This is the first of a two-part article on 401(k) Tax Mistakes.
Have you ever heard the story of the frog that was tricked into climbing into a kettle of nice, cool water by a hungry foe? Unbeknown to the comfortable frog, the kettle he was lounging in was really on a stove. Slowly but surely, the perpetrator of this dastardly deed, increased the heat, gradually warming up the water without ever calling attention to his real motive – to cook the frog! As the story goes, the frog didn’t realize he was in “hot water” until it was too late and he was “cooked.”
During the years I’ve paid close attention in seeking to help my clients retire and stay retired. I carefully note the victories and any mistakes of others who retired and try to prepare my clients accordingly. Most of my “professional” world centers around helping folks, both “young” and “old”, develop strategies that are aimed at building and sustaining the longevity of their retirement savings.
One huge retirement planning mistake that may cause you a great deal of pain down the road is “overdoing” your 401k contributions. That’s right. You may be investing too much of your savings into your 401k plan, IRA, or small business retirement plan. An unfortunate consequence of this typical strategy is that you needlessly lose control over your tax liability after retirement. This is not an obvious mistake, so it tends to sneak up on you over time. By the time you feel the heat, like our frog in the kettle, it’s too late to act.
In a typical pre-tax retirement plan, the participant benefits from laws providing a deduction when they make a contribution. These retirement plans provide a double benefit: a deduction from your normal income, coupled with tax-deferred earnings. Tax-deferred earnings allow your gains to grow unscathed by taxation each year until you want it or need it (after age 59 1/2), and then you pay taxes at prevailing tax rates.
Many articles and marketing messages tout the wonderful benefits of compounded growth. And those messages are valid to a great extent. However, the problem arises when you’ve created a financial house that is out of balance; and, you do not have sufficient retirement resources in after-tax or tax-free investments. When all your savings are in tax-deferred accounts, you’ve just sentenced yourself to pay Uncle Sam each and every time you need income or a withdrawal!
Sadly, I have seen that even though individuals may have the money, they will face every expense decision reluctantly because of the accompanying tax.
Here are Five Considerations about 401K’s to Keep in Mind
1. Despite common thought, you won’t necessarily be in a lower tax bracket in retirement!
2. Depending on the government’, it is very likely that future income tax rates could rise dramatically.
3. The old-school philosophy of maxing out savings in a 401k plan solely to avoid today’s taxes simply doesn’t hold water any longer.
4. Many retirees have fewer tax deductions to protect the income from their retirement plan.
5. The more you maximize your funding today, the more your required distributions will be starting after age 70 1⁄2, whether you need them or not.
In part 2 of this article, we’ll look at five tips that will help you avoid 401K tax liabilities.
If you don’t have a retirement plan, it’s never too late to start. Contact us today and let us help you discover clear direction for your retirement future. We’ll provide a FREE analysis of where you currently stand against your goals and provide important recommendations for getting all the pieces of your retirement puzzle to fit together!
Wotton Financial Group does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstances.