Is A 401K The Worst Account To Have In Retirement?
Let us talk about 401Ks not being the worst account to have in retirement. There are actually far worse accounts to have!
Retirement Basics: What Is a 401(k) Plan?
A 401(k) is a retirement plan set up by an employer. If your benefits package includes a 401(k) account, you can choose to contribute a certain amount of your salary, subject to annual limitations. Your employer might even match some of what you put in. Your retirement savings are invested in the stock market and grow over time to generate a retirement income.
How do 401(k) plans work?
A 401(k) is a type of defined contribution plan, which means that employees decide how much money to put into their accounts. The strange name "401(k)" comes from the section of the Internal Revenue Code that governs the plans. There are two kinds of 401(k) accounts that employers offer: Traditional and Roth.
In a traditional 401(k) plan, contributions are taken out of your paycheck before taxes are taken out. This means that your contributions immediately lower the amount of your income that is taxed. The money is put into mutual funds and other investments, which make the money grow over time. When you retire and withdraw money from your traditional 401(k), you pay ordinary income tax on the withdrawals.
With a Roth 401(k), contributions come out of your after-tax income, so they don't lower your taxable income. Like with a Roth individual retirement account (IRA), you don't have to pay income taxes on qualified distributions, like those made after age 59 12 if you've had the account for at least five years. If you think your tax bracket will be higher when you retire than it is now, a Roth 401(k) might make sense. With lower income levels and tax brackets, a Roth 401(k) could be a great choice for many young workers who are just starting out in their careers.
You don't have to choose between a traditional 401(k) and a Roth 401(k)—if your employer offers both, you can make contributions to both. When deciding between a traditional 401(k) and a Roth 401(k) or how to split your contributions between the two, you might want to talk to a tax expert or a financial advisor.
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Annual contributions to a 401(k) account are determined by the account owner, subject to IRS limits. When you start a new job, you can choose to save a percentage of your annual salary in your employer's 401(k), and you can adjust your contribution level as often as the plan's rules permit. You may stop all contributions at any time and for any reason.
Let's imagine your biweekly paycheck is $2,000, and you've decided to invest 5% of your annual salary in the company's typical 401(k) plan. In this example, $100 from each paycheck would be deducted and placed into your 401(k) account. You would have a taxable income of $1,900 (assuming no other pre-tax deductions). If you chose a Roth 401(k), $100 would be deducted from your paycheck after taxes. You may be automatically enrolled in a 401(k) plan at a predetermined contribution rate when you begin a new job, unless you choose to opt-out of the plan. Alternately, you may be required to affirmatively opt-in or opt-out of your employer's 401(k) plan.
Limits on Annual 401(k) Contributions
The maximum employee contribution for 2022 is $20,500, plus an additional $6,500 if you are 50 or older, for a total of $27,000. These limits apply to all 401(k) contributions, even if they are split between pre-tax and Roth contributions, or if you have two employers and two distinct 401(k) accounts in a given year.
Approximately one-fifth of employers permit after-tax, non-Roth contributions. In such instances, a combined limit on employee and employer contributions applies. In other words, the sum of your employer's contributions plus your pre-tax, Roth, and post-tax contributions cannot exceed this amount. The overall limit for 2022 is $61,000, or $67,500 for individuals 50 and older. These additional after-tax savings grow tax-deferred but not tax-free, unlike Roth contributions.
Employer and Employee 401(k) Annual Contribution Limits
The contribution limitations are revised annually, so it is important to check each year to see if you can contribute more.
How Do Employer-Matched 401(k) Contributions Work?
Some employers will match the 401(k) contributions of their employees, up to a specified percentage of their salary. Employers typically match employee contributions dollar-for-dollar, up to a total sum equal to 3 percent of the employee's salary. Another popular formula is for the employer to put in 50 cents for every dollar the employee puts in, up to a total of 5 percent of the employee's salary.
Consider the impact of an employer match of up to 3 percent of your salary on your 401(k) contributions. If you contribute 5% of your annual salary and receive $2,000 per pay period, you would contribute $100 and your employer would contribute $60 per pay period. Find out whether your employer offers matching 401(k) contributions and how much you must pay to maximize the match when you begin a new job. If they do, you should at least set your 401(k) contribution amount to receive the full match; otherwise, you're throwing away free money.
401(k) Matching Contributions and Vesting
Some employers offer matching 401(k) contributions that vest gradually. A vesting schedule allows you to progressively gain ownership of your employer's matching contributions over a number of years. If you continue with the employer for the duration of the vesting term, your 401(k) account is said to be "fully vested."
