Buzz
If you’ve been investing in a 401(k) or IRA for a few years, you may feel pleased with your current balance. While you’re generally aware that you’ll face some tax obligations when you withdraw, those thoughts often fade behind the satisfaction of seeing your retirement savings grow. Just look at the progress you’ve made!
However, your actual balance might be far less than what you see when you check your account. This discrepancy comes down to two factors: the taxes you’ll owe and the vesting schedule.
When planning your retirement and making financial decisions, it’s essential to understand exactly how much money you’ll have available when the time comes to retire.
Vesting
Vesting applies to employer contributions in your retirement fund. While the contributions you make are entirely yours (since you earned them), your employer's contributions usually follow a vesting schedule. For instance, you might receive 20 percent of their contributions each year over five years (known as partial or graded vesting), or become fully vested after a specified time, like a year (known as cliff vesting).
The goal of this system is to motivate employees to stay with the company and perform well. However, this means that if you're factoring in your employer’s 5 percent match into your retirement balance, you may need to adjust your calculations accordingly.
“Amounts that are not vested may be forfeited by employees when they are paid their account balance (for example, if the employee leaves the company) or if they fail to work more than 500 hours in any given year for five years,” according to the IRS.
This means that if you're not fully vested yet, your 401(k) balance may not accurately reflect the actual amount of money that’s truly yours.
“Your balance may initially show the full amount of employer contributions, only to be adjusted to match your vested share when you leave your job or roll over your plan,” states Go Banking Rates.
This will vary depending on your employer and plan provider. To get a clearer picture, reach out to your HR department to understand what your balance actually represents.
Taxes
In theory, we all understand that taxes will apply to our 401(k) or IRA funds when we withdraw them during retirement. These accounts offer the benefit of tax deferral (including taxes on investment returns) for decades, making them valuable retirement tools. But how much can we actually expect to lose to taxes?
This chart from the Federal Reserve’s 2016 Survey of Consumer Finances, first featured in Marketwatch, provides some insight into this question.
As shown, the tax rate can vary, but it can take a significant chunk out of your savings, depending on your income and how much you've saved. For example, if you took a $20,000 distribution and were in the 22 percent tax bracket, you'd end up with $15,600 after taxes.
Additionally, as CNN Money points out, “Social Security benefits won’t be taxed if your income is below a certain threshold, but withdrawing from your 401(k) might push you past that limit, making your benefits taxable.” This is another potential tax hit you may not have considered yet.
Unlike vesting, there's no time frame here. You'll owe taxes no matter what strategies you try (even if you roll over your account into a Roth, you'll pay taxes at the time of the conversion). Be sure to factor this into your retirement planning.
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