If you read any article over the past 30 years on how to save for retirement, you can pretty much guarantee that somewhere in that article, the author will tell you that you should do your best to maximize your contributions to your 401(k) / 403(b) plan if you can. The three reasons for doing so are familiar:
First, a 401(k) / 403(b) contribution represents “forced savings." This is a good thing. With that being said, if you are an adult, then this should not be a big issue for you.
Second, with your 401(k) / 403(b) you receive a tax deduction on your contribution. Often you will hear or read the argument that you should save tax today while you are working and paying a higher tax rate. You should pay taxes later when you are retired and in a lower tax bracket. (We will look into this one a bit later.)
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Third, you may get a company match on your contribution. That company match represents “free” money. This is a very good thing!
Given these three positive reasons for using your company retirement savings program, whether it be a 401(k) or 403(b) or something else that is similar, why wouldn’t a prudent person jump right on board?
Here’s why.
Reason #1: You create an enormous tax liability
Think about it this way. Let’s say you are saving $18,000 per year in your 401(k) or 403(b). You are deferring income tax on $18,000 each year you deposit the money. But when you retire, you may have built up an account worth $1 or $2 million. That is $1 or $2 million that has never been taxed! And you, or your heirs, will pay tax on every penny of it.
You saved tax on your seed, but you will owe tax on your harvest.
Reason #2: You are NOT in a lower tax rate bracket in retirement
401(k) and 403(b) plan providers will often tell you to take your tax deduction today and pay tax later when you are retired and in a lower bracket. Just one problem: Do you really want to be in a lower tax bracket when you retire?
Think about it. Do you want to retire with a lower standard of living? You save for 30 years, and if you do a good job, you get to retire into the SAME standard of living. This means you will have about the same amount of income, which means the same tax rate. But now your home is paid for, your children are gone, and your tax deductions have vanished.
The taxes you owe increase, and that assumes tax rates do not rise in the future. What do you think the odds are on that?
Reason #3: You are now a target
You might agree that the good folks in Washington, D.C., have a spending problem. But how are they going to pay for it all?
You can bet your last dollar that they all know that there are trillions of dollars sitting in 401(k) and 403(b) plans that have never been taxed. This is like candy to a baby, and they want it. Do you really want the bulk of your retirement dollars sitting in the crosshairs of a government with a spending habit?
What you should do:
1. Only put the minimum in your 401(k) / 403(b) to get your company match. Free money is a good thing. Take advantage of your employer match. Adding in additional funds beyond that is a mistake.
Note: If your company allows your contribution to be put into a Roth 401(k), then by all means, max that out. It is okay to max out your 401(k) into a Roth option, but not the traditional one.
2. Any additional dollars should go into Roth IRAs that will be tax-free for life. If you make too much money to contribute to a Roth IRA, just deposit your money into a non-tax deductible IRA, and convert it to a Roth the next day.
Note: Please verify this approach will work with your accountant. If you already have traditional IRAs out there, it may not work.
3. Look into “maximum-funded life insurance” as a 401(k) option. Be careful on this one, but if you have a really good financial person on your side, they can help you set it up in the proper way.
When it comes to taxes on your retirement plans, Uncle Sam takes a “pay me now or pay me later” approach. You know that in life, it is almost always better to just pay me now. The same is true with taxes and retirement.
It is okay to pay a little now to be tax-free later. In fact, it’s better than okay.
-
Dow Sinks 301 Points on Trade War Talk: Stock Market TodayThe contentious relationship between the world's two biggest economies continues to drive global financial markets.
-
Top Places to Park $10K (or More) as Rates Start to FallWith more rate cuts upcoming, here are some smart places to maximize your savings on $10,000.
-
Financial Fact vs Fiction: The Truth About Social Security Entitlement (and Reverse Mortgages' Bad Rap)Despite the 'entitlement' moniker, Social Security and Medicare are both benefits that workers earn. And reverse mortgages can be a strategic tool for certain people. Plus, we're setting the record straight on three other myths.
-
Medicare Open Enrollment: Why You Need to Pay Extra Attention to Part D, From a Financial AdviserThe lowest premium for prescription drug coverage might not actually save you the most money. Make sure you take copays into consideration and do the math.
-
Five Retirement Planning Traps You Can't Afford to Fall Into, From a Wealth AdviserTo help ensure you reach your savings goals and enjoy financial security in your golden years, be aware of these common pitfalls. The key is to be proactive, informed and flexible.
-
Your 401(k) Can Now Include Alternative Assets, But Should It? A Financial Adviser Weighs InMany employer-sponsored plans offer limited investment options, which can stunt growth. But participants considering alternatives might need some sound advice to get the most from their accounts.
-
Will Taxes Shred Your 401(k) or IRA During Your Retirement? It's Very LikelyConventional wisdom dictates that you save in a 401(k) now and pay taxes later, but turning that rule on its head could leave you far better off. A financial planner explains why.
-
More Retirees Are Renting: Should You? A Financial Adviser Weighs InIn some ways, renting is cheaper, more flexible and easier, but unless you understand the implications for your taxes and health costs, it might not be for you.
-
Where There's a Will, There's a Way Your Assets Will Be Distributed as You WishYour will is the backbone of a strong, adaptable estate plan that ensures what you leave behind goes to your selected beneficiaries. Without a will, state laws determine who gets your assets.
-
I'm a Financial Adviser: This Is What You're Really Losing if You Cut Back on Your 401(k) ContributionsMissing out on the benefits of the employer match and compounding growth could force you to work longer and lower your standard of living in retirement. Here are some alternative options.
