The Hidden Truth Behind Traditional 401(k) Plans
January 16, 2020
If you are like most Americans, you’ve heard the phrase “start saving for retirement,” drilled into your head by parents, bosses, and financial planners from the time you got your first paycheck. They weren’t wrong, as it’s definitely never too early. But for some, the tried and true methods of doing so may not be the best options anymore. If you’ve got a traditional 401(k) plan, you may want to look closer at how it could end up affecting your retirement plans.
It may sound odd to challenge three decades of retirement orthodoxy, but there are certain cases where a traditional 401(k) may end up costing you money over the long run, depending on your individual situation.
A Time Bomb?
Before you decide on if a 401(k) is right for you, it’s important to understand what’s at work when you utilize it to save for retirement.
One of the main reasons a traditional 401(k) is so attractive in the here and now is that it defers the taxes on the income. When you are just starting to save for retirement, that’s a good thing.
But that can set you up for trouble later. Benefitting from a 401(k) plan assumes that you’ll be living at a lower tax bracket in retirement than you are now. If you do well at saving for retirement, however, you’ll cost yourself money in the end.
That’s because once you age past 70.5 years, your traditional 401(k) mandates you start withdrawing a certain amount every year, called the required minimum distribution (RMD). If that forced withdrawal raises your income too high, it can trigger all kinds of financial issues.
Jumping into a higher tax bracket can result in your money being taxed at a higher rate at withdrawal than it would have been at deposit. It could also cause you to pay higher Medicare premiums and pay back some of your social security benefits in taxes. It doesn’t take a financial planner to recognize that’s not maximizing your investment.
Keep Your Options Open
This doesn’t mean that you should immediately stop contributing to retirement. It merely suggests exploring your options more fully as your career progresses.
One retirement option that many are focusing on is the Roth 401(k). A Roth 401(k) differs from a traditional 401(k) in that money deposited into your account is going in after taxes have been taken out. When the time comes to withdraw your money in retirement, it will be done completely tax-free.
Roth 401(k) plans are attractive for both young retirement investors, and those who can see the light at the end of the tunnel. Young people will be paying into their plans when their earning potential is low, and therefore money will go in at a lower tax rate. For those in their 40s and 50s, adding a Roth 401(k) can help diversify their retirement savings.
Both traditional plans and Roth 401(k) plans are excellent investment vehicles when utilized correctly. It’s worth mentioning that a Roth 401(k) is a Roth offered through your workplace, while a Roth IRA is one you open outside of work. Understanding how each is implemented can help you make the right choice for your retirement. We can answer your 401(k) questions and help you determine the best plan for you now and what will be good for you in the future. Contact us today to talk about your retirement plans with one of our financial specialists.
By Jeff Mohlman