When it comes to saving for retirement, the common advice is to take full advantage of your company’s retirement plan and invest for the future. However, if you are truly planning for tomorrow, relying on a Traditional 401(k) is not a good idea. Federal laws dictate that saving in a Traditional 401(k) can lead to:
- Lower initial Social Security benefits at retirement.
- Higher Medicare costs due to IRMAA (Income-Related Monthly Adjustment Amount).
- Higher taxes on both income and Social Security benefits for life.
- Faster depletion of your savings, unless you have a shorter-than-expected lifespan.
Better Alternatives
Instead of a Traditional 401(k), consider using a Roth IRA, Roth 401(k), or certain life insurance strategies that can provide tax-free withdrawals in retirement.
How a Traditional 401(k) Works and Why It’s a Bad Idea
A Traditional 401(k) allows you to contribute a portion of your salary before taxes. Your investment grows tax-free, and you only pay taxes when you withdraw the money.
Here’s the catch:
- At some point, you must take Required Minimum Distributions (RMDs)—whether you need the money or not.
- The financial industry sells it as a tax-saving strategy, arguing you’ll be in a lower tax bracket in retirement.
- But this logic is flawed.
Why This Strategy Doesn’t Work
- You’re delaying taxes now only to pay them later—when you actually need the money.
- You’re reducing your future Social Security benefits.
- Social Security is based on your 35 highest-earning years.
- If you lower your taxable salary today to save on taxes, you could be reducing your Social Security benefits later.
- Retirement is about income, not just assets.
- A Traditional 401(k) might look great on paper, but what really matters is your net retirement income.
Will a Traditional 401(k) Give Me More Money at Retirement?
Yes, it will help you save a lot while you’re working, but once you start withdrawing, here’s what happens:
- You’ll pay ordinary income tax on withdrawals.
- Your Social Security benefits may be taxed.
Social Security Benefit Taxation
If your total income (including 401(k) withdrawals) reaches:
- $25,000–$34,000 (individual) or $32,000–$44,000 (couple) → Up to 50% of Social Security benefits are taxable.
- Over $34,000 (individual) or over $44,000 (couple) → Up to 85% of Social Security benefits are taxable.
What Counts as Income for Social Security Taxation?
- ½ of your Social Security benefits
- Your adjusted gross income (AGI), including 401(k) withdrawals
- Any tax-exempt interest (e.g., municipal bonds)
The Problem with Traditional 401(k) Withdrawals
Newsflash: Withdrawals from a Traditional 401(k) count as income and contribute to Social Security taxation.
Shocker: Withdrawals from a Roth IRA or tax-free loans from life insurance do NOT count as income.
So, the more money you have in a Traditional 401(k), the greater the chances that your Social Security benefits will be taxed. You are literally reducing your retirement income by avoiding taxes today.
A Traditional 401(k) Makes Medicare More Expensive
Another often-overlooked issue is Medicare costs.
- Medicare is a great healthcare option in retirement, but it’s not free—and it gets more expensive if you have too much income.
- If your income is too high, you’ll be hit with IRMAA (Income-Related Monthly Adjustment Amount), an extra charge on your Medicare Part B & D premiums.
- Guess what? Traditional 401(k) withdrawals count as income for IRMAA—making your Medicare premiums more expensive.
What Doesn’t Count as Income for IRMAA?
✔ Roth IRA withdrawals
✔ Loans from life insurance
Required Minimum Distributions (RMDs) Make It Worse
- Once you reach a certain age, you must take RMDs from your Traditional 401(k), even if you don’t need the money.
- These RMDs increase your income, which can push you into higher tax brackets and trigger even higher Medicare costs.
- To make things worse, Medicare premiums are deducted from your Social Security benefits.
Final Thoughts: The Traditional 401(k) is a Retirement Trap
- It increases your taxes in retirement.
- It reduces your Social Security benefits.
- It makes Medicare more expensive.
- It forces you to withdraw money (RMDs), which can further hurt your finances.
