Retirement planning and the potential 401(k) fallacy

Andrey Popov / stock.adobe.com

Have you heard the phrases “It’s good to put money in a 401(k) because you save taxes” or “Deferring taxes to retirement is good because you’ll be in a lower income tax bracket when you retire?" If not, I would like to introduce you to one of the greatest potential fallacies existing in financial planning today: the way the 401(k) works.

Let’s say you made $100,000 this year. During the year, you contributed $10,000 toward your 401(k). This reduces your taxable income to $90,000 in this year. If you pay 24% in taxes on that $10,000, you theoretically save $2400 in taxes. Forget about the fact that it requires you to put in $10,000, which means you have to give up control of $7600 to do so. The $2400 doesn’t just go away, however; it is deferred and paid later when you take money out of the account. Therefore, if the $10,000 grows to $100,000 and you take out this amount in retirement because you need income, you will pay income taxes on 100% of that money based on the tax laws at that specific time in the future. What amount of taxes will you pay in the future? No one really knows, because no one can tell us what Congress will do between now and the time you access the money in retirement (unless you retire within the next few years before tax laws potentially change).

Putting money into an investment account that reduces your taxable income this year (and thus your taxes) sounds attractive. However, many individuals don’t realize taxes don’t go away; they’re just deferred to the time when you take money out of the account. So if you get to retirement and have a lower income, potentially putting you in a lower tax bracket, you would take out money and pay less in taxes on that income than you would have in the year you contributed to the account.

However, I am not sure anyone wants to plan for lower income in the future. Retirement can make every day feel like a Saturday, and with the amount of time a person has available, chances are they’d like to do more in their free time than when they were working. This leads many individuals to want more income in retirement because they have more time.

If you have good growth on your investments and your wealth is built up so the income it produces for you in retirement is higher than or about the same as when you were working, there’s a chance your taxes will be higher in retirement. Deferring taxes could mean you’ll be paying more in taxes than if you had not put the money in a 401(k) to begin with.

The 401(k) has become a retirement staple. It is something individuals feel they need for retirement, something they put money into without even thinking about why, how, or what it is because everyone around them seems to think it’s a good idea.

Even the pioneers of the 401(k) seem to regret pushing it so hard in the 1980s, because it is not used the way it was originally intended. The Wall Street Journal published an article by Timothy Martin titled, “The Champions of the 401(k) Lament the Revolution They Started.” Why would the individuals responsible for implementing the 401(k) back in the late 1970s lament what they had done? The article states, “Some say it wasn’t designed to be a primary retirement tool and acknowledge they used forecasts that were too optimistic to sell the plan in its early days.”

In other words, they don’t believe the 401(k) is bad; rather, it’s how individuals use it that creates a problem. These individuals see the 401(k) as the core aspect to funding their retirement rather than a supplement to an actual retirement plan.

A good plan has a backup option when nothing goes according to plan. Relying on a 401(k) alone for your retirement may work out just fine. However, many individuals we meet with don’t want to plan only for what they may need; they want to plan for what they will want. Needs-based planning isn’t a bad approach to financial planning. I just hope you realize there is an alternative: wants-based planning.

CJ Burnett, CExP, started focusing on his work with veterinarians in 2014, cofounding Florida Veterinary Advisors as a result. Over the years, he has experienced success working with veterinarians and business owners on structuring financial plans that give them the most control over the results they are after. Burnett not only wants to help individuals with their financial plans; he wants to change what’s possible for them, showing them how to master the short game to win the long game. He speaks at national conferences, is involved in many national veterinary associations, and is a host of the Smarter Vet Financial Podcast.

DISCLOSURE

This material is intended for general public use. By providing this content, Park Avenue Securities LLC and your financial representative are not undertaking to provide investment advice or make a recommendation for a specific individual or situation or to otherwise act in a fiduciary capacity.

CJ Burnett is a registered representative and financial advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial representative of The Guardian Life Insurance Company of America (Guardian), New York, New York. PAS is a wholly owned subsidiary of Guardian. Florida Veterinary Advisors is not an affiliate or subsidiary of PAS or Guardian. Florida Veterinary Advisors is not registered in any state or with the US Securities and Exchange Commission as a registered investment advisor. The individuals associated with Florida Veterinary Advisors do not maintain specialized licenses or qualifications for the financial services provided to veterinary professionals. CA Insurance License #0K79676. 2022-146071 Exp 10/2024.