close

Your Financial Future: Understanding 401(k) contributions, withdrawals

4 min read
article image -

This week we are going to continue celebrating Financial Literacy Month by discussing the accidental retirement plan, the 401(k).

Our fathers and grandfathers often received a defined benefit pension. They earned a certain amount of retirement benefits, usually based on amount of salary and number of years worked.

This worked fine when all of the competition was from American companies. They all had a similar cost structure. However, when we had to start dealing with international companies, we were at a disadvantage because they often did not have the same legacy cost. This is the amount of money a company owed to workers that were already retired.

Ted Berna discovered a section in the tax code where employees could contribute earnings and defer paying taxes until the funds were withdrawn from the account. The company would often match a certain percentage of contributions to encourage wider participation among the employees. All funding, longevity and growth were transferred from the company to the employee. By doing these things, American companies were better able to compete in international trade.

This means that workers now have to make sure they start saving soon enough and put away sufficient savings to enjoy their desired retirement. They also have to calculate the right withdrawal rate and manage the tax consequences. This requires the need for much more financial literacy that is not provided by the public education institutions.

Contributing to a 401(k) means the employee must defer some of the income that they could otherwise spend today. This requires budgeting for daily living expenses. Cash needs to be allocated between wants and needs. Wants are things we would like to buy, while needs are the things that we must actually purchase. Doing this allows money to be set aside to fund the future retirement.

Employees must be sure they are putting enough into the retirement savings to reach their goals. They must also allocate their investment between different asset classes to match their risk tolerance and provide the necessary retirement balance. All of these things require sacrifices and skill development.

If the employee does a good job of accumulating money during the accumulation phase of the money cycle, it takes a completely different skill set to manage the distribution phase where the employee stops working and begins to take funds out of the account to live on during retirement. Often, the advisor helping in this stage needs different skills than the advisor who helped with the accumulation stage.

This is because the rules change 180 degrees.

The number one fear of seniors during retirement is running out of money or longevity risk. No one wants to have to go get a job when they are in their eighties. Unlike the defined pension plans that guarantee a lifetime income to the worker and possibly a spouse, 401(k) plans can run out of money. There are several possible reasons this could happen. Withdrawals might be too large or start too soon. Return on investments might be to too low, or sequence of return risk could happen if there is a correction in the stock market at the beginning or early in retirement.

Taxes must be considered to provide the necessary spendable funds that are needed to support your desired retirement. At the death of one spouse, tax rates will increase, while income will go down due to the loss of one Social Security check.

There may be increased costs because of the widow’s penalty or an increase in Medicare Part B & D premiums. More people die on the way down Mount Everest than on the way up. Make sure you get the required knowledge or work with a retirement planning specialist.

Your Financial Future is written by certified financial planner Gary W. Boatman, MBA and CFP.

, who also wrote the book, “Your Financial Compass: Safe Passage Through The Turbulent Waters of Taxes, Income Planning and Market Volatility.” If there is an area that you would like to see discussed in the column, send your suggestions to gary@BoatmanWealthManagement.com.

CUSTOMER LOGIN

If you have an account and are registered for online access, sign in with your email address and password below.

NEW CUSTOMERS/UNREGISTERED ACCOUNTS

Never been a subscriber and want to subscribe, click the Subscribe button below.

Starting at $3.75/week.

Subscribe Today