Most individuals tend to fall into one of three categories of financial knowledge. Either they don’t understand it at all (which is absolutely fine as this is a complex financial world we live in) or they understand taxes or they understand investing. Very few people we run across have a good handle on taxation and investing. Sadly, understanding your 401(k) – the most common employer sponsored retirement plan – really requires a basic understanding of both elements.
The defined-contribution plan or 401(k), according to Section 404 of ERISA, is obliged to have at least three investment options and most plans have many more than that. The investment choices involve risk and you can make or lose money on these investments. It is your job as your financial decision maker to make the election regarding how to invest your money. Some people hire Registered Investment Advisors to help them manage the money and in exchange take on a fiduciary responsibility to always act in your best interest.
The employer puts the programs together and organizes the menu of choices. Sometimes the employer will even match or flat out contribute to the plan to help encourage individuals to participate in the plan. All of this is done with the best of intentions, but you should want to save not just for rainy days but for the sunshine filled days in your future. Money gives you choices and for most people if you don’t save you won’t have very many choices during your retirement.
One of the best parts about the 401(k) is the money comes right out of your check. There is no chance to spend it or give it away. This is a great way to put your contributions on auto pilot. So where is the concern? It is in the tax issue.
The early evolvement in retirement plans came when the top tax rate was over 70% and there were many brackets. It was believed that most people would retire in a lower tax bracket. President Regan changed the entire system in 1986 creating three brackets with the top being 31%. The notion of tax deferral already had challenges in my opinion. In 25 years of helping families plan for retirement I have seen very few that have reduced their tax bracket and some have even been forced into higher brackets due to required minimum distributions from their retirement accounts.
Many 401(k) plans have a Roth option. It still gives you the ability to contribute out of your paycheck but you will pay taxes at your marginal tax rate today rather than at your tax rate when the money comes out of the account. It won’t feel as good at this tax time but you may be happier in the future. However, your employer’s portion still has to go to the tax-deferred portion of the account.
We have seen families put money in 401(k) plans that were effectively in a zero percent tax bracket. Why defer zero taxes? Not all plans have the Roth option but they should! Don’t forget to consult with your tax and investment professional. This is your retirement and it is personal!
Joseph “Big Joe” Clark, whose column is published Sundays, is a certified financial planner. He can be reached at bigjoe@yourlifeafterwork.com or 640-1524.
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'Big Joe' Clark: Making the most of your 401(k)
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