401ks have been around for years and have been an ever increasingly popular way to save money for retirement.
More and more businesses run some type of deferred contribution plan and they are a great way to attract and retain key employees.
401ks are great from an employee standpoint because they are relatively quick to sign up for, fairly easy to pick funds in and once the initial set up has been done, your contributions are taken out of your paycheck automatically.
It’s an easy way to save.
But, did you know that by contributing to your 401k you could be creating a giant time bomb? Here’s a look at why:
What is a tax deferred account?
A tax deferred account is simply an account that allows you to put in pre-tax contributions for retirement. The money inside grows without having to pay taxes every single year – they are deferred until some time down the road.
Things like 401ks and IRAs and for small business owners – Simple IRAs and SEP IRAs are examples of tax-deferred accounts.
What is a retirement time bomb?
A retirement time bomb is when you put all or most of your retirement savings into these tax-defferred accounts like 401ks and Traditional IRAs.
When you get into retirement and start withdrawing your money, you have to pay taxes on every single dollar you pull out!
At what rate?
It depends, but the money you pull out is taxed as ordinary income, which means for those of you who think your taxes will go down in retirement – you might be in for a big surprise when all of that money is taxed as though you earned it!
For those of you who have socked away a lot of money into tax-deferred accounts for retirement – these have become a ticking time bomb waiting to explode!
And Uncle Sam is licking his chops!
What should you do about it?
- Figure out how much you need for retirement
- Re-evaluate your accounts – determine if you are properly balanced from a tax perspective
- Consider other options – look at accounts like Roth IRAs to detemine if it’s right for you.
- Make a plan to diversify from a tax perspective – figure out how muchyou can get into a tax-free bucket and start shifting money either through contributions or Roth Conversions.
What about you?
Are you holding a retirement time bomb? What have you done to diversify yourself from a tax standpoint?
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{ 7 comments… read them below or add one }
Great point. I just finished reading Conspiracy of the Rich yesterday, and Kiyosaki makes a big point about how retirement accounts such as 401Ks are bad.
One important point is that if you can get a high rate of return (let’s say at least 25%), then the money will grow faster because taxes are not taken out until later. The problem is that 99.9% of people cannot get a high return.
.-= George´s last blog ..Connecting with Favorite Authors through the Internet =-.
Hey George thanks for the comment. To clarify – I don’t think 401ks are bad, I just don’t believe they are the end-all be-all for everyone.
Rather – what I suggest is diversifying yourself from a tax-standpoint. Use your 401k (especially if you are getting a match from your employer), but then also take a look at Roth IRAs (if you qualify etc).
.-= Jason´s last blog ..The Paradox of Money and Satisfaction =-.
That’s why I have become a big fan of the Roth IRA. I like knowing exactly how much money is in my retirement account.
.-= Craig´s last blog ..When it Snows, it Snows Money =-.
Jason, this is a bigger issue than most people realize. I think that we often confuse tax deferred with tax free.
As I see it, there are two major ways the time bomb can go off. One is via higher taxes, which I wouldn’t bet against. The other is the very real possibility that many of us will be making more money post 65 than pre 65.
That may sound ridiculous, but when you add soc sec benefits, withdrawl of tax deferred funds and income from employment, your income could easily be higher than it was before 65.
I’m mentioning income from empoyment because it’s a solid bet that the combination of inflation, lower soc sec benefits and higher healthcare costs will force most people to work in the retirement years.
.-= Kevin@OutOfYourRut´s last blog ..Restaurant Tipping – How Much and When? =-.
Kevin, great point about higher income in retirement. Most people assume their income is lower in retirement, but it’s not necessarily true. Especially if you want to maintain your standard of living.
As you say, tack on healthcare costs and inflation and surely you are pulling down as much if not more than you were making pre-retirement.
Uncle Sam is a happy man at that point!
.-= Jason´s last blog ..4 Questions to Ask Before You Buy Life Insurance =-.
Jason,
Good post. The phrase “time bomb” is a real and appropriate attention getter.
You are right about retirees earning more than when they were working. I am “mostly” retired, drawing two defined pensions and social security which, combined, are more than I made when I was working. I rolled my 401(k) money into a traditional IRA, which I won’t touch until RMD kick in at age 70 1/2. I do pay income taxes on my pensions, but I am glad that I am not dependent on any tax deferred retirement investments. They can be time bombs.
.-= Joe Plemon´s last blog ..My Love File: 14 Critical Items =-.
Hey Joe you prove the point of the post exactly! Glad to hear you’ve got some good income coming in for your retirement – be careful when those time bombs start hissing at 70 1/2!
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