When planning your retirement, it’s important to consider which income streams you need to cover living expenses. For many people, Social Security is an important part of the income puzzle, although it may come with a 401(k) plan. If you’re new to retirement planning and saving, you may be wondering about the differences between Social Security plans and 401(k) plans. Both can help you fund your retirement goals, although it’s important to understand what makes each unique.
Work with a financial advisor to maximize your chances of arranging the right kind of retirement income for you.
Are Social Security and 401(k) the same thing?
When you talk about Social Security and 401(k) plans, you’re talking about two things that fulfill a similar purpose in different ways. Social Security is a federal program that provides financial benefits to eligible people. That includes disability benefits for people who are unable to work and retirement benefits for people who have chosen to stop working.
The Social Security program is funded through payroll tax deductions. So if you work for an employer or are self-employed, you pay Social Security tax on your earnings. This money goes to a trust fund, which pays monthly benefits to retirees. The amount of money you can receive from Social Security retirement benefits depends largely on your income and marital status. You can receive a Social Security pension at the earliest at the age of 62.
A 401(k) is a defined contribution plan. These plans can be offered by employers to employees who finance them through voluntary pay deferrals. In simple terms, you can fund a 401(k) through payroll deductions. Your employer may choose to match your premiums, but not all companies do.
The money in your 401(k) can be invested in mutual funds, target date funds, or other securities. Your options usually depend on what the subscription manager chooses. Your 401(k) contributions are tax-deferred and your contributions are tax-deductible. From the age of 59 ½ you can make qualified cash withdrawals from your account without any tax penalties. But you do owe income tax on the money you withdraw.
Will You Still Get Social Security If You Have a 401(k)?
Having a 401(k) plan at work doesn’t stop you from receiving Social Security benefits. The two are completely separate from each other, so whatever you get from Social Security won’t be affected by money you withdraw from a 401(k).
However, receiving Social Security benefits and taking withdrawals from a 401(k) in retirement can affect your tax bracket. Remember that with traditional 401(k) plans, withdrawals are subject to income tax. So the more you withdraw each year to supplement any benefits you receive from Social Security or other sources, the more you could pay in taxes.
Talking to a Social Security benefits specialist or your financial advisor can help you decide how much of your 401(k) you want to withdraw, based on your retirement budget and what you get from Social Security.
Should I use a 401(k) before Social Security?
The minimum age at which you can start taking Social Security retirement benefits is 62. Meanwhile, at age 59 you can start taking your 401(k) tax-free. The rule of 55 could technically allow you to take penalty-free withdrawals from a 401(k) as early as age 55 when certain conditions are met.
So whether you should use your 401(k) before Social Security can be a moot point in terms of when you can use it. However, there is good reason to consider relying on 401(k) withdrawals for as long as possible before taking Social Security retirement benefits. Postponing benefits for longer can lead to a higher benefit amount.
For example, if you can wait until age 70 to take Social Security, you could receive benefits equal to 132% of your normal retirement age. That’s a nice incentive to draw on your 401(k) first. Conversely, if you were to take Social Security at age 62, your benefit would be reduced because you have not yet reached full retirement age as defined by the Social Security Administration.
Do 401(k) contributions reduce Social Security benefits?
Again, it’s important to remember that your 401(k) plan is completely separate from Social Security. Your 401(k) is provided by your employer, while Social Security comes from the government. So contributing to a 401(k) will not reduce your Social Security benefits in any way.
And it’s a good idea to contribute to your 401(k) before retirement, even if you’re counting on taking Social Security benefits. For starters, you get some significant tax benefits, as your contributions qualify for an above-average tax deduction and growth is tax-deferred. For another, you can raise some free money for retirement if your employer matches the premiums.
In addition, it’s important to remember that Social Security benefits alone may not be enough to meet your income needs when you retire. Contributing to your 401(k) now will provide you with a vital source of income for several decades to come when you’re ready to retire.
How to Make the Most of Social Security vs. 401(k)
Maximizing Social Security benefits is largely about deciding when to get benefits. You have three options:
Waiting longer before taking a benefit can lead to a higher benefit amount. But whether that’s realistic may depend on how much you have in a 401(k), individual retirement account (IRA), or other savings accounts. You can therefore choose to receive benefits at your normal retirement age instead.
With a 401(k) plan, maximizing your savings starts with saving as much as possible or at least saving enough to receive the full company contribution. You can also get the most out of your plan by choosing low-cost investments so that you pay less in fees.
Above all, remember that time is on your side with a 401(k). The longer you have to save, the more time you have to take advantage of the power of compound interest. So, for example, if you’re just starting your career, don’t pass up the opportunity to enroll in your employer’s plan. You can start small with contributions and then gradually increase them year after year as your income grows.
It comes down to
Understanding the differences between Social Security and 401(k) plans is important to creating a well-rounded retirement plan. One doesn’t require you to do anything but work and pay Social Security taxes, while the other requires you to be a little more hands-on in charting your retirement future. But both can play a pivotal role in shaping your retirement dreams.
Retirement Planning Tips
Consider talking to a financial advisor about coordinating Social Security benefits and 401(k) plan withdrawals into your retirement income plans. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors in your area, and you can interview your advisors at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Social Security and a 401(k) aren’t the only ways to fund your retirement. You can also contribute to an IRA, open a taxable brokerage account, or purchase an annuity for guaranteed income. IRAs can provide tax benefits, while taxable brokerage accounts do not limit the amount you can contribute on an annual basis. And annuities can provide a steady income when you’re ready to retire in exchange for an up-front premium. They are all worth considering when working out your savings strategy.
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