Saturday, 25 May, 2024

Are 401(k) Plans Good or Bad?


Reading Time: 4 minutes

It’s almost an unquestioned truth that you should invest in your company’s 401(k) plan for retirement. If you need convincing, look no further than the obvious benefits:

  1. The employer match;
  2. The tax benefits; and,
  3. The excellent long-term returns of the stock market.

But is there more to the story?

The Risks And Benefits Of 401(k) Plans

The primary benefit of 401(k) plans are the 401 k employer match and the ability to make pretax contributions to the plan, deferring tax on income until you withdraw the money. The employer match is especially enticing, since it’s considered “free money”.

The main risk of 401(k) plans is the inherent uncertainty of future taxes, coupled with the uncertainty of future returns in your 401(k) plan. Since 401(k) plans are funded with pretax dollars, you’re essentially risking your future income tax payments in the stock market (or other investments available in the plan) until it’s time to pay your tax bill. 

Regardless of whether you make or lose money in your 401(k), you will still owe the IRS. Basically, there are 3 possible income tax outcomes you’ll experience from your 401(k):

  1. Income taxes will be higher in the future;
  2. Income taxes will be lower in the future;
  3. Income taxes will be the same as they are now.

Likewise, there are 2 possible investment outcomes you’ll experience:

  1. You’ll do well, and have a lot of retirement savings; or,
  2. You won’t do well, and won’t have a lot of retirement savings.

If future tax rates are higher, you’ll pay back everything you saved during your working years, and then some. If future tax rates are the same, you won’t benefit at all from the 401(k) plan.

The only way you benefit from the 401(k) plan is if tax rates are lower in the future and/or you don’t have a lot of money in your 401(k) plan when you retire. The more money you make in your 401(k) plan, and the higher your future effective tax rate is, the worse off you are, financially. 

For example, Let’s assume your current effective income tax rate is 10%. If you invested $100 with after tax dollars, you’d pay $10 tax and be left with $90 to invest ($100 – 10% = $90). If your money doubled, you’d have $180.

But, your friend at work told you that you could get a tax deduction by investing in a 401(k) plan using pretax dollars. So, you try that. If you invest $100 in a 401(k) plan using pretax dollars, you get to invest the entire $100. Let’s assume your money also doubles in this scenario. You’ll end up with $200. But now you have to pay taxes when you retire and withdraw the money. 

If you retire with an effective 10% tax rate, your 401(k) plan savings is worth $180 ($200 – 10% = $180), same as if you had invested with after-tax dollars. You received no net tax benefit from the 401(k) plan. If tax rates increase to 20%, your 401(k) savings will be worth $160, which is less than you’d have if you chose to invest with after-tax dollars. Finally, if tax rates fell to 5%, you’d have $190——more than if you’d invested with after-tax dollars.

401(k) Withdrawal Taxes: The Basics

You might be surprised to learn you do, in fact, pay income taxes on 401(k) withdrawals since everyone only ever talks about the tax benefits of 401(k) plans, and how you avoid taxes by investing in these things. 

Fact is, taxes are only deferred in a 401(k) until retirement when you need to start taking withdrawals and pay taxes on all the money that was deferred.

Usually, retirement age starts at 59 1/2. However, you don’t have to start taking withdrawals at this age. Instead, you can wait until age 73 (or age 75 if you retire in 2033). At the latter age, you must start taking withdrawals, called “Required Minimum Distributions” (RMD). If you don’t take your RMD, the IRS will assess a penalty equal to 50% on the amount you should have withdrawn, but did not. For example, if your RMD was $1,000, and you fail to take this amount, the IRS would assess a 50% excise tax of $500. This excise tax will be assessed every year on RMDs not taken from your retirement account. 

401(k) Withdrawal Penalties

Something else to keep in mind is you are not allowed to withdraw money from your 401(k) plan before your normal retirement age. If you make early withdrawals, the IRS will generally assess penalties equal to 10% of the amount withdrawn, plus ordinary income tax.

There are exceptions to the early withdrawal penalty, of course, which include:

  • Rule 72(t), which allows you to make substantially equal withdrawals based on your life expectancy until the account is empty. Once you start withdrawals, you cannot stop;
  • Hardship withdrawals. You can apply for a hardship withdrawal with your plan administrator;
  • Divorce. If you get divorced, you might be able to make limited withdrawals or transfers. This usually applies to instances where your spouse takes you to court and requests a Qualified Domestic Relations Order (QDRO), forcing you to give some of your retirement assets to your ex-spouse;
  • Disability. If you become disabled, you might qualify for an early withdrawal;
  • If you owe the IRS back taxes, you might be able to use your 401(k) savings to pay off your tax bill;
  • Moving the money to another retirement account;
  • If you give birth to, or adopt, a child;
  • If you need to pay for certain medical expenses;
  • If you were a disaster victim;
  • If you over-contributed to your 401(k) plan and need to make a withdrawal to comply with IRS contribution limits;
  • If you were in the military;
  • If you die, and your spouse or estate needs access to the funds or needs to arrange for distributions after your death;
  • If you have an emergency, and need up to $1,000 per year (starting in 2024).

Final Thoughts

A 401(k) plan is often thought of as the default option for retirement planning. But there are some risks to investing in them. The tax benefits are also not guaranteed. Whether or not a 401(k) makes good financial sense for you depends largely on how much money you end up with in the account, your future effective tax rate, and your income needs in retirement.

 

David has been a licensed life insurance agent since 2004. In addition to life insurance design and sales, he has also helped develop educational and marketing content for large financial firms like Allstate, New York Life, State Farm, AmTrust, and J.G. Wentworth. His articles and essays on life insurance and Human Life Value are currently taught at California State University (CSU) as part of its Expository Writing and Reading Course, and his articles on budgeting, life insurance, investing, and financial planning have been featured in online publications like ThinkAdvisorThe Huffington PostNuWire Investor, and RealClearMarkets. David is also the author of several short eBooks on budgeting and saving money, and the designer of the xFlow™ budgeting app and the xCalc™ suite of financial calculators.

Visit www.monegenix.com to learn more.

 

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