Although the 401k plan has not generally worked out as well as originally intended, it still remains perhaps the single best and most important retirement benefit for baby boomers, generation x and millennials. The 401k plan is a special, often lucrative benefit offered by employers to their valued employees. The 401k has replaced the pension annuity for your retirement in most situations. While the value of an annuity as a pension was much higher, it also “cost” the employer providing the retirement benefit much more.
Basically, the 401k is a plan that allows a portion of ones wagers or salary that an employee earns, be withheld from their paycheck, and redirected and invested into their choice of several different types of mutual funds in a 401k plan. The IRS limits the amount one may legally direct to be withheld from their paycheck. We will briefly address the history of 401k plans and their contribution limits.
Why Limit a Good Thing such as a 401k max contribution?
The IRS always wants their cut of your earnings as soon as possible. Thus, they will limit the amount one may contribute to an income tax deferred retirement plan, such as the 401k and IRA. Any money you contribute into your 401k will not only be done with “pre-tax” dollars (you do not pay income tax on money contributed into your 401k) but the money invested into your 401k will grow totally income tax-free; until the time you decide to take a withdrawal from the 401k. At that time in the distant future, is when you will pay income tax on the withdrawn money. Usually investments into mutual funds outside of a 401k plan will generate a 1099 form that will require you pay taxes on any increase or gains in the fund during that tax year. Thus, on even the best investment that is held outside of the 401k, you will pay the IRS their taxes due on gains at least annually.
However, when one has investments inside a tax-deferred plan such as a 401k, (or IRA) there are zero taxes due each year, regardless of how much you gain in any year, in your 401k. And since you may potentially work for an organization until you are retirement age (typically around age 65)…
you may legally delay the payment of taxes on increases of value inside your 401k for decades!
Well, obviously Uncle Sam doesn’t like this very much and thus limits how much of this “good thing” we are allowed to have each year. Generally, ANYTHING in which the IRS wishes to limit your participation, it is probably in your best interest to max out your contribution and participation as much as you are allowed. Until 2001, contribution limits increased slightly each year. But with inflation and the aging wave of retiring baby boomers, new rules and higher “catch up” contribution limits were established as part of the Restoring Earnings to Lift Individuals and Empower Families (RELIEF) Act of 2001. This act now allows individuals to start building-up their 401k retirement account, and possibly catch-up on some lost time.
In case you haven’t maxed out your 401k contributions yet, you are allowed to contribute up to $18,000 for 2015. And if you are at least age 50, you are allowed to contribute an additional $6,000 on top of that! Most 401k plan administrators will allow you to make changes to your contribution schedule; but if you wish to get your max benefit out of 2015, you’ll need to contact them ASAP. And if you are wanting to make a contribution to your IRA, usually you’ll want to do so before year-end. You are allowed to make an IRA contribution in addition to you 401k contributions.
401k contributions must be made before December 31st of each calendar year.
Beginning on January 1st, 2016 the max 401k contributions will remain at $18,000 along with the “catch up” contribution for those age 50 and over, will be $6,000. The max amount a person at least age 50 may contribute for year 2015 and 2016 is $24,000 for each year. There is a chance that the max 401k contribution limits will increase in 2017 due to a cost of living increase a.k.a.,inflation.
Best thing about a 401k
Many, if not most 401k plans will contribute “free money” into your companies 401k retirement account on your behalf. This is commonly done by the company “matching” whatever you directed from your monthly paycheck, into the company 401k plan. Generally, the company will match a portion of what you contribute, up to a limit of say 6% of your total annual salary. And typically the company will put in say $.50 cents for every $1.00 dollar you contribute. Our best advice is that almost everyone should try to contribute into their companies 401k plan at least up to the amount the company “matches.” This is literally “free money” and it too will grow totally income tax deferred.
Not the Best things about a 401k
Your money contributed into a 401k is long-term oriented and should not be touched until one is at least age 59 ½. Otherwise, there is onerous IRS tax penalties for cashing out any tax deferred retirement plan, including a 401k. There are a few exceptions that will allow one to avoid the penalty tax but not the income taxes due. Some 401k plans allow for one to borrow against their 401k plan balance but this “loan” must be paid back and will be treated as an early withdrawal if you leave the company or get fired. This could create excessive taxes at a time when you might not be in the best position to pay them. Plus, the average income tax rate including the penalty for early withdrawals from a tax deferred retirement plan is approximately 45%!
Some other things that are not-so-good about 401k deferred tax schemes are the fees and management expenses buried deep in the plans details. Greedy Wall Street Fat Cats historically charge exorbitant fees to administer and manage retirement plans. Studies show that these fees and charges could rob you of as much as 2% per year. Also, in the future, it is likely that income tax rates may be much higher than they are today. The last time our Nation was in a similar financial dilemma, were during the years 1945 – 1965; immediately following World War II. To pay off the debts accumulated defending our freedom…
the top income tax rate in the USA during those twenty years exploded to 91%… and for two years actually hit a top rate of 94%!
Our nation currently owes more than $18.4 trillion dollars; and that debt amount is growing daily. To see how much each person “owes”, click here: So factoring in the potential for much higher income taxes in the future; there might be a better alternative that would ensure you a totally income tax free retirement. In the future, when one makes a withdrawal from their 401k, it is 100% fully taxable. There may be better alternatives than a 401k plan, especially if your companies 401k doesn’t match your max contributions.
The wealthy and wise have opted to set up tax-free retirement plans instead of participating in a 401k.
A very well written and über informative article was published in TIME Magazine by one of their editors about the potential disappointments of a 401k and a potentially better retirement investment alternative. You may view the video by clicking the TIME cover:
The best investment idea for your 401k according to the TIME Magazine article is to utilize the newly created option of investing into a contractually guaranteed lifetime income generating account. These are generally an index annuity that best serves the need for building up an income account that would be “turned on” and activated at some date in the future. These risk free investments may be particularly desirable since interest rates on money markets or other “risk free” investment options in a 401k plan are basically zero percent.
What’s cool about the index annuity with a lifetime income account is that they only increase in value and never go backwards or lose value. They provide you with a known amount of future monthly income that is stable, reliable and contractually guaranteed by a financial institution. These new hybrid investments allowed in a 401k are technically called a Qualified Longevity Annuity Contract or QLAC for short. With the stock market cresting all time high valuations and our nation dealing with over $18 trillion in debt along with another $24 trillion owed by social security to baby boomers already retired; a more conservative investment, especially for a gen x –er or baby boomer, in your 401k might be a great idea. You are invited to contact Michael Ham and My Money Track for help, even if you reside outside of our local Dallas and Ft. Worth service area. We offer the best advice and best investment that’s custom tailored for you.