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Rethinking Your Focused 401k Strategy

401k Sign2

by Randall Neighbour, RICP, APMA

A couple in their mid-sixties came into the office with their 401k statements. They were pleased with how their accounts had grown over the 30+ years in these pre-tax investment accounts with company matching and their contributions. Their accounts totaled well over $1.5 million dollars, and outside of their Social Security benefit, this was their source of income for retirement.  

Burning in their minds was one important question: “How much can we safely draw off it and not run out of money?” While they used an online calculator and put in a rate of withdrawal and an average rate of return, they came to me to verify their results and ask an important question: What might we be missing?

Beyond spending, there are three areas to consider when it comes to using your qualified money (401k, 403b IRA) in retirement. Below I will share a client experience to illustrate the need to plan ahead.  

Income Taxes
Contributing to a qualified plan like a 401k is a great way to defer taxes on your investments and lower your taxable income while working. However, you will pay ordinary income tax on 401k or IRA withdrawals. Most everyone knows this, but what some do not realize is that only having a taxable bucket of money from which to draw in retirement has two other potentially costly implications.  

The Disney Promise
A client (let’s call her Irene) told us that for a number of years she promised her grandkids she would take them to Disney when she turned 70, which was in a few months’ time. Outside of her small emergency fund (which she didn’t want to touch) Irene had a sizable IRA which was rolled from her 401k plan when she retired. When she called, she asked for $10,000 to pay for the promised trip, which was above and beyond her normal withdrawal amount.

We asked her if she would like to have additional money withheld for taxes due and learn about the other costs involved. “No worries” she said, “I can afford the taxes. Grandma keeps her promises. I’ll call my CPA and get back with you.”

The next day she called back and said, “Please have an extra $1,500 withheld for taxes. Now what else should I know about the actual cost of my Disney Promise?”

Social Security Taxation
From previous meetings with her CPA, Irene was aware that 50% of her Social Security was being taxed from the regular withdrawals she was making from her IRA. But she didn’t realize that the cost of this trip would push her into the next Social Security income bracket, and she would be paying taxes on 85% of her Social Security benefit. [Social Security benefits are not taxed unless you have ordinary income over certain levels. However, up to 85% of your Social Security benefit may be taxed if you earn or withdraw more from your qualified accounts.]1

Sadly, this wasn’t the end of Irene’s Disney Promise expenses.  

Medicare Part B Premiums
Irene was paying $148.50 a month for her Medicare Part B premium. However, Irene needed $11,500 from her IRA for the Disney Promise. This higher annual withdrawal amount was going to push her Part B premium up to $207.90 a month, or $712.80 more in two year’s time when Medicare does an income look-back to determine premiums for the year. [The greater your taxable income, the larger your premium rises for Medicare Part B coverage … up to a current maximum of $504.90 per month.]2

When it was all said and done, Irene’s Disney trip for the grandkids ended up costing her almost 50% more than she anticipated because she did not have funds to cover the expense in a non-qualified or Roth IRA account.

In Conclusion:
Saving and investing in company plans and IRAs for retirement should be strategic and made thoughtfully about your future. You must consider the true costs involved with using only pre-tax money to fund retirement. The couple who came into my office for retirement planning were unaware of Social Security taxation and Medicare Part B premium calculations. Now you too know why it is important to consider all the costs associated with different types of retirement plans and accounts.

Do you have questions about your current retirement plan or need to formulate one? Let’s visit about how and where you’re saving for retirement and discuss the benefits and drawbacks of your current strategy. Give us a call at 832-474-7381.

[Note: Example is for illustrative purposes only. Your results may vary]

  1. https://www.irs.gov/newsroom/dont-forget-social-security-benefits-may-be-taxable
  2. https://www.medicare.gov/your-medicare-costs/part-b-costs

 

Other articles we think you will find helpful:
How Much Do I Need to Save For Retirement? – The many things to consider to accurately answer this question
The Three Bucket Strategy – A great tool for preparing for your future
Stock & Market Behavior and The Rubber Band Effect – Understanding Oversold and Overbought Markets

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