Microsoft has a comprehensive benefits package. Because of that, we’re going to do a series of blog posts covering how to maximize those benefits and minimize your tax consequences. Many of these benefits have the potential to build a solid financial planning foundation. In this first post, we’re going to dig into the 401(k) plan.
Microsoft matches 50 percent of your contributions that you make into your 401(k) account up to $19,000. This is $9,500 of “free money” if you contribute $19,000. The employer match portion of your 401(k) is considered pre-tax since Microsoft receives a deduction on their federal taxes. This means all employer contributions and their respective investment earnings will be subject to income taxes once withdrawn. As many have asked, you cannot elect Roth for the match. Roth is only for your “employee” contribution. While a 401(k) is technically one account, it is best to think of the Microsoft 401(k), in particular, as three separate accounts or buckets i.e. Roth bucket, Pre-Tax bucket, and After-Tax bucket.
You are allowed to contribute either pre-tax or Roth for the $19,000 elective deferral. Unlike a pre-tax contribution, which reduces your current tax liability, a Roth contribution does not. The primary benefit of a Roth contribution is that withdrawals are tax-free if certain conditions are met. The earnings on top of the Roth contributions accumulate tax-free just like a Roth IRA. While a Roth IRA has income limits for contributions, a Roth 401(k) does not. As many Microsoft employees quickly get phased out of Roth IRA contributions with income-inducing benefits such as stock grants and stock purchase plans, this is an important benefit to consider. Deciding to contribute pre-tax or Roth is primarily a tax planning issue. To make the most informed decision, please consult with both your CFP® and CPA before implementing
Some 401(k) plans offer a little known feature that allows you to contribute even more
than the employee contribution of $19,000. This is called after-tax contributions. Thankfully, the IRS recently provided guidance on this issue. Not to be confused with Roth contributions, this allows you to contribute excess dollars to reach the 2019 federal limit of $56,000. While it is estimated that less than 50% of companies offer this, Microsoft is one of them. This is a huge benefit as it could allow you to save an extra $27,500 on a tax-deferred basis. And it keeps getting better. In a normal situation, the earnings on after-tax contributions would be subject to ordinary income taxes once distributed in retirement. However, Microsoft automatically converts those after-tax dollars to the Roth bucket of your 401(k). This allows the earnings to grow tax-free. Doing this consistently over the course of a decade or longer could yield a massive tax free nest egg in retirement.
401(k) Investment Strategy
In the Microsoft 401(k), there are over 20 investments options. Brokerage links, bond funds, equity funds, target date funds, annuities and more. There is no one size fits all approach. And what I love about financial planning is that there is no single right answer; there are multiple strategies to get from point a to point b. However, what we do have is best practices and proven strategies using financial science.
Know your time horizon.
When deciding what investments to utilize, your first step is to understand your time horizon. Your time horizon should dictate the aggressiveness of your portfolio. A more aggressive portfolio means a larger percentage is allocated towards equities while a conservative portfolio holds more fixed income investments. With a time horizon of many decades your allocation can be more aggressive.
Pay attention to company-specific risk.
Companies such as Microsoft provide many of your benefits in the form of shares. In a short period of time you can accumulate a large position of Microsoft stock. Investing too heavily in your company’s stock creates a double risk( i.e. both your wages and your retirement savings) are controlled by the success of your company. As an employee, you may feel like you have an inside look into how your company operates. However, be aware that there are a variety of risks beyond your control regarding stock value. Diversification is important so you don’t have all your eggs in one basket.
Investment cost matters.
Look for options with relatively low expense ratios. For a long-term portfolio, high expenses can really eat away at returns. Vanguard's research on mutual funds has shown that higher-cost funds generally underperform lower-cost funds. Fortunately, Microsoft has a handful of low-cost options.
Avoid random acts of diversification.
Don’t dabble or experiment in funds for a short period of time based on a colleague’s recommendation, news headlines, or Morningstar ratings. Invest based on your personal situation and goals.
Use financial science and academic research to your advantage.
Invest globally, avoid timing the markets, overtrading, and rebalance occasionally. As Professor Robert Merton, a Nobel laureate, stated,“Timing markets is the dream of everybody. Suppose I could verify that I’m a .700 hitter in calling market turns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.” While favorable timing is theoretically possible, there isn’t much evidence that it can be done reliably, even by professional investors. The positive news is that investors don’t need to be able to time markets to have a good investment experience.
A 401(k) plan is an excellent tool for long-term retirement savings. How good depends on how well you implement it. And remember, you don’t have to do this alone. Working with a professional, like a CERTIFIED FINANCIAL PLANNER™ who knows the in’s and out’s of these plans can take much of the guesswork out of planning.
Not sure if you’re taking full advantage of your employee benefits or need help constructing a financial plan, schedule a complimentary consultation today.
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