Since its debut nearly 40 years ago, the 401(k) has emerged as one of the premier tools to save for retirement in America. In fact, when we poll 401(k) participants across the country, the majority of them consistently say it’s their largest — or only — source of retirement savings.*
One of the main reasons 401(k) accounts are so popular and effective is their tax treatment. A traditional 401(k) is funded from your pretax paycheck, so the money you put into your plan, and any potential gains on your investments, are not taxed until you ultimately withdraw the money. Importantly, contributions lower your taxable income, and contributing enough could even move you into a lower tax bracket in a given year.
The flip side is that when you eventually withdraw money from a traditional 401(k) in retirement, those withdrawals are subject to ordinary income tax. That’s why it’s referred to as a “tax-deferred” vehicle — taxes are deferred until you begin to take the cash out.
Those of us who work in the retirement industry tend to assume that people who are utilizing a 401(k) plan understand this basic tenet, but that isn’t necessarily the case, and it’s something that’s been on my mind as we’ve reached the end of another tax season.
On the eve of retirement, a diligent saver might see a million-dollar account balance and assume that’s the amount they have to work with to cover their expenses in their golden years. If so, they are in for a rude awakening. Realistically, today that million dollars is probably closer to $700,000, assuming they are paying federal, state and local income taxes. The same principle is true for those with lower balances. Simply put, a sizable chunk of the money in your 401(k) will be paid to the government.
With that in mind, it’s important for those saving in a traditional 401(k) — especially if they’re relying heavily on it for the money they’ll need in retirement — to keep their tax obligation in mind when they are setting and working toward a specific savings target. We don’t know where tax rates will be in the future, but you should probably plan on at least 20% in federal tax, and maybe another 2% to 10% in state and local tax, depending upon where you live.
And if you are using a retirement calculator to help you plan and estimate what you’ll have in retirement, make sure you understand whether or not it takes taxes into account. Let’s say an online calculator shows you might have $5,000 a month in income from your 401(k). Is that $5,000 a month after you pay taxes, or before? For example, that $5,000 may only be $3,500 to spend, plus $1,500 you’ll owe in income tax.
Everyone’s strategy for building a “retirement paycheck” will be different, but there are certain rules that apply based on age. For instance, once you turn 59½, you are able to take money from your 401(k) without an extra tax penalty, but again you likely will still pay at least 20% in federal income tax (or more if you’re at a higher income-tax rate), plus any state and local income tax. Keep in mind, if you withdraw at this age but are still working and taking home a regular paycheck, you could very well be putting yourself into a higher tax bracket, as the money you took out of your 401(k) will be factored into your taxable income along with your salary. And once you hit age 65, withdrawing enough to cross into a higher income bracket might also leave you paying higher Medicare premiums.
If you continue to work into your 60s or 70s, you may wish to preserve your 401(k) balance for as long as possible. You are not obligated to take money out of your traditional 401(k) until the year you turn age 70.5, at which point required minimum distributions (RMDs) come into play. RMDs are a minimum amount you must withdraw from your 401(k) each year once you reach that age — or else face a very steep IRS penalty. Those withdrawals are, once again, taxed as ordinary income.
Some retirees may be tempted to dip into their 401(k) to make a big one-time purchase, like a child’s wedding, or to pay off a mortgage or other large debt. But it’s important to keep in mind that that, too, is a taxable withdrawal.
To help streamline this process for workers, many 401(k) plan administrators will include tax withholding options on the withdrawal paperwork. Some might automatically withhold 20% and allow you to elect a percentage over and above that, as well as a certain percentage for state and local tax, if applicable. It’s important to pay attention to whether your plan administrator follows this practice so you’re not faced with a huge surprise come tax time.
In addition to traditional 401(k) plans, many companies offer what’s called a Roth 401(k). Unlike its traditional counterpart, the Roth is funded with after-tax money and then withdrawals you make in retirement are tax-free. A Roth often makes sense for those who anticipate retiring in a higher tax bracket — that is, they’ll bear the tax burden upfront and then not have to worry about it in retirement when it might be significantly larger. Some savers may devise a strategy wherein they split money between traditional and Roth accounts to give themselves various tax options. Consulting with a tax or other financial professional is a great way to come up with a plan suited to your situation.
To that point, working with a financial professional to figure out how much you should save, set retirement goals and make investment choices can help you become more educated about the nuances of 401(k) investing — and help you avoid surprises by the time you reach retirement. For now, remember that “tax-deferred” does not mean “tax-free” and prepare in the present for your obligations down the road.