Where are you saving for retirement? For many Americans, there is only one answer: in a workplace sponsored 401 (k). These tax-advantaged retirement accounts have about $ 6 billion in retirement assets from the United States. They offer savers a variety of benefits, including automatic pre-tax contributions, payroll, tax-deferred earnings growth, and often employer-funded contributions.
Unfortunately, the tax advantages associated with 401 (k) savings may lose their luster for years to come. Here’s why: When you take distributions from your 401 (k) in retirement, those amounts are fully taxable as regular income, just like a paycheck would be. You accept that future liability as compensation for tax-free contributions today and tax-deferred earnings over time. That compensation makes sense, because most savers expect their effective retirement tax rate to be lower than it is today.
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The problem? The coronavirus crisis and resulting unemployment means lower income tax revenues for federal and state governments. States are also feeling the sting of lower sales tax revenue as many companies closed in March and April this year. In addition, the federal government will end up spending billions on coronavirus stimulation programs. The CARES Act alone has an estimated cost of $ 1.8 billion.
The logical solution for governments facing budget deficits is to increase taxes. And when taxes are about to increase, deferring them by 401 (k) puts you at risk of paying more later.
Don’t give up on your 401 (k)
While the prospect of higher taxes is not great news for 401 (k) savers, it is not reason enough to completely ditch their work plan. Many 401 (k) are still funding employer contributions, and you should make the most of them. Matching contributions can accelerate your wealth production significantly. Let’s say you earn $ 70,000 annually and are contributing 10%. Your employer matches up to 3%. After 10 years of investing at a 7% growth rate, you would have about $ 132,000, with about $ 30,000 coming directly from your employer’s match. You don’t want to reject that kind of cash.
The funds in your 401 (k) are also protected from liens and creditors, which is a huge advantage over taxable brokerage accounts.
Create non-taxable income streams
You can protect yourself against future tax increases by taking steps now to generate nontaxable streams of retirement income. To do this, please keep in a Roth account or a taxable brokerage account. Contributions to designated Roth and Roth IRA accounts are not tax deductible, but earnings grow tax free and retirement distributions are tax free. Taxable brokerage accounts do not offer tax benefits. But if you pay taxes annually on realized earnings, dividends, and interest, you can withdraw cash without tax implications.
For most savers, the best option is to contribute to a designated Roth account if your 401 (k) offers that feature. Check with your plan administrator. The designated Roth account is basically a subset of your 401 (k); I would choose to make after-tax contributions there, and then the funds will be available for tax-free withdrawals later.
Your Roth deposits count toward the 2020 401 (k) contribution limit of $ 19,500 or $ 26,000 if you are age 50 or older. But there are no income limitations on these contributions.
If you don’t have a designated Roth account, you can channel cash to a Roth IRA account as long as you meet the income requirements. Typically, IRA contributions are capped at $ 6,000 or $ 7,000 if you are age 50 or older. But those limits gradually start to disappear when your modified adjusted gross income (AGI) is greater than $ 196,000 for married taxpayers or $ 124,000 for single taxpayers.
The last option is a taxable brokerage account, which incurs taxes year after year, but has no withdrawal limits, restrictions, or limitations.
Save on and off your 401 (k)
Even with the potential to raise taxes, keep saving on your 401 (k) and earn your free employer equivalent. But also protect yourself against future tax changes by developing your tax-free sources of retirement income. Having taxable and nontaxable income ready gives you the flexibility to manage through any tax increases you may encounter.
