Just recently, the brokerage firm Fidelity shared some noteworthy news: there are now a record-breaking number of “401(k) millionaires” among the 401(k) plans it administers. This exclusive group is about 168,000 strong, up from 118,000 last year.
And while there’s no doubt these 401(k) millionaires should be proud of their accomplishment (after all, the average 401(k) balance sits around $104,000), we’re here to burst their bubble: they’re not really millionaires.
Even though their 401(k) balance might read “$1,000,000” when they log-in to their account, that number is misleading. In fact, it’s a downright lie. And it’s all because of that dreaded five-letter word: taxes.
Remember, when you save in a traditional 401(k), you’re making a deal with the government: the government is saying, “We’ll give you an up-front tax break on your contributions as long as you agree to pay your taxes on this money at a later date, once the account has grown.”
Translation? Once retirement hits and you start making withdrawals from your 401(k), Uncle Sam gets a chunk of your balance.
For example, let’s say one of those 401(k) millionaires is in the 12% tax bracket in retirement. Instead of the $1 million, he or she really has about $880,000. Someone in the 22% bracket would have about $780,000.
Obviously, both of those scenarios still leave a nice amount of money for retirement. But neither is as much as originally thought.
This is one of the reasons why a Roth 401(k) is such a powerful retirement planning tool – you contribute money you’ve already paid taxes on, so the account grows tax-free. Then, assuming you’ve held the account for five years and you’re at least age 59 ½, withdrawals on earnings are tax-free. If you see a balance of “$1,000,000” in your Roth 401(k) account, you truly have $1,000,000.
The Simply Money Point
Traditional 401(k) balances don’t account for taxes. So, as you’re planning for retirement, don’t take the number you see at face value. It’s not a true indication as to how much is actually yours.
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