Many employees believe their 401(k) will be their primary source of retirement income. While these employer-sponsored plans do offer a number of significant advantages, it’s best to understand the possible tax-related drawbacks as well.

Let’s meet 45-year-old Peter. He knows that distributions from 401(k) plans are taxed as ordinary income.If he plans on spending $50,000 a year and is in a 20% tax bracket when he begins taking these distributions, he will need to withdraw $62,500 to have his $50,000 after taxes.This additional $12,500 withdrawal is a 25% increase that he will need to withdraw in order to have $50,000 available to pay for retirement expenses.

Additionally, Peter will find that 85% of his Social Security benefits become taxable when his income exceeds $44,000 (married filer).In other words, withdrawing from his 401(k) is affecting not only that income stream but is also reducing the purchasing power of his Social Security.

Finally, the government continues to use modified adjusted gross income as a measure of how much individuals pay for Medicare Part B and Part D premiums.In other words, using his 401(k) as his only source of privately funded retirement income is causing Peter to pay more in taxes and insurance premiums, thus reducing the amount of money that he has to spend.

Your advisor can work with you to mitigate or avoid many of these tax consequences by exploring different investment alternatives such as opening a ROTH IRA or moving that “orphan 401(k)” into a ROTH IRA.Taking these steps while you are in your earning years will provide years of growth and allow you greater flexibility in retirement.

How You Handle Your 401(k) Can Make All the Difference.
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