401k Retirement Planning

by Phil Cannella Financial Advisor

As a result of most companies moving away from pensions, many people in or near retirement now have a traditional 401k instead. There’s nothing wrong with that either; 401k retirement plans can provide you with a steady income in retirement just like a pension would.

A 401k works exactly like an IRA, in which you take distributions from the account during retirement, giving you the constant income stream you’ll need when you retire. Although a traditional 401k plan has its upside, it also has some downsides that make a bit of 401k strategy necessary to ensure you’re getting the best out of your 401k retirement plan.

The upside of a traditional 401k plan is that it’s tax-deferred. This means that when you contribute to a traditional 401k, you don’t have to pay taxes on that money in the year you made the contribution. By using a traditional 401k, you have in effect opted to pay the taxes later, when you decide to make a withdrawal. This tax-deferred status has all kinds of great benefits for the account holder.

Foremost among these benefits is that 401k contributions are pre-tax, meaning your tax bracket and adjusted gross income will be calculated after you make your 401k contribution. So if you’re hovering close to the edge of a higher tax bracket, you can simply contribute the difference to your 401k, which could drop your tax liability by as much as 10% all by itself.

IRA Strategies

As discussed earlier, a 401k functions just like an IRA, and you can apply IRA strategies to your 401k retirement plan to make it work better for you. Say you are past retirement age, but are still working and you are already satisfied with the amount of money in your 401k.

You know you’ll have to take required minimum distributions (RMDs) from your account when you turn 70½ and are not enthusiastic about the tax bill you’ll be saddled with when you do. Knowing that current tax rates are at a historic low, you would rather pay the bill now than pay it in the future, when taxes could (and most likely will) be higher than they are now.

The solution to this scenario is known as a Roth conversion. Roth IRAs came around in the late nineties and they function in exactly the opposite way as a traditional 401k or IRA account. Instead of deferring your taxes, you opt to pay them up front in exchange for not having to pay any taxes later.

This can be a big advantage in retirement, when you want to get the most out of your money. Future uncertainty about tax increases also makes a Roth conversion a smart move, as it will prevent you from having to pay taxes at a higher rate when you withdraw than you would now.

A Roth IRA also has the advantage of allowing your money to grow tax free, so you’ll only pay taxes on the principle and not on the interest. Essentially, you will roll over the money in your old 401k or traditional IRA and put it into a Roth IRA.

Unfortunately you will be hit with a big tax bill that year, as you will have to pay all taxes up front on this contribution. Although that seems like a disadvantage, you’ll be thanking yourself later when you begin taking withdrawals from the account and you get to enjoy the money you’ve earned, tax free!

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Phil Cannella is the CEO of Retirement Media Inc. and the founder of First Senior Financial Group.