Drill Down: Regular 401k or Roth 401k?

The original 401k plan took money that would otherwise have gone into your paycheck and put it into a 401k plan. That money was not taxed at the time it was earned, but it was taxed years later when you took it out during your retirement. Recently Congress added another possibility, the Roth 401k. Some companies give you this new choice, but others do not offer it. Here's how it works. The money that goes into your Roth 401k is taxed as you earn it, but is not taxed when you take it out during your retirement. If your employer matches your contributions, all of the matching money goes into a regular 401k. So you may well end up with both a regular and a Roth. Let’s figure out which type your money should go into.

Regular 401k

Roth 401k

Here’s an example. Reggie and Ruth both plan to save $300 this month. Reggie will put his money into a regular 401k, but Ruth will put her money into a Roth 401k. They are both in the 25 percent tax bracket now, and both will be in the same tax bracket when they retire. Both Reggie and Ruth will withdraw their money in 20 years. Their investments will also be identical. I’ve peaked into my crystal ball, and I can tell you that their money will grow by a factor of four over those 20 years, so each dollar they put into their retirement account today will grow to four dollars by the time they retire.

Here’s how the numbers work out:

• Reggie puts $400 into his regular 401k plan. This reduces his tax bill this year by $100, so it only costs him $300.
• Reggie’s $400 grows to $1600 over 20 years.
• Reggie withdraws his $1600, pays a 25 percent tax which costs him $400, and nets $1200.

It’s only a little different for his friend:

• Ruth puts $300 into her Roth IRA. She gets no tax benefit right now.
• Ruth’s $300 grows to $1200 over 20 years.
• Ruth withdraws her $1200 tax free.

The simple answer: it does NOT make any difference whether you choose the regular or the Roth IRA, under these assumptions. Let’s figure out if it might make a difference for you.

Lois won’t have much taxable income in her retirement; she’ll be living exclusively on Social Security and a little bit of money from her retirement account. Her tax bracket now is 25 percent, but it will only be ten percent when she retires. If she chose a Roth 401k, her results would be just like Ruthie’s. But if she chose a Regular 401k, look at what happens:

• Lois puts $400 into her regular 401k plan. This reduces her tax bill this year by $100, so it only costs her $300.
• Lois’s $400 grows to $1600 over 20 years.
• Lois withdraws her $1600, pays a ten percent tax which costs her $160, and nets $1440.

The moral to Lois’s story is this: If you will be in a lower tax bracket when you retire, use a regular 401k.

Hiram was unemployed for the first half of the year, so his tax bracket will be just 15 percent this year. However, he expects to be in a 25 percent tax bracket when he retires. If he uses a Roth 401k, his result is just like Ruthie’s. However, a regular 401k is a little different.

• Because he’s in the 15 percent tax bracket, Hiram won’t get as big a tax benefit from his contribution as Reggie did. Hiram puts $353 into his regular 401, which cuts his tax bill by 15 percent of that amount, or $53. Just like Reggie and Ruth, the contribution cost him only $300.
• Over 20 years, Hiram’s money has grown to $1412.
• Hiram pays a tax of 25 percent, which is $353, leaving him with only $1059.

Hiram’s results show another lesson: If you will be in a higher tax bracket when you retire, use a Roth 401k.

Now I’ll consider the most realistic case of all. Connie is confused. She isn’t sure what tax bracket she’ll be in when she retires. She listens to the politicians, but she can’t figure out whether they will raise taxes in the future or cut taxes. She’s concerned about the worst possible case: that she pays taxes that are higher than she has to.

Connie would benefit from “tax diversification.” That means having some of your assets taxed today, and some tomorrow. Connie’s best strategy is to use both a regular and a Roth 401k, or to make her decision so that, with her other investments, she is tax diversified. She won’t make the best possible choice, but she guarantees that she’ll be better off than if she made the worst possible choice.

Reduce your risk by having assets in different tax categories.

