In This Video:
Should you invest in your company 401k for your retirement? If you pay attention to all aspects of the 401(k) account, you may not want to contribute all of your retirement savings into it. In this post and video, I discuss the advantages and disadvantages of a 401k. Also, alternative strategies that you may want to consider.
Things To Consider:
Should You Invest in Your Company’s 401(k)?
Saving and investing in your company’s Traditional 401(k) for retirement is what most people have been conditioned to do. It’s what you may continuously hear or read from your company, in the news or in financial media. Yes, saving for retirement is a good thing to be conditioned to do. However, after understanding the aspects of the 401(k), you may want to adjust your approach of where you contribute your retirement savings. This could help keep more of your hard-earned money with you vs. giving it to the IRS in taxes.
Advantages of a 401(k)
In the video I discuss all of the advantages of the Traditional 401(k), here are some of the highlights:
Federal Legal Protection
Workplace retirement plans are protected by federal law: ERISA – Employee Retirement Income Security Act of 1974. The federal law sets minimum standards for employers and protects employees interest and the interest of their beneficiaries
Tax Deduction for 401(k) Contributions
A benefit of contributing to your 401(k) is that you get a tax deduction in the amount of your contribution in that year. By helping to reduce your taxable income, it helps keep your taxes lower in the years of your contributions. However, this does not mean you will always be able to avoid taxes on this money. When you do make withdrawals in the future, you will need to pay income tax on every dollar that you take out of the account.
You can invest your 401(k) for potential growth. The account structure allows you to keep the interest, dividends and gains taking place in this account out of your taxable income until you decide to make withdrawals in the future.
Some companies will contribute company dollars into your 401(k). Typically, this is set-up as a “match”. Meaning as long as you are contributing to your retirement account, your company will contribute a certain percentage to your 401(k) as well. This is a really nice benefit and can become a very big benefit over time. Make sure you pay attention to your company’s structure to maximize their matching amounts.
Be sure to also pay attention to the vesting schedule. The vesting schedule is the timeframe at which the company match becomes 100% owned by you the employee. Sometimes this is right away or it may happen over multiple years. If you leave prior to being 100% vested, you may be giving up some or all of the company contributions.
The benefits are attractive. However, it’s important to account for all aspects of the 401(k) before using it as your only retirement savings account.
Disadvantages of a 401(k)
In the video I go over all of the downsides of the 401(k), here are some of the highlights:
Age Limitations on 401(k) Withdrawals
While it is your money in the account, the IRS has put certain limitations on when you can make withdrawals. Taking withdrawals from your 401(k) prior to Age 59.5, you would incur a 10% early withdrawal penalty. While there are a few exceptions to the rule, primarily you are limited to waiting until later in life to withdrawal your funds.
One exception is the Rule of 55 which would allow you to make withdrawals from your 401(k) starting at Age 55. This rule is specific to the 401(k) of the company that you were working at or left at Age 55 or later. It is also company/plan specific. If you plan to retire early, you may want to consider giving yourself some flexibility and saving in alternative accounts.
401(k) Withdrawals Are Considered Taxable Income
While your account value might say $500,000 or $1,000,000 or $2,000,000 or more, not all of that money is actually yours. Part of it will go to the IRS in taxes. You will owe income tax on every dollar that you withdrawal from the account. While the tax deduction was a benefit when you put the money in, this could potentially cost you more in taxes in your future. One of the reasons for that is Required Minimum Distributions.
Required Minimum Distributions
The Traditional 401(k) is the only account in which you are forced to take withdrawals. These forced withdrawals are called your Required Minimum Distribution (“RMD”). If you don’t, you could incur a penalty of 50% of the amount you failed to take. Therefore, even if you don’t need the money or just needed a smaller portion to maintain your lifestyle, you will still have to take the full RMD amount. All of which will be added to your taxable income.
You might be thinking that is okay, because you’ve heard that typically your taxable income is lower in retirement. In working with clients and running projections we’ve seen many times where their taxable income may be the same or even higher in their future because of their RMD. Why? The IRS wants to get their share of the taxes that you’ve deferred and the RMD withdrawal rate (how much you have to take out of your 401k) increases with age.
Therefore, by taking the tax deduction today, you could potentially be putting yourself in a higher tax bracket in the future.
Tax Planning, Tax Diversification, and Alternative Strategies
Tax planning and tax diversification is one of the key parts of the process that we go through with clients. It’s a process to help keep more of your hard-earned retirement savings with you vs. going to the IRS in taxes. Here is what we look at that you may want to consider:
Your Taxable Income in Retirement vs. Your Taxable Income Today
Forecasting all of your current and future sources of income: employment, rental, pension, stock options, social security, RMDs, dividends, interest, etc.
Your View on Future Tax Rates vs. Today’s Tax Rates
Nobody holds the crystal ball on what congress will do in the future. When looking at your future it’s important to consider how and when Congress will begin to account for the growing national debt and what you think that means for your future tax rates.
Based on all of the aspects of the 401(k) and the unknown of future tax rates, you may want to consider adding tax diversification to your financial picture through alternative types of accounts. The alternative strategies that I cover further in the video:
Saving in a Taxable (“Brokerage”) Account
This is an account in which you will get taxed on interest, dividends and recognized gains/losses each year. This account type brings flexibility of being able to make contributions and withdrawals at any age. Also, with a longer term focus you may fall into the more favorable long-term capital gains rate vs. ordinary income tax rates
Saving in a Roth 401(k) / Roth IRA
While you will pay tax today on funds that you put into these accounts, they can provide you tax-free growth and tax-free withdrawals for your future.
How much should you save into each account type? That depends on your specific situation. Putting together a tax plan and taking small actions to diversify yourself could potentially make big differences in how much of your retirement savings you will keep vs. pay to the IRS over your lifetime.