The convenience and built-in tax advantages of your 401(k) make it one of the most effective ways to save for retirement. But is a 401(k) a retirement plan? Not quite.

In truth, your 401(k) is just one component of a larger retirement strategy that accounts for income, taxes, health care, inflation, and legacy planning and merges it all with the lifestyle you want to enjoy. While a 401(k) can help you save and generate income in retirement, you’ll probably need few more financial tools to protect you from other risks down the road. Here’s why.

FIRST, WHAT IS A 401(K)?

A traditional 401(k) is an employer-sponsored account that allows you to automatically save for retirement using pre-tax dollars from each paycheck. Pre-tax simply means the money is taken out of your check before taxes are paid, and that reduces your taxable income for the year.

For 2021, you can contribute up to $19,500, but if you’re 50 or older you can kick in an additional $6,500. Another perk: Many employers match some, or all, of your contributions (that’s essentially free money). Your 401(k) contributions can be invested in a variety of assets, but choices are usually limited to those offered as a part of your plan.

HOW A 401(K) WORKS WHEN YOU RETIRE

While contributions to a traditional 401(k) aren’t taxed today, they will be when you start withdrawing from a 401(k) in retirement. At that time, you’ll owe ordinary income tax on those distributions. Keep in mind, the IRS requires you requires you to begin taking annual 401(k) distributions once you turn age 72.

And those taxes add up quickly and can significantly reduce the amount of income you receive from each dollar you saved. The impact is further amplified if you drift into a higher tax bracket. What's more, your taxable income also impacts Medicare costs.

Fortunately, you there are ways to minimize the taxes you pay on income in retirement, but that requires some strategic planning and a few more tools.

RETIREMENT PLANNING BEYOND YOUR 401(K)

The most effective retirement plan strategies go beyond the 401(k) and diversify your sources of income to provide stability and tax flexibility in retirement. Here are a few additional income sources that typically make up a well-diversified retirement plan:

  • Social Security: Social Security benefits aren’t affected by the market and will provide steady income for the rest of your life. It’s a stable component of your plan that helps smooth market volatility and longevity risk (outliving your savings). While you can begin collecting Social Security when you turn age 62, you may want to wait and allow your benefit to grow, which you can do up until you turn 70.

  • Roth Accounts: With a Roth IRA (or Roth 401(k)), your money is taxed before you contribute it. The money grows tax free, and in general it won’t be taxed when you withdraw it later in retirement. That can help you be more tax efficient in retirement. For example, if you generate $50,000 in income and half is pulled from your Roth IRA and the other half is from your IRA, only $25,000 (the portion from your IRA) would be taxed.

  • Traditional investments: Beyond your qualified investment accounts (401(k)s, IRAs or their Roth counterparts), investments can also help you grow your money over time and manage your taxable income. A brokerage account won’t confer tax advantages (dividends and income will all be taxed as they are distributed or earned), but you can use strategies, such as tax-loss harvesting, to modify your taxable income for the year.

  • Annuities: Unless you’re lucky enough to retire with a pension, an income annuity is a comparable source of guaranteed income. You may also want to consider using an accumulation annuity to save for retirement when you’re younger. An annuity, quite simply, is a contractual agreement with an insurance company that it will provide you guaranteed, regular payments in retirement. An annuity helps manage longevity risk because it can serve as source of income for the rest of your life.

  • Cash reserves: Having liquid cash reserves in a high-yield savings account will come in handy for unexpected expenses that pop up in retirement.

  • Whole life insurance: Life insurance can be another powerful tool to supplement your retirement income. The policy itself builds cash value as you pay your premiums. This accumulated cash value doesn’t experience ups and downs like the markets and can be used at any time for any reason, including retirement income1. This can be especially helpful during periods of stock market volatility.

Your 401(k) is an important piece of the retirement puzzle, but a robust retirement plan is one that leans on a diverse mix of income sources, in addition to your 401(k), to create the income you'll need for the retirement you dreamed of. A financial advisor can help you build a plan for retirement, starting with recommendations about the best ways to save when you’re young all the way to the best ways to withdraw your money once you’re in retirement.

1The primary purpose of permanent life insurance is to provide a death benefit. Using permanent life insurance accumulated value to supplement retirement income will reduce the death benefit and may affect other aspects of the policy.

This publication is not intended as legal or tax advice. Consult with a tax professional for tax advice that is specific to your situation. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against a loss.

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