If you are 401(k) plan participant, it is important to understand that creating lifelong retirement income is entirely your responsibility. This is no easy task.
For decades the thinking was that if you limited annual withdrawals from your retirement funds to 4 percent you should never run out of money. But there are several flaws in this theory. One is that it ignores the impact of taxes and investment expenses. Investment expenses alone could reduce the actual spendable income for a 4 percent withdrawal down to just 3.5 percent of the initial value of the portfolio.
In other words, if you must limit withdrawals to 4 percent to reduce the risk of one day running out of money, any investment fees associated with your retirement account must come out of your withdrawals. If not, then the total annual withdrawal, including fees would increase the 4 percent to a higher rate.
Regarding taxes, it is important to consider that the entire withdrawal from a traditional 401k, IRA or other tax deferred plan is subject to income taxes. This means that the amount of an withdrawal that will be available for spending on your retirement needs will be further reduced by the your income tax rate.
When participants start contributing to their 401(k)s, fees and taxes are generally of little concern. If the total administrative and investment fees that are deducted annually amount to one percent (in many plans the fees are higher), the dollar amount of the deduction may not appear to be so large to a newer participant with a relatively small plan balance.
At one percent, the fee is only $100 when the balance is $10,000. But if over time and with additional contributions, your balance grows to $1 million, the one percent fee might be a fairly significant $10,000 annually.
As much as fees can eat away at these do-it-yourself retirement plans, taxes potentially represent a much greater challenge, especially for those who fear that their tax rates might increase in the future.
It’s not difficult to illustrate this if we remember that participants are only postponing the day when taxes must be paid on the money accumulating in their traditional 401(k)s, IRAs and other such retirement plans. When that day comes when you want to withdraw $50,000 for your retirement income, if the tax rate applied to the withdrawal is 20 percent, $10,000 will go to pay taxes. But if that tax rate has increased to 30 percent, the tax payment would go up to $15,000.
Every dollar you pay in taxes is one less dollar available to pay your grocery, utilities, and insurance, let alone to fund travel, hobbies and the fun things we hope to do during retirement.