What You Don't Know About Your 401(k) Can Hurt You

Quick: when you hear the word retirement what do you think of? You probably thought, 401k. If so, you are in good company. The 401(k) savings plan has taken the nation by storm. Just about every working adult owns a 401(k). The 401(k) plan is simple to set up, easy to fund, and if you're lucky, your employer offers matching contributions. Retirement planning doesn't get any easier than this. Now let me ask you this: Are you sure you're on track for a comfortable retirement? If you get a funny feeling in the pit of your stomach when you think of this, you are not alone. More people are concerned about weight loss than they are about planning for retirement.

Retirement is a big deal. Rather, it should be a big deal, but it's not. How well you plan now will greatly impact how you live out your Golden Years. It could mean the difference between downsizing to a smaller house and buying your dream house near the sunny shores of Florida. More and more retirees are opting for an active lifestyle, and that often requires a larger income. Sadly, most people who save for retirement solely by funding a 401(k) may be in for a rude awakening. The 401(k), as popular as it is, has a dark side. Here are some things you may not know about this popular retirement fund.

In order to retire and give yourself a $100,000 annual salary, you would need to save $1,000,000. That's a million dollars in a retirement account, assuming you are relying on monthly Social Security payments and pension payments. If you are skeptical about Social Security actually being around by the time you retire and your company does not offer a pension plan, you will need to stash away $2,000,000. That's a hefty chunk of change.

If you are planning on saving up 2 million dollars in your 401(k) account so you can have your nice $100,000 annual salary, you may actually need to save substantially more than that. Make that figure more like 2.6 million. The reason for the extra money is so that you have enough to meet your salary requirements after you take into account income tax. The Internal Revenue Code (IRC) allows you to save money in a 401(k) using pre-tax dollars, but when you start taking deductions from your retirement account, the IRC is going to tax it as income. Therefore, the $100,000 you budgeted each year will be more like $72,000 a year, assuming the tax bracket for a married filing joint couple remains at the same level decades down the road. Most people hear the term pre-tax dollars or tax-deferred and mistakenly think tax-free. Tax-deferred sounds great, but it puts you at a serious disadvantage later in life if you haven't planned for it. Later in life is not the time for bad surprises.

Because the IRC has given you ten, twenty, or thirty years of saving tax-free, it is going to want that money back. After all, fair is fair. The old adage, "there are no certainties in life except death and taxes," has never been so true. By roughly the age of 70.5, the IRC requires that a person begin taking the Required Minimum Distribution (RMD) from the 401(k) plan or face a 50% tax penalty on the amount that should have been withdrawn. This penalty tax is on top of regular income taxes. And of course, figuring out your RMD requires a degree in calculus. Bet you didn't know that about your 401(k)!

Another caveat to the 401(k) is the inability to withdraw from it without being imposed a severe penalty fee. Think about it for a moment. You've established a savings account that you hope to contribute to for many, many years. You plan on never touching the money until retirement. However, our society is not big on commitment. The divorce rate is hanging around 50%, and most of us cannot even follow through on a two-year commitment plan with our cell phone carrier. What are the odds that you will never, ever touch your retirement savings over the years? And what kind of savings account punishes you for withdrawing your very own hard-earned money before you reach a certain age? A government endorsed savings plan, of course!

The bottom line is this: whenever you sign up for a government endorsed savings plan, review the fine print carefully. Make sure you know what you are buying and that you can afford the strings attached in the fine print. If it sounds too good to be true, look for the details that were left out. They were left out on purpose. And remember, whenever something is touted as being tax-deferred or pre-tax, you will end up paying more taxes on it later, maybe at a time when you could really use a break.