Finally, let’s talk about Max, who wants to save the maximum amount possible. The federal government limits the contribution to $15,500. (This amount may change over time; for the latest limit, search “irs.gov 401(k) limitation.”) The same limit applies to both regular 401k plans and Roth 401k plans. That means that the Roth allows a greater effective contribution. If you are in the 25 percent tax bracket, a regular 401k contribution of $15,500 only costs you $11,625 (which is the $15,500 contribution minus the tax you would have had to pay if you had not made the contribution). A Roth 401k contribution costs you the full $15,500. When it comes time to withdraw the money, however, the Roth 401k withdrawals are all tax free, whereas the regular 401k withdrawals are taxed. Max uses a Roth 401k, paying more now so that he can sock away as much as possible. If you want to maximize your retirement contribution, use a Roth 401k.

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Drill Down: Tax Exclusion for Everybody

Cutting back your take-home pay to prepare for a distant retirement is a hard decision for many people, but it’s not as expensive as it seems. Money that goes into your regular 401k is not taxed, so you’ll have less withholding from your paycheck. People in the 30 percent tax bracket find that every $100 that goes into the 401k only costs $70 of take-home pay. That’s because when the $100 is “paid” to you, $30 of it goes to the government, and only $70 finds its way to your paycheck. This is why contributing to your 401k doesn’t cost as much as it seems.

To do the arithmetic yourself, you need to know your federal tax bracket. If you live where there’s a state personal income tax (and most people do), add the state tax bracket. A few cities also levy income taxes.

It’s important to use your “marginal tax rate” rather than average tax rate. The marginal rate is the tax on an additional dollar of income. This is different from your average tax rate, which is the total dollars you pay in tax divided by your total income.

At the federal level, your marginal rate may be as low as ten percent or as high as 39 percent. State tax rates range from one percent up to ten percent.

To find your marginal tax rate, first find your “taxable income.” Here’s where to find it, based on the kind of tax return you filed:

If you filed form 1040, line 43
If you filed form 1040A, line 27
If you filed form 1040EZ, line 6

Then use the following table to find your marginal tax rate:

After 2007, you can find updated tax rates from the Internal Revenue Service by searching for “IRS federal tax rate schedules” plus the year.

Don’t forget to add in your state tax rate. There are too many state tax rates for me to publish them all, but your state tax instructions will probably be helpful. A general guide to state taxes is available from the Federation of Tax Administrators (www.taxadmin.org).

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Drill Down: Retirement Savings Contribution Credit

If you earn relatively little, there’s even more good news: a federal tax credit. A tax credit is better than a deduction because it directly reduces the amount of taxes you owe, making it as good as cash. Unfortunately, the federal tax credit is limited.

Eligibility for Saver’s Credit (in 2007):
Single person with income less than $26,000 a year
Head of household with income less than $39,000
Joint return with income less than $52,000

These amounts change every year. Check out the IRS web site for the latest figures by searching www.IRS.gov for “Retirement Savings Contribution Credit.”

The credit is not available to full time students and people claimed as a dependent on someone else’s (like a parent’s) tax return.

The tax credit runs on a sliding scale, starting at 50 percent for single filers with income under $15,500 and joint filers with incomes less than $31,000. As incomes rise, the tax credit falls, until it reaches ten percent for those just under the threshold of eligibility.

Think about what this means for the lowest income workers whose companies will match their pay 50 cents on the dollar: 401k contributions are free! Half the contribution is matched by the company, and the other half offsets federal taxes. It’s a great deal if you can tighten your belt a little to be able to make the contribution.

Keep in mind, however, that this is not a “refundable credit.” If you have enough deductions that you owe no tax whatsoever, you will not get cash back from the government. You’ll only benefit if you have a tax liability. (I’m NOT talking about whether you get a refund after you file your taxes; I’m talking about whether your tax return shows that you pay any tax at all.)

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Drill Down: Contributions When Your Employer Offers a Match

When your employer offers to match your contributions, then the question of how much to contribute is pretty simple: contribute at least as much as your employer will match. If your employer will match 50 cents on the dollar for your contributions up to six percent of your pay, then contribute at least six percent. If your employer will match your contribution dollar for dollar, up to three percent of your pay, contribute at least three percent.

There are often good reasons to contribute even more, but if your employer does not offer a match, make your decision the same way you would if there were no match at all. I’ll discuss the issues involved later.

Bill Says: If your employer will give you more money, take it. Whenever you can get a match, contribute at least the maximum amount that will be matched.

