The 401 (k) program is a great tool for saving for retirement, if offered by your employer. After all, investing in one is easy because the money is withdrawn directly from your paycheck. And you save with dollars before taxes, making it much more affordable to deposit money into your account. Your employer can even match some of your contributions, which is a huge advantage because you literally get free money.
But the fact that a 401 (k) is a good choice for a retirement investment account does not mean that there are no disadvantages. One of the big disadvantages is that putting all your retirement savings in 401 (k) could lead to higher taxes on your social security benefits. Here’s the reason.
Breakdowns from 401 (k) are counted as income when determining whether your social security benefits are taxable
If you maximize your 401 (k), there is a good chance that most or all of your retired income comes from this account, along with your social security benefits. Unfortunately, a large split of your 401 (k) to supplement your Social Security retirement could lead to a reduction in the number of your Social Security administration checks.
This can happen because Social Security benefits are partially taxed when your income exceeds $ 25,000 as a single person or $ 32,000 as a married joint tax organization.
However, not all income is counted in this calculation – only half of your social security benefits and 100% of other taxable income are counted. And this category of “other taxable income” is a problem that may arise. See, distributions from your 401 (k) are taxed as ordinary retirement income, and therefore are counted as taxable income to determine which portion (if any) of your Social Security checks you will lose in taxes.
Since the average social security benefit replaces only about 40% of your pre-retirement income, you are likely to rely on your investment accounts for your benefits. And if most or all of your extra money comes from your 401 (k) because it’s the primary account you’ve contributed to, you’ll quickly find yourself above the thresholds at which some of your benefits will be taxed – especially since those the thresholds at which taxable benefits are taxed are not indexed to inflation, so they do not increase as much as wages and prices.
What you should do instead of maximizing 401 (k)
Most importantly, you should always contribute enough to your 401 (k) to get a full employer match. And you will also want to see if your employer offers a Roth 401 (k). If so, you can put money in it using dollars after tax and withdraw tax-free withdrawals, so any distribution from Roth will not count as income to determine if your social security benefits should be taxable. You get all the benefits of contributing to an account in the workplace without the big disadvantage of a traditional 401 (k).
But if your employer doesn’t offer a Roth 401 (k), you may want to contribute often enough to a traditional 401 (k) to get your employer’s match and then give extra money to the Roth IRA (provided you are eligible to contribute to the contribution to the based on your income).
Although investing money in Roth means that the contributions are slightly higher when you earn them, because you invest with dollars after tax, you will be able to choose from your Roth IRA as much as you want in retirement without having to pay taxes from distribution or the more your social security taxes are subject to tax. In other words, you may be able to avoid federal taxes on most or all of your retirement money.
Because every small number counts when you live on a fixed income, getting some of your retirement money from Roth to reduce taxes on your social security benefits could have a big impact on your financial security as a retiree.