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?

1. Figure out how much you need for retirement
2. Re-evaluate your accounts – determine if you are properly balanced from a tax perspective
3. Consider other options – look at accounts like Roth IRAs to detemine if it’s right for you.
4. 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?

There’s no question that 401k’s have become the norm for retirement savings.  More and more companies are putting the responsibility of saving for retirement on the employee and have gotten rid of traditional pension plans.

401k Popularity

According to a 2007 Hewitt & Associates survey, 64 percent of plan sponsors said they use a 401k for their organization’s primary retirement-savings program. That’s up from about 35 percent just 10 years ago.

Not only do employers like the 401k, but many employees love them as well.

Why people love their 401ks

Ease of Use

Most 401k plans are pretty easy to sign up for and begin saving into.  A couple forms, a couple signatures and you’re on your way to putting a percentage of your income away for retirement!

Bigger contribution limits

Unlike Traditional or Roth IRAs, which cap your contributions at $5,000 (with a $1,000 catch-up contribution if over age 50) the 401k allows up to $16,500 with a $5,500 catch-up contribution over 50!

If you’re making a good income, this is a great way to get additional money saved up for retirement.

Tax treatment

Contributions are tax-deferred, which means you don’t have to pay taxes on gains each year.  They are deferred until you withdraw your money in retirement.

Not only can you defer your taxes, you can also take a deduction on your contributions.  In other words, you get to deduct (or subtract) the amount of your contributions against your ordinary income.

That’s a pretty sweet deal.  Say you make $80,000 and put away $16,000 – your ordinary income is reported to be $64,000!

Why you shouldn’t love your 401k!

Limited Control

Here’s what I mean:

1. The employer chooses which company you will use (i.e. Fidelity, Vanguard etc)
2. In general, the employer chooses which funds you can pick from (you may only have 15-20 options)
3. You only have 11 years to control your withdrawals (59 1/2 – 70 1/2 – there are penalties for withdrawing before that and penalties if you don’t withdraw after that).

Government Forced Withdrawals

Many people don’t realize this – but at age 70 1/2 the government forces you to take money out of your 401k (unless you’re still working).

How can the IRS force you to take money out?  By whacking you over the head with a 50 percent penalty for not taking the withdrawal!  50 percent!!

So all that money you’ve managed to save up for retirement – and perhaps you don’t need – you MUST withdraw.  Why would the government do this?  To get tax revenue silly!

401ks are Tax Infested

This is the biggest reason not to fall in love with your 401k.  All those taxes you deferred for all those years have to be paid some time.

People often assume their income will be lower in retirement and therefore their tax bracket will be lower – which means that they’ll pay less taxes.

That’s not necessarily true.

You’ll probably want to maintain your standard of living, which means you’ll need the same amount of income.  Factor in inflation and depending where tax rates are - you could actually be paying more in taxes than you ever imagined!

That pretty balance you had on your 401k statement isn’t really yours.  You may be giving 25 percent or more back to good ol’ Uncle Sam.

These things are loaded with taxes.

If you pass away, your beneficiaries are forced to take money out (again think penalties here) and will have to pay ordinary income tax on every single dollar that’s pulled out at whatever tax rates apply to them!

What should you do?

Use it wisely

The last thing you want to do is throw the baby out with the bathwater as the ol’ saying goes.  The bottom line is you need to use the 401k wisely.  If your employer is matching contributions – you want to definitely take advantage of that!

Make informed decisions.

Take a look at your situation to determine if you’re creating a tax-infested monster.  Crunch some numbers to determine if using a Roth IRA or Roth 401k is better for you.  There’s some handy calculators out there that will help you figure this out.

Diversify

Diversify yourself from a tax perspective.  In other words, make 401ks and IRAs, taxable accounts, municipal bonds and Roth 401ks and IRAs a part of your overall tax strategy.

Bottom Line

Don’t get caught up in the hype of 401ks.  That doesn’t mean you don’t use them, but just don’t fall in love with them!  Make informed decisions and understand what you’re saving into.

What about you?  Are you in love with your 401k?  What have you done to diversify yourself?