Have you ever thought about how much of your 401(k) balance belongs to you?
You may be shocked at the answer!
The contributions you (and potentially your employer) have been making over the years have not been taxed. Hopefully, the money you contributed has been growing inside your 401(k). However, that growth has not been taxed yet either.
Consequently, as you withdraw money from your 401(k) plan, taxes must be paid on that money…federal taxes and state taxes (except for the nine states with no state taxes). The money you withdraw is considered “income” because, even though you earned it years ago, it was not taxed at the time it was earned. Therefore, those withdrawals are categorized as “income” on your Form 1040.
Form 1040 Pitfalls
Most of us know what happens to “income” on our 1040. It gets taxed!
We worked hard earning our income for 30-40-50 years, filing Form 1040 every year, and now that we are in our wealth distribution years, we may still be reporting sizeable amounts of “income” and paying taxes on it.
Not only that…most of us start Medicare at age 65. Medicare premiums are means tested based on income reported on Form 1040. At this writing in 2023, Medicare Part B monthly premiums range from $164.90 to $560.50/person.
And currently…the latest we can delay taking Social Security is age 70. Social Security benefits are considered “income” on Form 1040 and are similarly figured into how much tax we owe each year. For many retirees, 85% of their Social Security benefits will be taxed at their ordinary income tax rate in the year they receive the benefit.
Let’s talk about taxes for a minute.
Passed by Congress on July 2, 1909, and ratified February 3, 1913, the 16th Amendment established Congress’s right to impose a Federal income tax.
The early days of taxes saw the rise and fall of top tax brackets based on economics at the time. For example, taxes went up to finance WWI, went down during the roaring 20’s, and went up during The Great Depression and WWII.
The top tax bracket peaked in 1944 at 94% on taxable income over $200,000.
Interesting Tax Fact #1
In 1940, the top tax bracket was 81% on taxable income over $5,000,000.
In 1941, the top tax bracket was 88% on taxable income over $200,000.
What happened? The tax code changed!
Interesting Tax Fact #2
Actor Ronald Reagan was at his Hollywood height in the 1940’s making $400,000 per picture. With the top federal tax rate at 94% , Reagan told his White House chief of staff Donald Regan, “I chose to ‘loaf’ around rather than make more than two pictures a year. Why should I have done a third picture, even if it was Gone with the Wind? What good would it have done me?” As president, Ronald Reagan made drastically reducing the tax rate his first major White House priority.
Interesting Tax Fact #3
From 1964 – 1980, taxes were 70% on taxable income over $200,000. Highly compensated employees were increasingly agitated. Their incomes were increasing into the 70% marginal tax bracket.
Johnson Companies hired a benefits consultant named Ted Benna to help them devise a plan to defer some of their income to the future when tax rates would presumably be lower. Ted utilized a little-known section of the tax code passed as part of The Revenue Act of 1978. Tax code section 401(k) allowed employees to defer compensation from their bonuses and stock options. By the end of 1982, half of all large employers offered 401(k) plans to their employees.
Many have labeled Ted Benna as “The Father of the 401(k)” ; however, at the time, he had no idea his creation would balloon to what it is today. He told the Wall Street Journal, with some regret, that he “helped open the door for Wall Street to make even more money than they were already making.” And, “Unlike defined-benefit pensions, which provide set payouts for life, 401(k) accounts rise and fall with financial markets.” In a 2013 interview, Benna said, “I created a monster. If I were starting over from scratch today with what I know, I’d blow up the existing structure and start over.”
What does this mean for you?
Those who contributed to their 401(k) plans in the early-to-mid 1980’s, when the top tax bracket was 70%, benefited from the tax code. Why? Because as they started distributing those funds, top tax rates averaged 30%.
Taxes over the past 35 years have been the lowest they’ve ever been since 1913. However, what are taxes going to do over the next 35 years? What will tax rates be when you distribute funds out of your 401(k) plans?
The 401(k) plan is over 40 years old. The financial services industry has changed and evolved over the past 40 years. So, we must ask ourselves: Why is the 401(k) plan still the retirement vehicle of choice for most Americans?
One Final Question
How much of your 401(k) balance will belong to you…after taxes?