Employers implement vesting schedules to encourage employees to remain with the company. Imagine, for instance, that 50% of your employer's matching contributions vest after two years of employment and that you become fully vested after three years. If you were to quit your firm after two years and accept a new position, you would lose half of your employer's matching contributions.
Keep in mind, however, that you always maintain full ownership of your 401(k) contributions. Only the employer's matching contributions are involved in vesting.
So, which retirement account is the better option?
Most people choose the traditional option because you get the deduction in the present. Although it's human nature to want everything immediately, a Roth IRA is the wiser choice given the likelihood that your tax rate will be higher in retirement. You get a little bit less of each paycheck, but it will pay dividends (no pun intended) down the road with a stream of tax free income in retirement.
Withdrawing funds from your 401(k)
The primary distinction between a traditional 401k and a Roth 401k is when taxes are paid. When you contribute pre-tax money to a regular 401(k), you obtain an immediate tax deduction and pay less in current income taxes. Your savings, including contributions and returns, grow tax-deferred until you withdraw them. Withdrawals are then considered ordinary income and must be paid to Uncle Sam at your existing tax rate, in addition to any applicable state taxes. If you are younger than 59 and a half, you will be subject to a 10% penalty (with a few exceptions).
In a Roth 401k, it basically works the other way around. Your contributions are made with after-tax money, so there is no initial tax deduction. However, if you hold the account for five years and are over the age of 59 & 1/2, withdrawals of both contributions and earnings are tax-free. Therefore, the main decision is whether it is advantageous for you to pay your taxes now or later. And a lot of that depends on your timeframe and what the potential future holds.
The money you save in a 401(k) is meant to pay you when you retire.
Evaluating Now Versus Later
Even if it seems like a wonderful deal right now, you need to plan forward. According to current tax regulations, depending on your tax status, every dollar you remove from a traditional 401k at retirement might be cut by 20 or 30 percent (or more!). You will therefore need to save significantly more money to cover your retirement cash flow.
The Roth 401k can be a wise decision if you are young and certain that you will be making more money and will be subject to a higher tax rate in the future. However, even if you are in your 40s, 50s, or 60s, you might want to give the Roth option some serious thought. Why? Because withdrawals from your traditional retirement plans may force you into a higher tax bracket even if you retire in a lower income tax band. This can raise your tax bill and even impose taxes on your Social Security benefits, which might lower your available cash. Your Medicare B premiums in retirement may cost more if you have a higher taxable income. Therefore, forgoing the tax deduction now can be well worth it to enjoy tax-free withdrawals in the future.
Using Both to Protect Your Bets!
The best part is that you do not have to choose between a traditional 401K and a Roth 401K all or nothing. You might be able to do both, and you could choose where to put your money each year. You may even be able to split your contributions between the two types of accounts if your employer's plan lets you. As stated above, in 2022, you can put up to $20,500 into your 401k. (Plus, you can add an additional $6,500 if you are 50 or older.) So, depending on the rules of your plan, you might decide in 2022 to put $10,250 in your traditional 401(k) and $10,250 in your Roth, getting the benefits of both.
A Few More Things to Think About:
You have to take a required minimum distribution (RMD) from a Roth 401k, just like a traditional 401k, but not from a Roth IRA, unless you are still working for that employer. The SECURE Act of 2019 raised the age to 72 for people who are not already 7012 to take their first RMD. Before, the age was 70 & 1/2. If you roll over your Roth 401k into a Roth IRA, you can get rid of this rule. But before you decide, you should carefully look at other things about each account, like fees, legal protection, loan terms, and other details. When making plans even further ahead and thinking about your estate, having your heirs inherit money in a Roth could be good news because, as long as the Roth 401k is at least 5 years old, they would not have to pay income taxes on the money they took out.
It is great that you have a choice, and the best choice may be to invest in both types of accounts. No matter what you choose, you are already saving and planning for retirement. That is the best thing you could do!
I hope this information was helpful. If you have any questions, feel free to reach out. I’d be happy to chat with you.
About the Author
As a Partner and Financial Advisor here at Vincere Wealth, Tim helps clients navigate their financial challenges and decisions. Having someone guide you today in making sound financial decisions can have a substantial impact on your future financial well-being. Tim takes great pride in guiding clients through the complexities of insurance, estate planning, and cash flow optimization.
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