What Do You Really Know About Your 401(k)?

Transcript of Podcast Episode 193

Hello this is Bill Rainaldi, with another edition of Security Mutual’s SML Planning Minute. In today’s episode, what do you really know about your 401(k)?

There is no doubt 401(k)s serve a useful purpose.  401(k) contributions come directly out of a  worker’s paycheck—before they have a chance to spend the money.  And the “forced savings” involved help improve America’s pitifully low savings rate.  In fact, for many Americans, it is the only form of savings they have.

But a recent survey by the National Institute on Retirement Security (NIRS) indicates  401(k)s are failing middle class Americans.  NIRS is a nonprofit, nonpartisan organization based in Washington, DC.  The study concludes the tax breaks associated with 401(k)s disproportionately benefit high-income taxpayers, and do little for middle-class families.

By their reckoning, more than half of the tax benefits from a 401(k) end up going to the top 10 percent of taxpayers. The report suggests a number of proposed solutions, among them shoring up Social Security and eliminating the deduction-based system in favor of a refundable tax credit.

Another recent survey shows just how confused many taxpayers are.  According to a recent article in Think Advisor, nearly half of the older participants in 401(k) plans, age 45 to 75,  have “no idea” how they will get cash out of their accounts.  This was based on a study conducted by the National Bureau of Economic Research.

One often overlooked aspect to a 401(k) is the fact that the account is only tax-deferred.  It is not tax-free.  When the money comes out of the account, it is 100 percent taxable.  And even worse, if you are under age 59½, there is an additional 10 percent penalty. Of course, we are assuming that the taxpayer is participating in a traditional 401(k) that does not have a Roth option.Another article, this one in Kiplinger’s, outlines what they say are the five major tax disadvantages to a 401(k) when it comes time to take the money out.

1. Every distribution will be taxed at your highest rate.

Many people have been told they will be in a lower tax bracket when they retire, but that may not be true.  If you want to maintain your current standard of living, you likely need the same amount of income.  That would mean the same tax rate, at least for now.  Future tax rates are anyone’s guess.

2. You may pay more income tax on your Social Security benefits.

Is Social Security income taxable?  Few people realize that it may be, depending on your other income.  Aside from the income tax that you may have to pay on the money you withdraw, you also could end up paying more income tax on your Social Security benefit as well.

But there’s more.  In retirement, taxable distributions may also end up costing you more in Medicare payments.  When you enroll in Medicare Part A, most people also sign up for Parts B and D.  But those cost extra and how much extra depends on your other income.  In 2022, Part B alone could be as much as $578 per month.

3. You have to start taking withdrawals when you reach age 72, whether you want to or not.

Most older 401(k) participants are familiar with Required Minimum Distributions or RMDs.  Once you get to age 72, if you’re retired, you have to withdraw a certain percentage of your account.  And the percentage goes up every year after 72.

4. It’s “absolutely the worst account” to leave to a surviving spouse.

Here’s one thing to keep in mind: If you want your spouse to live off of your IRA or 401(k) after you’re gone, just remember it is still fully taxable.  And worse, your spouse will be going from married filing jointly to a single taxpayer.  If the income stays the same, the tax burden will be higher.

5. Your account is vulnerable to tax law changes.

Congress is perpetually looking for new revenue, and large tax-deferred accounts seem to be a popular target.

Careful planning may help mitigate the cost of taxes in retirement, and whole life insurance can be part of that picture.  In certain circumstances, whole life insurance can be used as a source of non-taxable retirement income, which can reduce your income taxes as well as the cost of Social Security and Medicare.  Your Security Mutual life insurance advisor can help you sort through the issues that are really important to you and your family.

This podcast is brought to you by Security Mutual Life Insurance Company of New York, The Company That Cares®. The content provided is intended for educational and informational purposes only. Information is provided in good faith. However, the Company makes no representation or warranty of any kind regarding the accuracy, reliability, or completeness of the information. 

 The information presented is designed to provide general information regarding the subject matter covered. It is not to serve as legal, tax or other financial advice related to individual situations, because each person’s legal, tax and financial situation is different. Specific advice needs to be tailored to your situation. Therefore, please consult with your own attorney, tax professional and/or other advisors regarding your specific situation.

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