Your 401(k) retirement account, untaxed until you start withdrawing money from it, may actually end up socking you with a heavy tax bill then. That shocks a lot of retirees, who thought their taxes would be lighter. But there’s a way to get around this problem.
Most people fall into one of three categories of financial knowledge. Either they 1) don’t understand it at all (which is absolutely fine as this is a complex financial world we live in), or 2) understand taxes or 3) understand investing. Very few we run across have a good handle on taxation and investing.
Sadly, understanding your 401(k) – the most common employer-sponsored retirement plan – really requires a basic understanding of both elements.
The defined-contribution plan or 401(k), according to tax law, is obliged to have at least three investment options, usually mutual funds. Most plans have many more than that. The investment choices involve risk, and you can make or lose money on them.
You are the financial decision maker here: You decide how to invest your money. How it performs is your responsibility. With old-style defined-benefit pension plans, where your retirement payout rests on your final salary and years of service, a professional pension manager steers investment policy. So with a 401(k), some people hire a financial advisor to help them manage the money.
The employer puts the programs together and organizes the menu of choices. Sometimes, the employer matches employees’ contributions to the plan to encourage individuals to participate. The maximum contribution for 2013 is $17,500, and those over age 50 can add an extra $5,000.
All of this is done with the best of intentions, but you need to save for both rainy days and sunny ones in your future. Money gives you choices. If you don’t save, you will have very little financial freedom during your retirement.
One of the best parts about the 401(k) is that the money comes right out of your paycheck, automatically. There is no chance to spend it or give it away. This is a great method to put your contributions on autopilot.
The tax issue is the downside. You do not pay tax on money that you contribute to a 401(k). The IRS can tax you only once you withdraw money in retirement, when your income – and thus your tax burden – is presumably lower. But it doesn’t often work out that way.
Congress created the 401(k) retirement plan in 1978, when the top tax rate was over 70% and there were many brackets. The plan’s authors believed that most people would retire in a lower tax bracket. President Ronald Regan changed the entire system in 1986, creating three brackets with the top at 31%.
But after 25 years of helping families plan for retirement, I count very few that reduced their tax bracket. Some are even forced into higher brackets due to required minimum distributions from their retirement accounts. With an RMD, as it’s called, you must start taking money out of your 401(k) or individual retirement account at age 70½. That’s true even if you don’t need the money – and it adds to your tax exposure.
Many 401(k) plans have a Roth option. A Roth 401(k) still lets you contribute out of your paycheck, but you will pay taxes at your marginal tax rate today rather than at your tax rate when the money comes out of the account. It won’t feel as good at the current-day tax time, but you may be happier in the future.
As you near 70, a good idea is to shift your Roth 401(k) money, which has an RMD, into a Roth IRA, which does not. Note that you can’t place everything into a Roth: Your employer’s match has to go to the tax-deferred portion of the account, i.e., a traditional 401(k).
We have seen families put money in 401(k) plans when they were effectively in a 0% tax bracket. Why defer zero taxes into the future, when you may have to pay the IRS on the money? It’s better to put the money into a Roth and pay no taxes on it now. Not all plans have the Roth option, but they should.
Don’t forget to consult with your tax and investment professionals. This is your retirement and it is personal.
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Joseph “Big Joe” Clark, CFP, is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He teaches financial planning at Purdue University and is the host of Consider This with Big Joe Clark, found on WQME and iTunes. He is a Registered Principal offering Securities and Registered Investment Advisory Services through World Equity Group, Inc, member FINRA/SIPC. Big Joe can be reached at firstname.lastname@example.org, or (765) 640-1524. Follow him on Twitter at @Big Joe_Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.
Securities offered through and by World Equity Group Inc. Member FINRA/SIPC. Advisory services can be offered by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.
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