What Investopedia Can’t Tell You About Your 401(k)

You should be proud of yourself for contributing the maximum amount to your 401(k) each year. After all, you’re giving up a bigger paycheck today for financial security in the future. But is it enough to see you through your retirement?

Alicia Munnell, executive director at the Center for Retirement Research at Boston College (and longtime critic of the 401(k) ) has this to say: “The 401(k) system is not working as well as it can.” That sums it up quite nicely. The average $129,157 retirement savings held by near-retirees is nowhere near enough to fund a comfortable lifestyle. In Munnell’s words, “That’s a pittance. But the 401(k) is here to stay, and we need to make it work effectively.”

Thanks to inflation, taxes, contribution limits, and withdrawal rates, anyone who hopes to rely on their 401(k) is really up against the ropes. 

Let’s take a closer look at these 4 “enemies” of the 401(k).

Inflation: It’s No Joke

On the day you retire, your 401(k) retirement account may appear to be adequate, but you still need to account for the stealthy, deceptive impacts of inflation.

The main enemy for retirees on a fixed income is the slow but steady rise in the cost of goods and services, which over time reduces their purchasing power. 

Think about it: To replace 80% of their income, a person retiring this year at age 65 and earning $250,000 would require $200,000 annually. Assuming a 3 percent yearly inflation rate, that person will require $361,222 merely to maintain their current quality of living over the next 20 years.

People often assume that when they enter retirement they won’t have as many expenses. While it’s true that their house may be paid off and they no longer have kids to put through college, they don’t take into account inflation and how it impacts the value of a dollar. 

People are astonished to learn that if they generate the same retirement income in 20 years as they do now, they will have to make lifestyle sacrifices of more than 50%. And who really wants to downsize their lifestyle in retirement?

Taxes: Daylight Robbery

The fact that a standard 401(k) is funded with pre-tax money presents another difficulty. As a result, you get a tax credit in the year you contribute, but you’ll also owe a lot of money in taxes when it comes time to start withdrawing funds from the plan when you finally hit retirement. And withdrawal isn’t exactly optional.

The required minimum distributions (RMDs) from defined contribution plans, such as 401(k) or 403(b) plans, must be started by taxpayers by April 1 of the year after they turn 72. You can postpone your RMD for as long as you are employed by the firm that sponsors your plan at that time if you do not own 5% or more of the business. 

It’s important to remember that the recently passed SECURE Act, however, will push back the age at which withdrawals must begin to age 72 when the new law takes effect.

Everyone considers maxing out their regular 401(k) to earn a tax benefit, but they fail to think about how they will pay their income tax when they leave their jobs. Many people are duped into believing that their regular 401(k) will be tax-free or that their income tax bracket will be lower when they retire.

Contribution Limits: Can You Save Enough?

In many ways, retirement planning is a crapshoot. You have no idea how long you’ll live, how the markets will do, or what your costs will be in the future. Will you relocate to a state with cheaper costs? What will the cost of your medical care be? Spend enough time and you’ll come up with a seemingly endless list of questions you’ll never be able to answer in advance.

Many financial experts advise saving between 10% and 15% of your salary annually from the day you start working if you want to have a fair chance of maintaining your quality of life when you retire. Some people argue that it should be substantially higher, about 20%. For high-income earners, it’s virtually impossible to save that much using a 401(k) alone. 

The amount you can contribute annually to your 401(k) or other defined contribution plan on a pre-tax basis is capped by the Internal Revenue Service. This cap, which is periodically raised to reflect increases in the cost of living, is $20,500 for 2022. 1 In 2022, those 50 and older can increase their 401(k) catch-up contributions by $6,500 a year.

As their wages rise over the course of their careers, many employees will therefore need to supplement their 401(k) payroll deferrals with investments in either an IRA or brokerage account.

Withdrawal Rates: What’s Safe?

The final reason your 401(k) account may put your retirement plan at risk, is the ever-shifting mindset surrounding the so-called “safe withdrawal rate.” 

The 4 percent rule has been the subject of heated dispute among financial professionals for years. Many analysts previously felt that this “rule” allowed many retirees to securely withdraw money from their retirement accounts without outliving their assets. But how helpful is it really?

First proposed in 1994 by financial professional William Bengen, the 4 percent rule is frequently used as a starting point for the retirement planning process. Depending on your level of savings, market performance, interest rates, and your guaranteed sources of retirement income, it may be increased or decreased (pensions, Social Security, trust funds, annuities). In order to account for inflation, it also anticipates an annual increase in the cost of living. 

Although some have claimed that the 4 percent withdrawal rate may be too conservative, particularly for retirees who modify their spending in reaction to market returns, a rising number of financial experts claim they think it is really too aggressive. A rate closer to 3% — or even less — may be preferable, especially if the retiree expects to leave behind a financial legacy. This is because of a number of issues, such as greater market volatility and the low interest rate environment.

If you exclusively rely on a 401(k), the major issue is that the suggested withdrawal rate was recently reduced from 4 percent to 2.8 percent. We don’t live in the same world that recommended the 4-percent rate more than 20 years ago. 

Diversification: The Smart Choice

Remember that your 401(k) may not be enough when you squirrel away funds for your retirement. A diversified portfolio of taxable and tax-favored accounts, plus an emergency fund, could help to protect your retirement savings against the effects of taxes, inflation, contribution limits, and increasingly conservative withdrawal rates.

The good news is that there’s more than one way to keep more of your hard-earned money. At The Charitable Payraise, we’ve developed a new system to help retirees close the gap between their cost of living requirements and their cash flow. Want to know more? Reach out and we’ll give you a walkthrough.