A 401 (k) plan is a great tool to save for retirement if your employer offers one. After all, investing in one is easy since the money is withdrawn directly from your paycheck. And you can save with pre-tax dollars, making it much cheaper to put money in your account. Your employer may even match some of the contributions you make, which is a great benefit since you are literally getting free money.
But just because a 401 (k) is a good choice for a retirement investment account doesn’t mean there are no downsides. And one of the big disadvantages is that putting all of your retirement savings into a 401 (k) could lead to more taxes on your Social Security benefits. This is why.
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Distributions of 401 (k) count as income when determining if your Social Security benefits are taxable
If you maximize your 401 (k), it is highly likely that most or all of your retirement income will come from that account, along with your Social Security benefits. Unfortunately, taking large distributions of your 401 (k) to supplement your Social Security retirement income could end up reducing the amount of your Social Security Administration checks.
That can happen because Social Security benefits become partially taxable once your income exceeds $ 25,000 as an individual filer or $ 32,000 as a married joint tax filer.
However, not all income counts in this calculation: only half of your Social Security benefits count, as well as 100% of other taxable income. And that “other taxable income” category is where a problem may arise. See, your 401 (k) distributions are taxed as ordinary income at retirement, and therefore count as taxable income to determine what part (if any) of your Social Security checks you lose with taxes.
Since the average Social Security benefit only replaces approximately 40% of your pre-retirement income, you are likely to rely heavily on your investment accounts to supplement your benefits. And if most or all of your extra money comes from your 401 (k) because that’s the primary account you contributed to, you’ll quickly find yourself with income above the thresholds where some of your benefits will be taxed, especially from those thresholds in which the benefits are subject to taxes are not indexed to inflation, so they do not increase even as wages and prices do.
What should you do instead of maximizing your 401 (k)
First, you always want to contribute enough to your 401 (k) to get full match from your employer. And you’ll also want to investigate if your employer offers a Roth 401 (k). If they do, you can contribute money with after-tax dollars and make tax-free withdrawals in retirement so that any distribution of your Roth does not count as income for the purposes of determining whether your Social Security benefits are taxable. You’ll get all the benefits of contributing to a workplace account without the major drawback of a traditional 401 (k).
But if your employer doesn’t offer a Roth 401 (k), you may want to contribute enough to a traditional 401 (k) to get your employer match and then put extra money in a Roth IRA (assuming you’re eligible to contribute to one based on your income).
While putting money into a Roth means contributions cost a little more when you make them, since you are investing with after-tax dollars, you will be able to withdraw as much of your Roth IRA in retirement without paying distribution taxes or making more of your Social Security income taxable In other words, you can avoid federal taxes on most or all of your retirement money.
Since every little bit counts when you live on a fixed income, getting some of your retirement money from a Roth so you can limit taxes on your Social Security benefits could make a big difference to your financial security as a retiree.