People worried about investment returns can sleep easy. If your employer is matching 25 cents on the dollars that you contribute, that’s a 25 percent return with no risk. Not even Warren Buffett would think he could do better than that.

If you are worried about your other priorities, like debt reduction, college savings, etc., I’ll address those issues soon. But if you simply think that money is too tight, then the solution is—more money.

OK, I understand that saving more money out of your paycheck doesn’t sound like the answer to money being tight in your family. Let’s address that concern. If money is tight, and you are not saving anything for your retirement, what do you figure the solution is? In the long run, you need to save for retirement. Putting off the time that you begin saving will merely increase the amount that you have to save later.

What has to change so that you will be able to save money for your retirement? Write down a list of areas that need adjustment. In many cases, it is behavioral changes that are needed: eating at home more often, less impulse buying, cheaper vacations, etc.

There is more justification for not contributing to a 401k if you have temporary needs that you are certain you will meet within the next few months. In that case, you need strong discipline to meet those other needs as soon as possible, so that you can get started contributing to your 401k as soon as possible. The benefit of having your money matched by your employer is so great that you don’t want to miss a single dollar of that contribution.

One cautionary note should be considered. Many employers have a vesting schedule for the employer match. For example, you may have to remain at the company for three years before you have earned the full match. The match money is going into your account, but you don’t really own it until you’ve completed the vesting period. After the vesting period, the match money is all yours. If, however, you leave your company before the vesting period is over, your 401k will have to surrender a portion of the match. Usually the vesting is gradual, such as: one fourth of the match is yours immediately, another fourth becomes yours after one year, yet another fourth after two years on the job, and the final fourth after three years.

If you think you might leave or be laid off before the vesting period, consider making a contribution amount that would be midway between what you would have contributed without a match and what you would have contributed with a match.

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Drill Down: Contribute to a 401k or Pay Off Credit Cards?

Here’s the most extreme question about contributing to a 401k or paying off debt. Assume for the sake of argument that you have a credit card that charges a fairly high interest rate. Should you pay off the card first, or contribute to the 401k first?

Let’s describe the happy case where you pay off the credit card first. You put all of your discretionary income to work paying off the credit card tab and avoid adding any more credit card debt. You get out from under the 18 percent (or whatever) interest rate you had been paying on the debt. Now that you are used to living on less money, it’s easy to contribute to your 401k.

Now consider the unhappy case: you don’t contribute to the 401k, and you still rack up credit card debt. This leaves you with high debt and no retirement savings, the worst of all worlds.

So what should you do? First, let’s look at how you incurred the debt. Let’s say that your debt was relatively small, but then you had a major unavoidable expense, like a large medical bill, or the car you use to get to work needed a major repair. You don’t have a behavioral problem—you simply need to dig yourself out of some bad luck. Okay, delay contribution to your 401k, but put yourself on a firm schedule to pay down the credit card debt by a specific date. And keep to that schedule.

Now let’s look at the harder case: you racked up a large credit card debt simply because you spent too much. Not once or twice, but over and over again. Clothes, sporting goods, and vacations have all added up over a period of years to a large credit card bill. You really need to change your behavior. If your behavior is not going to change, at least fund your 401k so that you’ll have a retirement account, even though you are wasting thousands of dollars paying a high interest rate. However, I’d prefer to see you work on the behavior. Here are some steps that frequently help. First, figure out where you are spending money. Use Quicken or another computer program to track expenses.

Second, create a belt-tightening budget. This is a two-step process. The initial step is to create an extremely severe budget, which eliminates all luxuries, frills and recreation. The next step is to add back a little money for the luxuries and recreation that are most valuable to you. For instance, most married couples should get out of the house without the kids every week or two, so you might add enough for a date—a cheap date, though.

Some people find it hard to avoid using credit cards for impulse buying, but they want to keep a credit card handy for emergencies. Here’s the solution: put the credit card in a zip-lock bag filled with water and place the bag in the freezer. You have to thaw the bag to use the card, giving yourself some cool-down time. A simpler version is to keep your emergency credit card in your wallet, but wrapped in paper, taped shut. That may create enough of a bother that it prevents impulse buys.

The hard numbers show that paying off a high interest rate debt before contributing to your 401k makes sense, but only if you follow through by paying off the debt and then getting started with your 401k. If you can’t do that, contribute to the 401k and accept that you’ll be in debt for a longer time.

