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Misconceptions of the 401(k)

If the goal when you retire is for you to maintain your current lifestyle, if not better, then why do so many Americans end up living in a lower standard of living in retirement? It may be due to the fact that they bought into the myth that the 401(k) retirement plan was key to a successful and comfortable retirement.

The 401(k) is tax-deferred, which means tax postponed. You contribute money into it on a pre-tax basis, but the government will tax those withdrawals fully upon retirement, and without income deductions previously enjoyed such as mortgage interest, dependent children and business deductions, the retiree likely ends up in a higher tax bracket. In layman’s terms, this means you may be paying higher taxes than you were while you were working. One of the biggest misconceptions about 401(k) withdrawals is that you will be paying less taxes.

The Roots of the 401(k) Misconceptions

The 401(k) tax-deferred retirement accounts became popular in the 1980’s, embraced by big companies as a replacement for costly pension funds. Back then it made sense for U.S. workers to defer taxes in the 401(k) account when there were many more tiers to tax rates and those marginal rates were much higher. With continued high progressive tax rates and over a decade of economic stagnation, the common thought was that future tax rates would be lower.

That was a misconception of the 401(k) because those tax advantages have all but dissipated; we would be lucky if tax rates remain the same when we retire – it could very well be higher. The tax advantage of deferring taxes today in exchange for paying less tomorrow would disappear.

If tax rates in fact remain the same when one retires, then common sense would dictate that the tax “advantage” of the 401(k) disappears and any current tax savings are wiped out when one actually cashes out their 401(k). Then one must question if there is any point in investing in the 401(k) if the best we can do is to break even.

Another misconception of the 401(k) is the assumed advantage of pre-tax investment. If you have more money to invest up front, one would assume that it would be an investment advantage to do so pre-tax. But when you consider that your long-term investment strategy would achieve long-term gains, when it’s time to withdraw from your 401(k) plan, you will be taxed at your personal income tax level. Those gains should have been taxed at the much lower capital gains tax rate level, and under the 401(k) structure they are considered income. The perceived pre-tax advantage up front is offset by the tax disadvantage at the end.

Today, baby boomers are the first generation of retirees to fully rely on their 401(k) accounts. According to government data, an estimated 60 percent of middle-income earners nearing retirement have 401(k)-type accounts, which represents the majority of their savings. Another misconception of the 401(k) is that contributing 6 percent annually with a 3 percent company match would be enough to maintain your current, pre-retirement lifestyle.

Because of the shortage of savings many people have no choice but to postpone retirement, move into cheaper homes, eliminate dining out and other luxuries. In sum, they face a radical and overall downsizing of their lifestyles. Others have also considered part-time work in their 70s.

The status quo advice is that retirees need to cover 85 percent of their pre-retirement income, but the Federal Reserve data suggest that many people will not be able to do so, especially those who had hoped to rely on their 401(k) accounts. Social Security will provide up to 40 percent of pre-retirement income and most 401(k) accounts do not come close to making up the gap.

The financial crisis from 2007 – 2009 worsened the challenges of Americans who invested in 401(k) accounts. Many people lost half, if not all, of their 401(k) retirement savings when the housing and financial markets collapsed.

For those saving for retirement, one must gain an understanding of how income streams work and how it will affect your lifestyle. Saving for retirement is significantly different from living off those assets. Having a clear understanding of those rules will have a significant impact on your retirement income. When the proprietary, self-created Personal Pension Formulation strategy is applied, in some cases retirees can maximize their spendable income.

If Americans were made aware of these common misconceptions of the 401(k) retirement plan, they may have chosen to invest their monies in other plans that would give them a better chance of maintaining their current lifestyle.