Just about every financial expert I know advises savers to contribute to their company’s 401(k) plan — at least enough to receive the employer’s matching contribution.
I can’t argue any differently.
That company match is free money — a bonus from the boss — so why not cash in if you can?
And, of course, the tax breaks are another bonus. Because the money comes out of your paycheck before taxes are calculated and compounds every year without a bill from Uncle Sam, investing in a defined contribution plan is bound to make April 15 more tolerable.
Not a bad deal, right?
Until you’re ready to retire, that is. That’s when a 401(k) (or 403(b) or traditional IRA) suddenly becomes the worst possible retirement plan, from a tax perspective, a saver could have. Here’s why:
1. Every distribution you take will be taxed at your highest rate.
When you eventually make withdrawals from a traditional defined contribution plan, you'll have to pay regular income taxes on that amount each year, whether the money came from your contributions, dividends or capital gains. And the money will be taxed at your income tax rate at the time you withdraw it — whatever that may be. (The top marginal income tax rate for 2019 is 37%, but it's likely to change down the road.)
You’ve likely been told you’ll be in a lower tax bracket in retirement, but that isn’t necessarily true. If you keep the same standard of living, you will require about the same amount of income, which means the same tax rate. And in retirement, when your children are grown, your house is paid for and those substantial tax deductions have gone away, you may end up in a higher bracket.
2. Double taxation is often the ‘norm.’
Besides paying income taxes on the money coming out of your retirement plan, depending on how much you withdraw each year, you also could end up paying more taxes on your Social Security benefits.
If you are like many retirees, you may not realize that distributions from your retirement plans (with the exception of a Roth IRA) count against you when you calculate how much of your Social Security is subject to tax. So you pay tax on your retirement plan distribution, and then you pay tax again on more of your Social Security income. And, don’t forget, if you have capital gains, dividends and interest from investments, you may end up paying more taxes on those as well.
3. Ready or not, you have to withdraw money when the IRS says so.
Your traditional defined contribution plan is pretty much the only type of retirement account that requires you to withdraw money even if you don’t want to. The IRS won’t allow you to keep retirement funds in your account indefinitely; you generally have to start taking withdrawals when you reach age 70½. If you don’t, or if you make a mistake in calculating your required minimum distributions (RMDs), you may have to pay an additional 50% tax.
4. It’s absolutely the worst account to leave to a surviving spouse.
If you want your spouse to be financially secure and your solution is to leave behind a big IRA or 401(k), think again. You’re leaving behind a fully taxable account to someone who is about to go from the lowest-obligation tax status (married filing jointly) to the highest-obligation tax status (single). It’s the opposite of what you should do.
5. Your account is fully exposed to tax law changes.
You have a silent partner in your 401(k), and his name is Uncle Sam. Every time Congress meets, there’s a chance the government could decide to increase the IRS’ share of your savings — and quite frankly, you have nothing to say about it. If you don’t think that’s a problem — if you don’t expect tax rates to increase in the future — check out www.usdebtclock.org (opens in new tab).
So, what should you do if you’re somewhere between Point A (when saving money in a 401(k) plan seems like a great idea) and Point B (when withdrawing money from a 401(k) seems like a very bad idea)?
You should sit down with your tax planner (not your tax preparer) every year to identify strategic ways to exit out of these accounts. What’s the difference between a tax planner and a tax preparer? Well, a tax planner educates you on ways to reduce your taxes now and in the future, while a tax preparer just calculates your tax bill and sends it off to the IRS.
You may want to move that money from a traditional IRA to a Roth IRA through Roth conversions — realizing that you’d have to pay the tax bill on the amount you’re converting. Or you could move it into a specially designed life insurance plan that works very similarly to a Roth. (Don’t mess with the life insurance option unless you’re working with someone who truly understands that environment, though.)
You’ll pay a little extra in taxes today, but you’ll eliminate every problem I’ve talked about here:
- Any future distributions from those accounts will be tax free instead of taxable.
- They won’t count against your Social Security or capital gains tax calculations the way they do when you’re in a traditional IRA.
- You won’t have forced distributions from either of those options.
- You’ll have tax-free money to leave behind for a surviving spouse.
- And you should be immunized against any actions Congress might take to increase the government’s share of your savings.
Here’s the thing to think about with all your accounts: You can pay taxes now or you can pay taxes later, but taxes will be paid. So, talk to your financial adviser and/or tax professional about what that looks like for you and your family. And be prepared to make some moves as you transition toward retirement.
Kim Franke-Folstad contributed to this article.
Michael Reese, CFP, CLU, ChFC, CTS is the founder and principal of Centennial Advisors LLC (opens in new tab), with offices in Austin, Texas, and Traverse City, Mich. Michael's vision is to help American retirees "re-think" how they manage their financial portfolios during their retirement years. His focus is to help retirees enjoy financial security in any economy, something that he believes is sorely lacking in today's financial world.
You Can Tip Your Amazon Driver Through Alexa. It Won’t Cost You a Dime
Amazon is rolling out a service that will reward its drivers and customers won't pay a dime...
By Bob Niedt • Published
10 Most Tax-Friendly States for Middle-Class Families
state tax If a move from one state to another is in your future, you could save big bucks by relocating to one of these states where the tax bite is light for middle-class families.
By David Muhlbaum • Published
Where Is the Economy Heading? Velocity of Money Provides Clues
Financial adviser looks at the rate at which money is being spent in the economy for an idea of whether we’ll see a recession in 2023.
By T. Eric Reich, CIMA®, CFP®, CLU®, ChFC® • Published
7 Financial Planning Steps to Take at the End of the Year
These moves are good to make at any time of the year, but doing them before 2023 arrives can help you enjoy a fresh, confident start to the new year.
By Andrew Rosen, CFP®, CEP • Published
4 Steps to Take if You Lose Your Job Near Retirement
Being let go from a job later in life can lead to financial disaster, but there are some things you can do to help lessen the damage.
By Tony Drake, CFP®, Investment Advisor Representative • Published
Divorcing a Trustee: Do You Need a Prenuptial?
For any corporate trustee you choose, there should be some minimum requirements, and it’s best to check its reputation ahead of time to find out if its trust relationships end amicably.
By Timothy Barrett, Trust Counsel • Published
Doing Your Retirement Income Planning in the Right Order Matters
A strong retirement income strategy considers many factors, including the retiree’s unique financial resources and needs. How and when you tackle them is critical.
By Jerry Golden, Investment Adviser Representative • Published
2 Ways Retirees Can Defuse a Tax Bomb (It’s Not Too Late!)
If you’re retired and find yourself sitting on a “tax bomb,” you may think there’s nothing you can do. But two strategies could seriously reduce your taxes in retirement.
By David McClellan • Published
Short-Term Investments to Protect Against Inflation and Market Volatility
Rates on Series I savings bonds, T-bills and fixed annuities are all above historical averages and could serve investors well during turbulent times like these.
By Bradley Rosen • Published
What’s the Difference Between Average and Actual Rate of Return?
An average rate of return can mask losses over time, so what investors really want to keep an eye on is the actual rate of return.
By Carlos Dias Jr., Wealth Adviser • Published