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Drill Down: Contribute to a 401k or Pay Off the Car Loan?

Should you pay off that car loan before starting contributions to your 401k plan? To answer that, let’s begin with a simpler question. Suppose you lend your brother $100 at eight percent interest and borrow $100 from your sister at eight percent interest. When the two loans are paid off, will you be better or worse off than when you started? Obviously, you’ll be in exactly the same position. To be better off, you need to charge your brother a higher interest rate than you pay your sister. So the simple starting point for the car loan question is whether the total return on your 401k will be higher or lower than the interest rate you’re paying on your car loan.

Over the last few years, banks have been charging between six and eight percent interest on car loans. (We don’t count financing arranged by dealers, because they often grant lower interest rates in exchange for a higher price on the car.) The investment returns on your 401k are not so simple to calculate, unless your employer offers to match your contribution. If the employer matches even a little of your contribution, then your 401k will earn far more than the interest you pay on your car loan.

If there is no match from your employer, a rough long run average for a moderately conservative investment portfolio is roughly eight percent a year. Car loans, on average, cost a little less than what you can earn in your 401k. In other words, you’re better off leaving the car loan in place and contributing to your 401k.

However, the difference in interest between the two choices is small enough that other factors can be considered. For instance, if you have a very strong urge to be debt-free and if you are definitely going to stay out of debt after the car is paid off, then it’s not such a bad idea. However, most people will find it easier to discipline their spending if they contribute to the 401k rather than making extra payments on their car.

The decision is up to you, but in most cases, you’ll be better off contributing to your 401k rather than paying off your car loan early.

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Drill Down: Contribute to a 401k or Pay Down Your Mortgage?

Would you like to pay off your mortgage? Some people can shrug off six figures of debt, but other people feel a weight on their shoulders. They want to burn the mortgage and be debt free. Good for you if you are one of them, but...

Making extra payments on your mortgage should be a lower priority than funding your retirement plan.

Making extra payments on the mortgage to pay down the balance due does not add to your flexibility should you lose a job or have an unexpected bill. This is a weird thing about mortgages: no matter how much extra you paid in the past, you still have to make your monthly payment in full. (There is one type of mortgage, called an “Option ARM,” that does allow a lower payment in some cases.)

Assume your mortgage payment is $1,000 a month, but for each of the past six months you’ve been paying $1,500. You’ve sent in a total of $3,000 more than your required payment. Don’t you think you should be able to skip one, or two, or even three payments? Well, you can’t. You are legally obligated to keep making that $1,000 monthly payment. So paying down the mortgage does not provide you with flexibility.

One way to think of paying off debt is that you earn a return equal to the interest rate on the debt. What should you do if you have an extra $1,000 lying around? If you put it in a certificate of deposit at the bank you might earn, say, five percent interest. If you pay down your credit card balance, you might earn 18 percent interest. You’re not technically earning interest, but avoiding interest is just the same.

Now back to your mortgage payment. It is probably the lowest interest rate debt you have. Because there’s equity in your home, lenders have given you an interest rate not much higher than the very best borrowers in the world have. You don’t earn very much by paying off the mortgage. In fact, you’re very likely to earn a higher total return in your 401k account than you pay in mortgage interest.

Bill Says: Fully fund your 401k plan first, before you consider paying extra on your mortgage.

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Drill Down: Contribute to a 401k or Build Up a Savings Account?

Financial planning experts have long advised families to have an emergency fund, often suggesting it total six months of income. Although that is a high hurdle for most families, the logic of a rainy day fund is strong.

Let’s consider your risks. If you car’s transmission blew up tomorrow, would you be able to get to work? If your son broke his arm while trying to climb a tree, would you be able to pay the deductibles and co-pays required by your medical insurance? If you suddenly lost your job, would your family have food on the table and a roof over its head until you found work?

If the answer is “no” to any of these questions, you have a problem. But the answer may not be “no” even if you don’t have much savings. First, let’s look at the degree of risk you face. If your car is still under warranty, you have less risk than if you’re driving a well-used car. You have less risk if your health plan requires only minimal cash payments or if you work for a healthy company in a stable industry.

