For decades, many investors have taken advantage of tax-deductible opportunities to save money for retirement through the use of IRAs, 401(k)s, 403(b)s, and a variety of other “qualified” retirement plans. Many have maximized their contributions, often with the added incentive of employer “matching contributions.” All too often, however, accumulating savings outside of qualified plan opportunities has been neglected. In some cases, this is a costly mistake that cannot be easily corrected after retirement.
Take, for example, the Wilsons, who have combined 401(k) balances of $1,000,000 earning 4% and are retiring at age 65 this year. They feel that they have sufficient money in the 401(k)s to provide an adequate level of income in retirement. In fact, with their combined Social Security benefits of $30,000, they only project a need for an additional $20,000 income from the 401(k)s to provide the retirement lifestyle they anticipate.
A closer look at their situation reveals pitfalls they never planned for:
Pitfall # 1 – Taxation – Every dollar of the 401(k) withdrawal is taxable at ordinary income tax rates. As inflation increases the need to make greater withdrawals, they will likely see more of their Social Security benefits become taxable. This problem becomes exacerbated even more by Pitfalls #2 & #3.
Pitfall # 2 – Age 70 1/2 Required Minimum Distributions – Not understanding the distribution rules for qualified plans can be a costly mistake!
In our example, the Wilsons only “need” $25,306 (inflated dollars) at age 70 for income. They discover that they are “required” to take a minimum distribution of @$42,000. They must pay tax on the $42,000 as well as a higher percentage of their Social Security benefits which are now subject to taxation.
Pitfall # 3 – Lack of Liquidity – The Wilsons planned and saved adequately for retirement “income” but overlooked the need for “liquidity.” Let’s say they need to replace the car two years after retirement and determine they need $25,000 to pay cash for the new car.
At first glance, with over $1,000,000 in their 401(k)s, they see they can afford the purchase. However, to withdraw the needed $25,000 from the 401(k) they must withdraw $31,000 to cover income taxes.
Solution – Don’t put everything in your qualified plan.
If the Wilsons had known the potential pitfalls facing them in retirement, the solution would have been simple. Rather than directing all of their savings into their 401(k)s, they could have reduced those contributions and directed that money into a variety of other investments such as CD’s, mutual funds, bonds, etc. The short-term cost of not being able to deduct those savings dollars would have been a price well paid to have an adequate source of “liquid” savings after retirement.