Sunday, December 30, 2007

Why I'm Sticking with a Traditional 401 (k)

This is the time of year to set up my 401 (k) for 2008.

During 2007, I had a pre-tax $1000 per month going into it. My plan was to raise that by the amount of whatever raise I got for 2008. Well, surprise! No raise. Nonetheless, in the spirit of good financial management, I'm going to increase my contribution by $25 a month.

The bigger question is whether to put my contributions into a Roth IRA or the pre-tax 401 (k). For the first time, my employer is offering both options. My employer does not match my contributions, but does contribute an amount equal to 6% of my income into my 401 (k)--no choice there--it cannot go into a Roth. The dollars I contribute can go into either.

After looking at all the numbers, as well as making some predictions about my future plans to retire in 11 years, I've decided to stick with my current 401 (k).

Why?

Well, first of all, I need available cash to pay down debts. Given my short time line to retirement, I have to both fund that retirement AND get rid of my indebtedness. Funding a 401 (k) with pre-tax dollars gives me a stronger immediate cash flow which allows me to do both.

But is that at the cost of less money during retirement? I'm betting not.

Right now, I'm in the 25% federal tax bracket, creeping up toward the 28% bracket. But when I retire, I will most likely be in the 15% tax bracket. My house will be paid off, leaving me only with taxes and insurance to pay each year. I live in a city with a great transit system, so will not need a vehicle. My retirement date is well after Medicare kicks in, which will help with my insurance needs. Even with the anticipated expense of supplementary health insurance and long-term care insurance, I expect to need $3000 a month, maybe less. Social Security will make up around $1600 of that, based upon current projections. The remainder will come from retirement savings, but will be less than the $32,550 line dividing those in the 15% bracket from their brethren (sisteren?) in the 25% bracket.

When I help my friends analyze whether they should use pre-tax or after-tax dollars for their retirement funds, I find that in most cases, the Roth is the better choice.

But there's always an exception. That would be Grace.

10 comments:

4Life said...

I think you made a good decision to increase your 401(k) contribution even though you did not get a raise. Never under estimate the power of compounding.

Best Wishes,
Dividends4Life

louise said...

it's a juggle isn't it to try and balance the debt reduction with the retirement planning when you get to the other side of 45!
I have decided to increase my pre-tax super contribution when I start my full time job. I htink you amde a good decision as well. Also spending the money on repairs for the house will keep it's value up and make it an even better investment in the long run. Best wishes for 2008 Grace :)

Jessica said...

Hi Grace,

I think you are on the right track. Opting for a 401k with pre-tax dollars is a great way to reduce your taxable income and at the same time you can get cash to pay off your debts.

Besides 401k, there are other options that help you deduct taxes, such as those available at:

http://www.cbsnews.com/stories/2007/02/18/uttm/main2491641.shtml
http://www.mortgagefit.com/tax/34tips-deduction.html

Regards,

Jessica

Engineering My Finances (EMF) said...

When analyzing what your tax bracket will be in retirement, you should consider the taxation of Social Security benefits can effectively push you into a higher marginal tax bracket. See the Sept 9 post on my blog for more details.


I ran your numbers through a tax spreadsheet I set up. In 2008, a 65-year-old single with $1600/month Social Security and $1480/month tax-deferred distributions would net $3001 month after paying federal tax, assuming no deductions beyond the standard amount. That person would be in the 15% bracket but because she paid tax on $.50 of Social Security for each of the last few dollars of tax-deferred withdrawal, she is really in the 22.5% marginal bracket. This year she pays taxes on $1180 of her SS. But next year she'll pay taxes on even more of her SS benefit because the formulas for computing the tax is not indexed for inflation. And if tax rates go up in the future, say the 15% bracket were raised to 18%, then taxing $.50 of SS benefit would make it effectively a 27% bracket.

Even if it is to your benefit to stick with the traditional 401k based on your average expenses, it may be to your benefit to have some money in a Roth IRA. Let's say you have a major expense one year, such as a new roof or furnace for your house. Pulling the funds from your tax-deferred 401k in a single year could quickly push you into a higher tax bracket, while have some funds in a Roth IRA to cover it would prevent that.

If you decide that some of your savings should be in a Roth account, I'd look at the fees in your employer's plan. It might be better to use their plan up to the point of getting the match and then use a low fee provider such as Vanguard for a Roth IRA.

SavingDiva said...

I'm currently contributing to both a Roth IRA and a traditional 401k. I hope that it helps to break up the taxes I have to pay during retirement

I'm Grace. said...

As usual, EMF, you've given me more to think about. I won't being doing a Roth this year--too many cash-flow issues and too much debt to pay, but since it looks to me like you are correct, I'll need to take a closer look at a Roth in the future.

Thanks for the heads up.

Stephanie said...

While you might be in a lower tax bracket during retirement, you are still going to pay taxes on more money. Say you put in $250,000 which grows to $1,000,000. You have to pay taxes on $1,000,000, no just the $250,000. Let's assume you put in $250,000 into the 401k. Your total taxes would then be $150,000, at best. To get the same amount of growth in a Roth, you would need to put in more money (same amount, but after tax). Say the total put in was $340,000 in pre tax dollars. This would also grow to $1,000,000. but you would pay only $80,000 in taxes. I don't see a way that doing a 401k over a roth would make any sense (except for doing the 401k through the match.)

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