More and more people are focused on growing their 401K retirement savings. That’s a great thing. You need to have money when you retire. You want to have a diverse array of retirement income options. Maxing out your 401k contributions is a wise thing to do. However, there are 401K drawbacks. You shouldn’t forget about those as you plan for your future.
401K Money Is Taxed When You Withdraw It
People frequently seem to forget that one of the biggest 401K drawbacks is that you have to pay taxes on that money. You don’t pay taxes when you deposit it. People love that part. In fact, contributing to your 401K plan is a great tax benefit when you’re still working.
However, when you reach your retirement and start using that money, you’ll have to pay taxes. That can be a huge shock if you haven’t planned for it in advance. The money is taxed as though relative to your income. Therefore, if you’ve done a great job of setting yourself up with a high level of retirement income, you could find that you have to pay more than a third of your 401K withdrawal money to taxes.
On the plus side, if you’re in a lower income bracket post-retirement than you were before you retired, then you may have set yourself up for some success. You’ll still need to pay taxes on that money, of course, but the hit might not be as big as it would have been if you didn’t set that money aside. There are clearly pros and cons.
Plan Ahead for Withdrawing Your 401K Money
The big question isn’t whether or not to set aside money in your 401K. If you have the option, the benefits outweigh 401K drawbacks. The issue is that you simply have to plan ahead. Make sure that you’re fully aware of how much money you’re going to have to pay to taxes when the time comes.
The biggest problem is if you fail to think about taxes when you mentally plan for your retirement years. If you just look at what’s in your 401K and assume that’s how much money you’ll have when you retire then you’re going to be in for a shock. Make sure that you’re thinking realistically about how you’ll use that money each year and what amount of it will go to taxes.
Other Tips for Minimizing 401K Drawbacks
You might want to look now to see if you should have a Roth 401K instead of or in addition to your traditional 401K. That money gets taxed ahead of time, which means that you won’t have to worry about paying taxes on it once you’re in retirement. If you have the ability to maximize contributions to both types of accounts now then you’ll set yourself up well for financial success in retirement.
Then, once you’re in retirement, make sure that you use the Roth 401K money first. Or for that matter, use any money that isn’t taxable in retirement. You want to withdraw as little money as possible that will require you to pay taxes. Pay attention to your tax bracket and the impact that withdrawals will have on that. As long as you plan in advance, you can minimize 401K drawbacks and make the most of your money.
- 3 Effortless Ways to Prepare Your Finances for Retirement
- Financial Freedom: Step-by-Step Stages for Goal Setting
- Why You’re Likely to Be in a Higher Tax Bracket when You Retire
Kathryn Vercillo is a professional writer with more than a decade of experience writing about healthy living and personal finance. She lives in San Francisco, where she has learned to maximize frugal living tips in order to thrive as a freelancer in one of the nation’s most expensive cities. When she’s not writing, she’s exploring the city on foot with her rescue dog. Learn more about her at www.kathrynvercillo.com.
Kathryn also writes about saving money with coupons over at GroceryCouponGuide.com