As a CFP, I advise all my clients to never put more than 7% of total income in a 401(k) or other qualified plan. Here are some of the reasons for my recommendations.
1. Don’t try to put the maximum into a 401(k). A good rule is not to start your 401(k) until you are setting aside 15% of annual income in safe, fixed, saving vehicles like money market accounts, savings accounts, CD’s etc., until you have at least 50% of one years income. If you research some of the questions here on Askville, one of the things you will see asked most often is, "how do I get money out of my 401(k)?" This comes up because too many people started putting the maximum in the retirement account before have liquidity someplace else. Then when they need money in an emergency, (laid off, medical, disability,) they reach for the only large source of money they have, the 401(k). (Then they face tax and penalty.)
2. Once you have 50% of one years income saved, start the 401(k) using 7% of the 15% or up to the company match, whichever is greater. The other 8% should be moved into an investment portfolio outside the 401(k) that fits your investment risk profile.
3. 401(k) plans are tax deferred plans, not tax advantaged plans. Too many financial planners interchange the terminology. A 401(k) allows you to deferrer taxes. This means there is part of your 401(k) that you will never have access to. Most people don’t understand the tax savings is locked in the plan. You never have access to it, that is why it is deferred. For example, if you were to put 7% of $100,000 ($7,000) each year for the next 35 years at 5%, you would accumulate $663,854. $100,000 of income would put you in the 28% tax bracket if single, so you would save $185,879 in taxes. (This assumes you always earn $100,000 a year) Assuming you are in the same tax bracket at retirement (28%) you will owe $185,879 in taxes, exactly the same that was deferred. You never got to spend the $185,879. You are left with $477,975 to spend.
4. Don’t think you will be in a lower tax bracket at retirement. Most people are in the same or higher. And with the way the government is spending money, there is a good chance you tax bracket at retirement could be double what it is now. That means you will give back twice what you got credit for. Remember, you give up almost all money control with a qualified plan. In 1973 when the first IRA law was passed, top marginal tax brackets were 70%.
5. Equity investments inside a 401(k) are taxed at ordinary income rates instead of capital gain rates. So any mutual funds or stock you sell inside the 401(k) at retirement will be taxed at ordinary income tax rates, (as high as 35%) instead of the capital gain rate of 15% outside the plan.
6. You can not tax deduct investment losses inside a 401(k). You can if the investment losses are outside the plan.
7. The government has a Required Minimum Distribution rule at age 70 1/2 that says you must start taking money from your 401(k) whether you want to or not. This distribution is based on a government table. http://www.bankrate.com/finance/money-g ... table.aspx
. The figures are the same for IRA and 401(k). This means you have no control over how much income you take after age 70 1/2. You must take the minimum. This gets added to interest, dividends, Social Security, pensions and any other income source you have to determine your taxable income for that year. Here is a calculator to let you play with a 401(k) balance to see what the minimum is. http://www.cpasitesolutions.com/content ... strib.html
. Notice how clever the government is. If you just take the minimum, the amount you need to take each year increases, pushing you into a higher tax bracket. (Unless you have a major loss inside the plan.)
8. Watch out for plan fees. Some of these 401(k) plans can have very high fees, (150 to 200 basis points, 1 1/2% to 2%.) These fees can really eat into your account balance over the years.
9. Make sure you have a well planned exit strategy. Most people have good entrance strategies, but never look at the tax consequences, minimum distribution calculations, or what can happen if tax laws change.