How To Use Your 401k to Make Money and Lower Your Taxes
- A 401(k) is one of the best tools for retirement savings, offering tax-deferred growth and a potential employer match.
- You can choose between Traditional (pre-tax) and Roth (after-tax) 401(k) contributions, depending on your marginal tax bracket now vs. in retirement.
- To maximize your 401(k) benefits, invest in low-fee index funds and check the IRS website for current contribution limits.
Retirement is one of the most important financial goals for many, and a 401(k) is one of the best tools for achieving it.
By contributing to a 401(k), you can reap the rewards of tax-deferred growth, meaning that you can realize a profit without paying taxes right away, helping generate more savings for retirement. In addition, you can often earn more money by taking advantage of an employer match and lowering your taxes through pre-tax deductions.
But most importantly, you can enjoy the peace of mind that your assets are protected and shielded from creditors on your path to financial independence. Through ERISA creditor protection, your 401(k) assets are shielded from creditors in Arizona.
What Is A 401(k)?
A 401(k) is a retirement savings plan offered by an employer to its employees. It allows employees to contribute a certain percentage of their salary to the retirement plan, and the funds can be invested in stocks, bonds, mutual funds, and other investments.
The employer may also match some or all of the employee’s contributions. Withdrawals from a 401(k) can be subject to income tax and may be subject to early withdrawal penalties before age 59.5.
401(k)s are tax-advantaged, meaning all of the growth within the account is tax-deferred, meaning you only pay tax when you take the money out in retirement. Contrast this to a standard brokerage account where you owe taxes any year in which you realize a profit.
401(k)s are available in two distinct types: Traditional and Roth.
Traditional 401(k)s are referred to as pre-tax, and contributions are taken from your paycheck before taxes are taken out. This means you get a tax deduction now but will be taxed when you withdraw the money at retirement age. A Traditional 401(k) is best for those in a higher tax bracket now who anticipate being in a lower one during retirement.
Roth 401(k)s are considered after-tax, and contributions are taken from your paycheck after taxes have been taken out. This means you’ll be taxed when you contribute the money but not when you withdraw it at retirement age. A Roth 401(k) is best for those in a lower tax bracket now who anticipate being in a higher tax bracket during retirement. Click here to view current tax brackets.
One thing to consider when using a 401(k) to save for retirement is the withdrawal restrictions. Generally, you can only withdraw money from a 401(k) once you reach retirement age or if you have a qualifying exception. If you take money out of your 401(k) before 59.5, you may be subject to a 10% early withdrawal penalty and taxes.
Are you curious about what your 401(k) could grow into? Consider the following example:
Jenn has started saving for retirement using her 401(k) to take advantage of tax-deferred savings. Assuming she invests $23,500 per year into her 401(k) from age 30 to 65, she can expect to have $3,371,735 saved for retirement by age 65, assuming a 7% annual return. Then, using a 4% safe withdrawal rate, Jenn can expect to withdraw roughly $134,000 annually from her portfolio. After taxes, she can spend the rest!
How Much Can You Contribute To Your 401(k) Each Year?
Because 401(k)s have unique tax advantages, there are also certain limits to how much you can contribute each year.
For 2023, you can contribute $22,500 annually, and those aged 50 and over can make additional catch-up contributions of $7,500 annually. But that’s just the amount you can contribute. The total limit of employer and employee contributions is much higher at $66,000 per year for 2023 ($73,500, including catch-up contributions.)
Contribution limits increase with inflation, so check the IRS website for the most up-to-date figures.
How Can You Invest Your 401(k)?
Your employer typically offers limited investment options, often called the ‘fund line-up’ within your 401(k).
But fortunately, your fund line-up should have all the components you need to build a diversified portfolio. Often, this includes several different funds that give you access to various aspects of the stock and bond market.
When selecting your investments, choose index funds that invest in the entire US stock market and charge low fees—ideally with an expense ratio between 0.02% and 0.15% per year. You may find a fund called something like, “US Total Stock Market” or “500 Index”.
