4 Reasons 401k Plans May Be Dangerous to your Retirement

Does the “K” in 401k Stand for Retirement Killer?

There are two exceptions in shunning your 401k plan: You’re paying a very high effective tax rate and you’ve confirmed that your retirement tax rate will be less; or your employer matches some part of your contribution. Other than those two exceptions forget it.

The first step in determining whether you should stay or leave your 401k plan is to calculate where you are in the progressive marginal tax system. There are three mitigating items that can lower your tax bill: exemptions, deductions and tax credits. (And based on your income you may or may not be able to take advantage of these items.) Once you’ve determined your tax bracket you can weigh the restrictions of your 401k against the tax savings of your contributions. Many middle class Americans are paying a blended tax rate of 18%.  A $1,000 contribution saves $180 and over 30 years that tax savings totals $5,400. But when you take a distribution from your 401K, you pay ordinary income taxes on the distributions and those distributions figure in the calculation on the taxes you’ll pay on your Social Security benefits.

Those annual taxes during retirement will exceed the tax deductions you saved during your working years. There’s no ultimate tax benefit. And when you consider the restrictions and penalties during the accumulation and distribution periods under your 401k plan, it’s just too punitive. Keep in mind when you deduct your 401k contributions you’re not deducting FICA, FUTA, SUTA and you have lost your tax-free basis. During retirement, you’ll need tax diversity to manage your taxes in retirement. The loss of basis can have a profound effect on cash flow, which can lower your net spendable income.

There may be time for some Generation X and Y retirement savers to disengage with their 401k plans and slowly convert their existing 401k plans to Roth IRAs. But for most Millennials, the math supports an immediate exit from their 401k plan to an alternative retirement plan that utilizes tax favored vehicles that, under current law, can generate a tax-free income retirement, i.e. keep more of your hard earned money.