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The Dark Side of 401(k)s

When it comes to 401(k)s, we all know Carmen’s position(company match = free money!). But even these excellent investing tools have a dark side, she said. And it comes in the form of taxes.

While 401(k)s are tax-friendly, they can still bump you into a higher tax bracket, explained Jerry Lynch, certified financial planner and co-founder of JFL Consulting. And that can be costly when it comes time to withdraw.

You should have three buckets of money with different tax benefits, Lynch said: Ordinary income (IRA), capital gains and tax free (muni bonds, primary home sale, etc.). By spreading your retirement money in these three buckets, if ordinary income rates go up you don’t need to pull all your money from that bucket. By doing that, you can use your 401(k) to your benefit. If you have all your money in one bucket and taxes go up, you are out of luck.

Another thing to keep in mind, especially now as unemployment is rising and people are feeling the cash and credit squeeze, is that your 401(k) is not liquid. You can’t access it in case of an emergency and if you do you suffer tremendously from penalties – usually upwards of 40%. With the market already down around 40%, that is a huge loss if you try to access that money. Instead, Lynch recommended building an emergency cash savings – something Carmen is always pounding the table about – as well as some after-tax investing that is also liquid, which goes in the capital gains bucket as long as stocks are held for a year.

Got a question about retirement planning? All this week, Jerry Lynch will be in our Forums answering viewers and giving advice. If you're not a member, you can sign up here. It's free and it only takes a minute.