Tax Considerations When Using A 401(k).
One of the primary benefits of using a 401(k) to save for retirement is the tax advantages you receive.
But, with those advantages come a handful of considerations and decisions you must make.
Traditional vs. Roth
First, most employers will offer a Traditional and Roth option when contributing to your 401(k), so deciding which is best is critical. When evaluating your options, boil it down to one simple question: Is your marginal tax rate today higher or lower than you anticipate in retirement when you withdraw money from your 401(k)?
If you think your marginal tax rate is higher today, it may be wise to make Traditional contributions so you can benefit from the tax deduction now and pay taxes on the distributions later, during retirement.
Alternatively, if you believe your marginal tax rate is lower today, it may be wise to make Roth contributions to lock in that low rate now and make tax-free distributions during retirement.
If you’re unsure about how your current marginal tax rate stacks up against your future marginal tax rate, schedule a call with our team to take a look. That way, you can enjoy the peace of mind that you’re saving for retirement in the most tax-efficient way possible.
Required Minimum Distributions
Required Minimum Distributions (RMDs) are mandatory withdrawals from certain qualified retirement accounts such as 401(k)s, 403(b)s, and IRAs. These begin when you reach certain ages.
With careful planning, individuals can minimize taxes by strategically managing their RMDs using Roth conversions and other strategies. It’s important to understand that RMDs have the potential to severely impact your tax situation in retirement, so it’s critical to understand and plan for them. For the full scoop on RMDs, including when they start, which types of accounts they affect, and how they can impact your tax situation, check out our Guide to Tax Planning in Retirement.
Common Mistakes To Avoid When Using A 401(k).
While 401(k)s can be a powerful account, there are a handful of common mistakes to avoid when using them for retirement savings. Here are some of the most common mistakes we see:
- Cashing out instead of rolling over. If you quit your job, you can transfer your 401(k) to your new employer’s plan or your personal IRA. However, it’s important to “roll it over” rather than cashing it out. A rollover is not taxable and only shifts the money to a different account, whereas cashing out is a taxable event that incurs a 10% penalty if you’re under 59.5 years old.
- Missing out on the full employer match. Studies show that 25% of people miss out on free money from their employer through their company match. Be sure to understand how much you need to contribute to get the full employer match and take advantage of free money for your retirement nest egg.
- Contributing without investing the funds. Remember, your 401(k) is just an account, not an investment. So, if you contribute money without picking a specific fund or investment, your money will sit in cash, without earning a return for you. Be sure to specify which investments you want your contributions to purchase when contributing to your 401(k).
- Using your 401(k) as an emergency fund. Your 401(k) is not a savings account and should be used for long-term retirement planning. The best way to prepare for unexpected expenses is to have an emergency fund outside your 401(k). As Charlie Munger once said, “Never interrupt compounding unnecessarily.”
- Getting hit with early withdrawal penalties. It’s important to remember that withdrawing any money from your 401(k) before age 59.5 will incur a 10% early withdrawal penalty in addition to taxes. So try to avoid withdrawing money from your 401(k) as much as possible, and if you do, be sure to understand the potential tax implications.
- Stopping contributions when the market goes down. When the market takes a dip, it’s easy to become discouraged and stop contributing. However, staying disciplined with your contributions over time can help you take advantage of lower prices and keep your long-term goals on track. Remember the Mr. Market Parable from famed investor Benjamin Graham and remember: when the market is down, stocks are on sale.
In conclusion, a 401(k) is an incredibly powerful tool for retirement savings. But, while taking advantage of its benefits can be very rewarding in the long run, it’s essential to understand how your decisions impact your financial future. To learn more about tax planning in retirement, RMDs, and strategies to maximize your retirement accounts, schedule a complimentary call with Farnam Financial today. Together, we can help you create a retirement plan tailored to your needs.
