Are 401(k)s the best vehicle for retirement?
Who does not love free money? No one. That is what you can get when you contribute to your company’s 401(k) plan if they match any of your contributions.
Our advice: take full advantage of that matching.
That is free money, a bonus, a perk, a great reason to be saving for the future.
Another win for the 401(k) are the tax breaks, initially. The money comes out of your paycheck before taxes and which means you are lowering your tax bill for this year and the years that you are working.
Sound good? At first glance it does but what about when you are ready to retire? At retirement is when a 401(k) or other traditional IRAs suddenly become taxable and potentially the worst retirement plan you could have.
Let’s break that down.
1. You will be taxed at your highest rate.
No matter how you withdrawal money from your traditional IRA, you’ll have to pay regular income taxes on that amount each year. That money will be taxed at your income tax rate at the time you withdraw it, whatever that may be.
You’ve likely been told that you will be in a lower tax bracket when you retire, but that is not necessarily the case. When someone starts working out of college, they are earning considerably less than the executives that have been in the workforce for 30 plus years. So really, as time goes on you will likely make more money the older you get compared to when you were young.
Let’s take a quick look at America’s tax rate history. The highest our tax rates have been in the past have been more than 90%. Ouch. The average from now, which is one of the lowest tax rates in history [currently 37% for the highest bracket] throughout our nation’s history, the average tax rate is around 60%, so we could have a long way to go.
So when it comes to retirement you will likely be in one of the highest tax brackets you have ever been in and your 401(k) will be subject to unknown tax rates in the future.
This section could go on and on but we have more to get to.
2. Stealth taxes
You understand that you will pay taxes on your withdrawals from your 401(k) in retirement, but you could also end up paying two additional taxes that we call “stealth taxes.”
Stealth tax #1 – By taking money out of your 401(k) you could end up having to pay taxes on your Social Security benefits. You likely are not aware but paying taxes on your Social Security benefits is optional, if your income is coming from the right source. If most of your retirement is coming from a 401(k) then you will end up paying unnecessary taxes on your Social Security.
There are a few financial products that would not count against your Social Security that you could use for retirement income and we suggest you use these if you can. Most people can use at least one of them.
Stealth tax #2 – If you make “too much money” the government is going to charge your extra premiums for your Part B and Part D for Medicare. This year the maximum amount they charge extra is over $9,000. For no additional benefits.
If you have too much money coming form traditional IRAs you will have to pay extra for your Medicare. Just like reducing or eliminating taxes on your Social Security can be done if you have income sources coming from the right places, this Medicare stealth tax can be reduced or eliminated too.
3. You have a partner in retirement.
Like it or not you have a partner in your retirement, Uncle Sam. Because of this the government can tell you when you can access your money without penalty. Even worse, they tell you that you have to access your money by a certain age. Why?
Well, your retirement plan is the government’s retirement plan and they want their money. The government tells you that you have to take your money out by age 70 ½ or they will assess a penalty, even if you don’t need the money.
The government wants their “share” of your money that you have worked hard all your working life to earn, save, and grow.
If you don’t want this kind of partner in retirement, there are ways that you can avoid these kinds of rules in retirement and have lots more flexibility and options.
4. It’s the worst account to leave to a surviving spouse.
Sure, leaving behind a big IRA or 401(k)s to your spouse sounds like a good idea, but you would be wrong. You would be leaving 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 exact opposite of what you should do.
So, what are some things that you can do from here…
- Take advantage of matching programs at work
- If you are putting additional funds above what is being matched at work, consider a different retirement vehicle.
- Considering using a financial vehicle that allows you to pay taxes now, and none later, such as a Roth IRA.
- If you make too much to contribute to a Roth IRA, consider using permanent life insurance with cash value that works similar to a Roth IRA.
- Consider converting some of your taxable retirement money to tax-free retirement money now. Since we are in the lowest tax bracket in history, now is the time to do it. Think of it like the basics of buying stocks, buy low and sell high. Taxes are low, so you buy those low taxes now so when they do go back up, they don’t impact your retirement.
- Make sure you have your retirement income flowing from the right sources to avoid or eliminate the stealth taxes.
- Consider having tax-free money to leave behind to your spouse. Life insurance is the ideal solution for this.
Bottom line: taxes can be paid now or later, but taxes will be paid. If you wait to pay them later you will pay much more back to the government.
We recently helped someone save over $400,000 in taxes in retirement by using the ideas we discussed here.
If you would like to visit with us about how you may be better prepared, give us a call.
ABOUT THE AUTHOR: Don Meyer is the President and a Co-Founder of Both Hands Financial Group. He is also an Investment Advisor Representative and insurance advisor and has helped thousands of people across the country understand how investments and insurance work together. Don has dedicated his career to informing and educating people so they can make informed and educated decisions about their insurance and investments.