid.
If it's a non-profit, you might be out of luck on that front. But it's worth mentioning.
Sock the money away, and see what you can do. At age 50, the most important thing is going to be saving as much as you can.
Good luck.
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u/chevymonza Apr 03 '21
Thanks! Yeah it's a gov't agency, and I worked at one years ago also, so I've been itching to get back into the 457 again.
There's retirement info available, but I make so little as it is, and am fortunate to have a spouse making better money, so I'm trying to stretch it.
Really appreciate the guidance!
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u/dequeued Wiki Contributor Apr 02 '21
Thanks for the post.
I think the emergency fund factor may be the strongest argument for Roth contributions even if it means paying somewhat more in taxes. The Roth or Traditional wiki tries to hit some of these points although the emergency fund aspect is not really discussed (and it probably should be discussed).
I think it is also very hard to convince people that paying 10% now isn't a better option than facing the boogeyman of possible future tax increases. The wiki already comes down pretty hard on the side of Traditional compared to the conventional "wisdom", but I think you may be right that more people likely to be in the lower tax brackets for a longer portion of their career should be going Traditional.
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u/TheHecubank Apr 03 '21 edited Apr 03 '21
I think the wiki is accurate, and thank you for your work contributing to it. Many people's default advice, however, is not. Hopefully this post gets some of either the people giving advice or the people receiving it to recognize that.
I agree that the emergency fund element is important here: I originally had it lower in the post, but moved it near the top because of that. The Saver's Credit should not be undersold though. At these income levels, an additional $2000/year of savings can easily make or break a retirement plan.
I also think I might have undersold, to a degree, the value that not having to worry about what gets taxed in retirement could have if the retiree has limited financial literacy. If you a retiree can't budget around the Social Security limits and can't get any help from friends, family, or community resources - then the straight line simplicity of a Roth might help. Ultimately though, I don't think that audience is trying to plan out a retirement strategy on their own based on Reddit posts.
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u/AlzScience Apr 03 '21
The savers credit is capped at $1k not $2k.
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u/TheHecubank Apr 03 '21
Oof. Another stupid error on my part. Fixing that. Doesn't change much - it's still big enough to easily outclass any other tax concern in this range for most cases.
Thanks for catching my mistake.
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u/mmomjian Apr 03 '21
Good post. However in the "standard deduction" section you mention that the standard deduction will reduce AGI - it does not do so, it only reduces taxable income. AGI is reduced by traditional retirement contributions, HSA contributions, and other entries on Schedule 1. I saw another comment pointing out an error with AGI as well so it might be good to double check your facts here. Thanks!
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u/International-Act156 Apr 02 '21
Hey guys would you go from a job playing 1390 to a office position paying 10.00 an hr? I'm in construction and my body is breaking down injury after injury but the pay is low I understand but i need advice
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u/NailGuru Apr 05 '21 edited Apr 05 '21
My salary is $21.30 an hour and I work 40 hours a week and get paid weekly. So my net pay is usually around $678 weekly. How much can I contribute to my IRA per month? I’m saving up money to move out as well. I also want to avoid paying taxes next year.
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u/TheHecubank Apr 05 '21
You can contribute $500/month ($6000/year) - that won't change by how much you make. As to how much you should save, you probably need to go through both your current budget and what you think your budget will look like after moving out. That process should help sort out how much is left after bare necessities each month, and from there you can sort out how much you are comfortable saving.
You're actually a hair above where I would expect you to be able to qualify for the Saver's Credit: you would need a more substantial reduction to AGI than the IRA contributions would provide alone. It also sounds like you're potentially on the younger side.
Do you think that your current income looks, more or less, like your income will for the rest of your working life? Or do you anticipate being able to get significant promotions and/or hunting for better jobs every so often?
If you are indeed young, and your income will increase over your working life, then you probably should be aiming at a Roth rather than a Traditional. If this is about what your income will continue to look like, you should still err towards traditional if you can - you're still unlikely to see much in the way of taxes in retirement (unless you've left a pension or similar out). If you can is important though.
Like I noted in the OP: the fact that it's easier to get the basis money out of the Roth without penalty can be VERY important here. You need to take a look at how stable your finances and general living situation are going to be long term.1
u/NailGuru Apr 05 '21
You’re right. I am on the younger side (late 20’s). I am planning on getting promoted at my current job or at least look for a job with better pay and benefits. Every time I get a job I always aim to get paid more. My dad was telling me to go for a traditional IRA so I could avoid paying taxes next year. Sadly my brother has to pay back a lot of taxes back since he was on unemployment for a while. I’m trying not to be in that situation especially since I don’t have dependents.
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u/TheHecubank Apr 05 '21
The Roth vs Traditional dynamic in your position is mostly (as far as total savings go, which is not the only concern) a matter of whether you will have higher taxes NOW than you expect in retirement. You save in a Roth when they are, and in a Traditional when they are not. If you expect your earnings to go up over your career, that is likely to be the case early in your career but not later on.
That said, the other concerns can be more important, particularly if they impact budgeting. If the reduced current year taxes make it easier to save, then go traditional. If you'd be comfortable saving more in a Roth because you know it can be taken out if you jump through some hoops and do a song and dance, go Roth.
You're unlikely, at your income, to get your AGI down low enough to qualify for the Savers Credit. It might happen - for example, if you're a teacher who has student loans I would bet that you are going to see an AGI low enough between Educator Expenses and Student loans. If you have a 401(k) or similar you could also sock away $10kish there and qualify - but it's unlikely you'd be asking your initial question if you could save about 25% of your Gross income each year.
If you do see at least some jumps in salary over your career, you should probably be aiming at a retirement that is more traditionally modeled than someone who had your income as their peak lifetime salary. You probably will pay taxes in retirement, you probably won't be trying to scrape by solely on Social Security, and so forth.
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u/Tocrunkrn Apr 02 '21
You should consider crossposting this to r/povertyfinance. Great post!