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This is an article in an occasional series on personal finance. Each article will address a different aspect of personal finances and provide some tips for you. However, always consult your own financial adviser or tax professional for your specific situation.
Saving in your 401k may now be hazardous to your (financial) health.
With the recent passage of the Tax Cut and Jobs Act, a 401k may not be such a great option anymore. Yes, everyone should be saving for their retirement, but a 401k is hardly the only way to do it.
How does tax reform impact this? Remember that contributions today to a 401k (or traditional IRA) are tax deferred, meaning that you get a tax break today but pay taxes upon withdrawal. With tax reform, that may be a bad deal.
Let’s consider $1 in contributions into a 401k. Today, the math works like this. Let’s assume that your taxable income is $100k, putting you in the 22 percent tax bracket in 2018 for married, filing jointly. Remember that gross income is much higher; the $100k in taxable income is after deductions.
401k contribution – $1
Tax deduction today – $0.22 (22 percent of the $1)
Net cost today – $0.78
But 10 years from now, after the personal tax changes expire, the rates will revert to what they were in 2017. With $100k in taxable income, the tax bracket is 25 percent, So the withdrawal of that dollar looks like this:
401k withdrawal – $1
Taxes owed – $0.25 (25% of the $1)
Net income – $0.75
You put in 78 cents today to get out 75 cents later. You lost 3 cents simply from changing tax rates. Is that a good deal to you? In reality, the loss may be even greater because you’ll likely be making more 10 years from now which may put you into an even higher tax bracket.
Losing money due to taxes, and given that tax rules can change means that you need to be tax diversified – and save for retirement other than in your 401k. Here are some ways:
- Roth IRA / Roth 401k – probably the best known way to create tax free money in retirement. You pay tax on contributions today, in exchange for tax withdrawals after age 59 1/2.
- Mortgage / Reverse mortgage – owning your own home free and clear is a laudable goal. But it also means that there’s an asset that isn’t available unless you take out some sort of mortgage, or sell the house. Being able to access your equity is key as loan proceeds are not considered as income.
- Life insurance cash value as a buffer – you can withdraw the principal or borrow against the cash value in a permanent insurance policy (whole, universal or variations thereof). As with mortgages/reverse mortgages, loan proceeds from a life insurance policy cash value are not treated as income.
- Life insurance as a permission slip – life insurance death benefit is income tax free and can provide a pool of money to support the spouse. This allows a couple to spend all of their retirement assets without having to worry about how much one spouse has to leave the other.
- Health savings accounts – this is the only thing in the tax code that is triple tax free. Tax deferred contributions, tax deferred growth, and tax free withdrawals for qualified expenses. Qualified medical expenses include such things as prescriptions and co-pays which can be major expenses as we age.
Why all of these buckets? Flexibility and control. No one can control what the markets do, but you can control our costs and taxes. Each year, depending on what you get from work, Social Security, how markets perform, and tax rates, you could pick and choose which bucket of money to use that will support your lifestyle but minimize taxes. By doing so, you can make the money last longer.
And for the next 10 years, these may be far better ways to save for retirement.