“The trouble with retirement is that you never get a day off.”— Abe Lemons
Retirement planning is a relatively new fad, even if it seems like you’ve heard about a 401k since, well, forever. There was a time when people just worked… if you lived, you worked. In 1881, Otto Van Bismarck petitioned the Riechtstag to create a government system to support the elderly, and the German parliament gave birth to “retirement” as we know it today — they cleverly pegged their retirement age at 70, nearly the same as life expectancy. America followed suit with the Social Security Act of 1935, creating an official retirement age of 65 for us Yankees. A couple generations of Americans went on planning for retirement by working and counting the days until they could collect Social Security and their pension. Then things changed.
As demographics spun wildly out of control, with people working less, retiring more and living way longer, defined benefit plans went by the wayside. These days, there are now over 30 million employer sponsored retirement plans with total assets exceeding $7.7 trillion. It’s worth noting that IRA’s (Individual Retirement Arrangements), which are often funded by old company retirement plans, also hold over $8.6 trillion. Let’s take a look.
Taxes On Your 401k
One of the main “benefits” marketed by 401k providers and accountants who are looking for a better current-year tax return is the ability to defer income. It’s worth repeating that word, defer, as it’s often confused with the word- savings. A very common saying is, “Contribute $10,000 to the 401k at work, you’re not paying for it, Uncle Sam is.” Wrong! Yes, it’s true that a person making a $100k salary and contributing $10k pre-tax into their 401k has lowered their taxable income to $90k just this year (notwithstanding other deductions). However, that deferral creates a corresponding compounding tax liability. Qualified distributions in retirement will be subject to ordinary income tax, not just your contributions, but all your investment gains as well.
But You Will Retire In A Lower Tax Bracket
Or will you? Most of my clients want to maintain, if not increase, their lifestyle in the Golden Years. This comes at a cost, though. Affluent individuals may find that Social Security, pensions and retirement distributions send them into a higher tax bracket than initially planned for. Not to mention many of your previous write-offs may no longer be available — such as dependent kids who have moved out of the house, your mortgage interest is paid off, pre-tax retirement contributions, etc. Also, today’s tax rates are not set in stone. With over $21 trillion of national debt, there’s a slight chance that tax rates could go up at some point. Retirees are often surprised when statements they’ve been receiving for so long with a lofty balance begin spending far less.
Then I’ll Keep Deferring
No you won’t. The IRS wants their tax revenue, so, by age 70.5, you must begin making Required Minimum Distributions (RMD). Failing to take your RMD can result in a 50 percent tax penalty!
This Money Is Just For Retirement
It certainly is. Unfortunately, life isn’t lived in a laboratory and, many time, the unexpected occurs. 401k participants generally are not allowed to access their funds before Age 59.5, as doing so may incur a 10 percent penalty on top of additional income taxes. Your plan may allow for hardship withdrawals and waive your penalty — like purchasing your first home, paying for unreimbursed medical expenses, paying for college, etc.). Your employer plan may provide another option to take a 401k loan up to $50k or 50 percent of your plan balance (the lower of the two). Either way, be prepared to jump through some hoops or pay a stiff penalty if your household happens to need some extra cash.
I Can Invest In Whatever I Want To
Not really. 401k plans have limited investment options, typically confined to mutual funds and, sometimes, ETF’s (exchange traded funds).
My Retirement Plan At Work Is Free
Nothing is free. A 401k carries administrative costs, and its underlying investments still hold fund fees based on company and management activity. Some 403(b)’s for school systems even use a Variable Annuity chassis, which can carry even greater fees and restrictions.
The 401k definitely has a place in today’s retirement-planning environment, offering several smart incentives like automatic payroll deductions and, sometimes, a very valuable employer match. Some plans have also begun offering a Roth IRA option to combat some of these tax woes. But, as we’ve seen, there are a lot of strings attached that a participant must be aware of. A smart investor must carefully consider market risk, current and future tax liability and liquidity before making any investment decisions.
Lead image via Getty
Bryan M. Kuderna is a CERTIFIED FINANCIAL PLANNER™, Life Underwriter Training Council Fellow and Investment Adviser Representative with Kuderna Financial Team. He is a perennial qualifier for the industry’s prestigious Million Dollar Round Table®, Leaders Club and Inner Circle. He is the author of the best-selling book, “MILLENNIAL MILLIONAIRE- A Guide to Become a Millionaire by 30”.