401(k)s

5 Reasons a 401(k) May Be the Worst Account to Have in Retirement

That massive 401(k) nest egg that you're so proud of comes with some serious baggage. Here are five major cons of these accounts and a couple of alternatives to consider instead.

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.

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.

About the Author

Michael Reese, CFP®

Founder and Principal, Centennial Advisors LLC

Michael Reese, CFP, CLU, ChFC, CTS is the founder and principal of Centennial Advisors LLC, 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.

Most Popular

The 15 Best Stocks for the Rest of 2022
stocks to buy

The 15 Best Stocks for the Rest of 2022

The lesson of the past two years: Be ready for anything. Our 15 best stocks to buy for the rest of 2022 reflect several possible outcomes for the seco…
June 21, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Retirement Comfort: How to Avoid Running Out of Money
retirement planning

Retirement Comfort: How to Avoid Running Out of Money

When it comes to retirement planning, one thing all of us worry about is whether we will have enough money to last. Financial professionals can help y…
June 25, 2022

Recommended

Taxes on Unemployment Benefits: A State-by-State Guide
state tax

Taxes on Unemployment Benefits: A State-by-State Guide

Don't be surprised by an unexpected state tax bill on your unemployment benefits. Know where unemployment compensation is taxable and where it isn't.
June 23, 2022
33 States with No Estate Taxes or Inheritance Taxes
retirement

33 States with No Estate Taxes or Inheritance Taxes

Even with the federal exemption from death taxes raised, retirees should pay more attention to estate taxes and inheritance taxes levied by states.
June 23, 2022
Tax Changes and Key Amounts for the 2022 Tax Year
tax law

Tax Changes and Key Amounts for the 2022 Tax Year

Americans are facing a long list of tax changes for the 2022 tax year. Smart taxpayers will start planning for them now.
June 10, 2022
When Are 2022 Estimated Tax Payments Due?
tax deadline

When Are 2022 Estimated Tax Payments Due?

If you're self-employed or don't have taxes withheld from other sources of taxable income, it's up to you to periodically pay the IRS by making estima…
June 10, 2022