Severe limits on 401(k) contributions initially proposed by the GOP as part of tax reform are off the table, at least for now.
Yet the reality is that while nearly eight in 10 Americans have access to a 401(k) retirement investment plan, only 41% use them. As a result, just one-third of all Americans have a stake in the 401(k) system.
Read: The Republican tax proposal doesnt touch 401(k) plans, but maybe it doesnt matter
Lost in the political headlines was the other half of the Republican proposal, which would have encouraged savers to use Roth IRA accounts instead.
Roth accounts are funded with after-tax money theres no tax savings now but the investment growth and withdrawals are tax-free forever. Short-term pain for long-term gain.
The tactic by Congress is plain: Collect more in taxes now, worry about tax-free withdrawals later. A lot could happen to tax reform in the coming months, but the Roth idea is an interesting one.
Is a Roth IRA the best way to save and invest? Should you have one, and why?
The logic of the 401(k) system is well understood by most people. Saving more results in an immediate reward lower taxes today.
Every dollar you put into a 401(k) or a traditional IRA is untaxed this year. It grows free of investment taxes, too. The government gets its cut years later, once you retire.
Even then, the taxes taken on those withdrawals are at your personal income tax rate. Presumably, you will spend less in retirement and fall into a lower tax bracket.
Thats a great deal if you do in fact, spend less in retirement. Yet many retirees spend more, at least at first, then slow their spending, only to pick it back up later on.
Thats the retiree spending smile. Newly retired people often go on a spending spree, upgrading cars, buying second homes and traveling more.
Then reality kicks in and spending flags. Only when health costs go up with age does spending once again rise, completing the smile.
People also tend to ignore two big factors that affect retirement income taxes: Social Security and required minimum distributions (RMDs).
How much you make from Social Security monthly is based on when you choose to begin taking checks.
The government considers the normal retirement age to be between 65 and 67, though you can take reduced benefits at 62 or enhanced benefits (more money) by waiting until 70.
It makes sense. If you take Social Security earlier you are likely to take it for more years and, if later, for fewer years.
Tax avalanche
Say you have a 401(k) with a $200,000 balance at age 60. Invested properly, you should expect it to compound to $400,000 by age 70 or so, then $800,000 by age 80. Nice, right?
There are couple of scenarios here that can directly affect your taxable income in retirement:
Scenario 1: You choose to put off Social Security to age 70 for the higher monthly payout. You let your 401(k) compound, too, taking nothing. Ah, but at age 70陆 the government will require you to take income out of your 401(K) in the form of RMDs.
How much is complicated, but the idea is to spend down your accounts while you are alive and, of course, to pay taxes on those withdrawals. It can quickly become tens of thousands of dollars each year, all taxable income.
The worst case is paying taxes on both Social Security income and on required withdrawals from your 401(k) at the same time. It happens to millions of people every year. Essentially, you fall victim to an avoidable tax avalanche.
Scenario 2: Lets say you put a fair amount of money a Roth account instead of saving solely to a 401(k). Now you have flexibility to plan around that potential retirement tax avalanche.
For instance, you could take more withdrawals from a 401(k) early in retirement and put off Social Security for a few years. Youll be taxed, yes, but only at whatever income you choose to withdraw before 70陆.
You then tap into Social Security during the lean years between, when spending is likely to be lower.
Finally, as spending increases the Roth IRA comes into play. Those funds have had years to compound quietly into a larger balance but, being tax-free, Roth withdrawals are not stacked on top of your continuing Social Security income taxes.
Thats a broad example. Every personal situation is different and its prudent to make decisions in the company of a trusted financial adviser and tax expert, working as a team.
Whatever comes of tax reform, the Roth concept is not a bad one. Common sense suggests that far more people should target savings for a Roth while they can.
