Key Points
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Traditional 401(k)s give you a tax break on contributions.
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The problem is that withdrawals, which eventually become mandatory, are taxable.
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Consider branching out into a Roth account to avoid a nasty tax surprise.
For working Americans with access to a 401(k), there’s perhaps no easier way to save for retirement. You tell your employer how much money you want to contribute per year or per pay period, and that money gets deducted from your paychecks accordingly.
Plus, if you’re lucky, you may not only have access to a 401(k) plan but also a workplace match. That’s free money you can invest alongside your own contributions.
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But a lot of 401(k) savers overlook a big financial risk that could become a problem later on in retirement. And if you’re saving in a 401(k), it’s something you absolutely need to know about.
Required minimum distributions can create a costly surprise
One of the biggest risks of saving in a 401(k) is required minimum distributions (RMDs). Once you turn 73 or 75, depending on the year you were born, you’re forced to withdraw a certain amount from a 401(k) each year or otherwise risk a large penalty.
RMDs aren’t just annoying. They could push you into a higher tax bracket in retirement, cause you to get taxed on your Social Security benefits, and leave you paying surcharges on your Medicare premiums.
Of course, the larger your 401(k) balance is once RMDs start, the larger those mandatory withdrawals are apt to be. But if you don’t need to withdraw all that money each year, it could create a huge headache.
And if you contribute steadily to a 401(k) over decades, all the while investing in the stock market, it’s conceivable that you could have a few million dollars sitting in that account by the time you reach the age when RMDs begin. That’s a good problem to have — but it’s a problem nonetheless.
Planning ahead is crucial
While RMDs could become a big hassle for you if you have your retirement savings in a 401(k), there’s one way to make them less of a problem: Do Roth conversions before they begin.
With a Roth conversion, you move some (or all) of the money from your 401(k) into a Roth IRA. Roth IRA withdrawals are not taxable and are not subject to RMDs.
Another option is to carefully manage 401(k) withdrawals before RMDs begin. Taking larger withdrawals during lower-income years could reduce your future tax burden.
For example, you may have a period when you retire from your job and only live on Social Security for a while. That could be a good time to do Roth conversions or strategically withdraw from your 401(k).
While 401(k)s make it easier for some people to accumulate retirement wealth, they have a huge potential drawback. It’s important to understand how RMDs might affect your taxes and overall financial situation in retirement so you can plan around them.
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