A 401(k) plan is a great tool to save for retirement if your employer offers one. After all, investing in one is easy since the money is taken out of your paycheck directly. And you get to save with pre-tax dollars, which makes it much more affordable to put money into your account. Your employer may even match some of the contributions you make, which is a huge benefit since you're literally getting free money.
But just because a 401(k) is a good option for a retirement investment account doesn't mean there aren't downsides. And one of the big disadvantages is that putting all your retirement savings into a 401(k) could lead to more taxes on your Social Security benefits. Here's why.
Distributions from a 401(k) count as income when determining if your Social Security benefits are taxable
If you max out your 401(k), chances are good that most or all of your income in retirement will come from that account, along with your Social Security benefits. Unfortunately, taking large distributions from your 401(k) to supplement your Social Security retirement income could end up reducing the amount of your checks from the Social Security Administration.
That can happen because Social Security benefits become partially taxable once your income exceeds $25,000 as a single filer or $32,000 as a married joint tax filer.
Not all income counts in this calculation, though -- only half your Social Security benefits count as well as 100% of other taxable income. And that "other taxable income" category is where a problem can arise. See, distributions from your 401(k) are taxed as ordinary income in retirement and so they count as taxable income for determining what portion (if any) of your Social Security checks you lose to taxes.
Since the average Social Security benefit only replaces about 40% of pre-retirement income, you'll likely rely a lot on your investment accounts to supplement your benefits. And if most or all of your extra money comes out of your 401(k) because that's the primary account you contributed to, you'll quickly find yourself with income above the thresholds at which some of your benefits will be taxed -- especially since those thresholds at which benefits are taxable aren't indexed to inflation so they don't increase even as wages and prices do.
What should you do instead of maxing out your 401(k)
First and foremost, you always want to contribute enough to your 401(k) to get your full employer match. And you'll also want to look into whether your employer offers a Roth 401(k). If they do, you can contribute money to it with after-tax dollars and make tax-free withdrawals in retirement so any distributions from your Roth won't count as income for purposes of determining if your Social Security benefits taxable. You'll get all the advantages of contributing to a workplace account without the big downside of a traditional 401(k).
But if your employer doesn't offer a Roth 401(k), you may want to contribute just enough to a traditional 401(k) to get your employer match and then put extra money in a Roth IRA (assuming you're eligible to contribute to one based on your income).
While putting money into a Roth means contributions cost a little more when you make them since you're investing with after-tax dollars, you'll be able to withdraw as much as you want from your Roth IRA in retirement without owing taxes on the distributions or rendering more of your Social Security income subject to tax. In other words, you may be able to avoid federal taxes on most or all of your retirement money.
Since every little bit counts when you're living on a fixed income, getting some of your retirement money from a Roth so you can limit taxes on your Social Security benefits could make a big difference in your financial security as a retiree.