Transitioning Military Officers May Be Offered an Unmatched 401(k)
I'm fairly certain that the most common retirement plan offered in the civilian world is the 401(k). I'm also fairly certain that most employers also match a portion of contributions or make profit sharing contributions. But that isn't always the case. If you're separating or retiring from the military and have a job that offers an unmatched 401(k) you'll need to decide if you want to participate. Here are 6 considerations.
1. Your Overall Tax Picture
If you contribute to a pre-tax 401(k), you reduce your taxable income. How much will the reduction reduce your taxes? Most of us look at our marginal tax rate and multiply the contribution by that amount. But that is just the tip of the iceburg. If you're a retired senior military officer and your combined income is significant, the reduction in income could make significant changes to your overall tax picture. Here are a couple examples where reducing your income below a threshold could result in big tax savings.
- The American Opportunity Credit which can add up to a $4,000 reduction in your tax bill for each child you have in college (assuming you're paying for school). The credit starts to phase out at $160,000 of Adjusted Gross Income (AGI) for those who file jointly. It is completely phased out at $180,000 of AGI. Reducing your income by $19,000 could cut your tax bill by up to $3,900 or so on top of the savings due to your marginal tax rate.
- If you have high income, you become subject to ObamaCare surtaxes on investment earnings if your AGI is above $200,000 if single and $250,000 if married. Get below those thresholds and you'll save the 3.8% tax on investment earnings.
2. Is There a More Tax Efficient Way to Invest?
If the majority of your investment will be in assets that increase in value (stocks as one example) and there won't be much current income, then a 401(k) might not be your best option. This is because 401(k) distributions are taxed as ordinary income at your marginal rate. Long-term capital gains and qualified dividends, when the assets are held in a taxable account, are taxed at a preferential rate. For most retired military officers with a new career their marginal tax rate will be 22% or more. Conversely, their long-term capital gains and qualified dividends will be taxed at 15% or maybe $18.8%. Regardless of tax bracket, capital gains are always taxed at a lower rate than ordinary income.
3. What are the Fees?
Some 401(k) plans have very high fees. Take a look to see if these fees make the 401(k) less appealing. It is unlikely that they will offset the tax advantage of a 401(k), but when combined with some of the other considerations, it could tip the scales.
4. Do You Want to Deal With Required Minimum Distributions?
When you turn 70 1/2, you'll have to start taking distributions from your 401(k). When you take distributions, you have take a required minimum and you have to pay taxes on those distributions. With a taxable account or a Roth IRA, you don't have to sell and with a Roth IRA you don't have to take a distribution. In fact if you hold your taxable assets until you pass away (assuming you don't need the money), the basis in the assets will "step-up" to the value on the date of death and can be sold with no tax bill.
5. Do You Have Asset Protection Fears?
If you are in a profession where you are likely to be sued (doctors as one example), having funds in a 401(k) can protect them from a lawsuit. This is because you can't be forced to use funds from an employer sponsored plan to pay creditors.
6. Do I Ultimately Want the Funds to End Up in TSP
If you contribute to a 401(k) and leave the employer either through retirement or getting a new job, you'll be able to roll the funds into TSP. This can be a pretty good idea as TSP is a great place to accumulate funds for retirement.
There is Always More to the Story
It may be tempting to say "No match, no contribution". But as with most things associated with your financial future, there is always more to it than what you see on first glance. Take the time to do your due diligence or work with someone who can do it for you.
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