A 401 (k) plan is a great tool to save your pension if your employer offers one. After all, investing in one is easy as the money is taken directly from your salary. And you have to save dollars before tax, which makes it much more affordable to put money in your account. Your employer may even match some of the contributions you make, which is a huge benefit as you are getting literally free money.
But just because a 401 (k) is a good option for a retired investment account does not mean that there is no advantage. And one of the big disadvantages is that putting all retirement savings at a 401 (k) could lead to more taxes on Social Security benefits. That is why.
Distributions from a 401 (k) count as income when determining whether your Social Security benefits are taxable
If you use your maximum 401 (k), chances are good that most or all of your retirement income will come from that account, along with your Social Security benefits. Unfortunately, receiving large deductions from your 401 (k) to supplement your Social Security pension income may result in a reduction in the amount of your Social Security Administration checks.
This can happen because Social Security benefits become partially taxable as your income exceeds $ 25,000 as a single filler or $ 32,000 as a married tax couple.
No, it all counts as income in this calculation, though – only half of your Social Security benefits, as well as 100% of other taxable income. And this “other taxable income” category is where a problem can arise. See, distributions from your 401 (k) are taxed as regular retirement income and so they are counted as taxable income to determine that portion (if any) of Social Security checks you lose on taxes.
Since the average Social Security benefit replaces only 40% of pre-retirement income, you will surely 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 this is the main account you contributed to, you will quickly find yourself with income above the thresholds at which some of your benefits will be taxed – especially since those thresholds at which benefits are taxable are not indexed to inflation, so they do not rise as wages and prices.
What should you do instead of maximizing your 401 (k)
First and foremost, you always want to contribute enough to your 401 (k) to get your employer full match. And you will also want to see if your employer offers a Roth 401 (k). If they do, you can contribute cash to them after tax and make tax-free retirement withdrawals, so any distributions from your Roth will not be counted as income for the purpose of determining if your Social Security benefits taxable. You will get all the advantages of contributing to a workplace account without the major disadvantages of a traditional 401 (k).
But if your employer does not offer a Roth 401 (k), you may want to contribute just enough to a traditional 401 (k) to get your employer’s match and then put extra money into a Roth IRA (assuming you are entitled to contribute to one based on your income).
While putting money into a Roth means that contributions cost a little more when you make them after investing in dollars after tax, you will be able to withdraw as much as you want from your retired Roth IRA without having to pay distribution taxes or giving more income from social security subject to taxes. In other words, you may be able to avoid federal taxes on most or all of your retirement money.
Since every bit counts when you live on a fixed income, getting some retirement money from a Roth in order to limit taxes on your Social Security benefits can make a big difference in your financial security as a retiree.