Even with significant risk, there are alternatives to six months of income in the bank. Your credit cards offer a last line of defense against temporary emergencies. Notice the key point of that sentence: The credit card should be a last line of defense, not a routine way of funding vacations and retail therapy. Let’s say that you follow my recommended practice for credit cards and pay the balance off in full every month. Then you have a good bit of credit available when your car gets sick. If your credit limit is low, ask for an increase; you can often get a higher credit limit just for asking if you have a good credit history.

If you own your own home, and you have some equity, consider a home equity line of credit. Your bank agrees to lend you money in the future, but you don’t have to take the money out now; you just wait until you need it. You may be able to get a line of credit without paying any fees in advance, which is great if you are planning on using it as a safety net. Just be sure that you have the discipline not to tap into your credit line for luxuries.

But suppose that you don’t have much available credit on your plastic or home equity, and you have normal risk of financial difficulties. Then you need to get a savings account.

In most 401k plans, you can borrow money from your own 401k. That provides another layer of protection from the devilish transmission or the unexpected medical expense, but it does not help at all in the event that you lose your job. In fact, you may have to repay any loans to your 401k immediately if you lose your job. If you can’t pay off the loans, the money you borrowed is considered a distribution. You owe tax on it, as well as a ten percent early distribution penalty if you are under age 59 1/2. All of this would happen at a time when you are least able to pay extra taxes. (See the chapter on loans for more details.)

The bottom line on loans from your 401k is that they add a layer of protection. If your job is very secure, then the layer of protection is thick. If your job is at risk, then it’s a thin layer. Don’t count on it. And while hardship withdrawals could also be an option, they have tax consequences and are limited in use. (See the chapter on that subject for details.)

The worst part about the idea of building up a savings account first is that you can’t just ignore the 401k in the hopes that someday you’ll build up a savings account. You need to make a definite plan to build up that savings account. Allocate all available cash for the next six months to the savings account. Decide on a fixed amount you’ll add to savings out of every paycheck. Put the money into a separate account, not your routine checking account. Cut expenses to the bone. Every payday, put money into the savings account before spending it on other things.

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Drill Down: Contribute to a 401k or Build Up a College Savings Account?

This one’s easy: 401k first. There are many reasons.

If your family might qualify for financial aid based on need (rather than based on skills in football or basketball), then consider this. When colleges figure how much financial aid your child will get, they expect you to put all the money in a college savings plan into college expenses. However, you will not be expected to put any of your 401k money into college expenses. So if you fund a 401k, your financial aid will be larger than if you fund a college account.

If that’s not a big enough reason, consider what is better for your child:

• Alan: Money for college is tight, but with summer and part-time jobs, and a student loan, Alan makes it through. After graduation, he gets a job and is on his own. His parents share with him the happy news that they have sufficient resources for their retirement, so the son does not need to worry about them in their old age. In fact, Alan might even receive a bit of inheritance to help his own retirement plans.
• Barbara: College was a financial breeze, thanks to Barbara’s parents funding a college savings plan. She did not have to work while in college. But after graduation, Barbara learned some bad news: her parents did not have enough saved to maintain their lifestyle while retired. She felt an obligation to send money to her parents every month, even while she was raising a family and trying to save for her own retirement.

Would you rather your child be Alan or Barbara? Which would make him or her a better person? Which would build family ties?

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Drill Down: The Gradual Option for Building a 401k

The best choice for most people is to fund their 401k both fully and immediately. That’s easy for me to say—I’m not going to have to cut back my spending, so what should I care about your current hardships? But I think this is good advice for almost everyone, because after you adjust to less take-home pay, you won’t really feel the bite. You will, however, be building up a retirement nest egg.

But let’s say that you’ve reviewed your family budget and you just cannot find enough expenses to cut to enable a full contribution. Here’s my suggestion. Start with whatever you can manage today. Then, every pay raise you get, put the full amount of the raise into your 401k plan. You won’t have to cut back on current expenses, but you will gradually increase the pace at which you contribute to your 401k.

As of this writing, wage increases in the average job are running over three percent per year. That does not include promotions that trigger pay raises. Pretty soon you could be up to six percent contribution of your pay.

Here’s a numerical example. (If you don’t like numbers, just skip the rest of this section.) Assume the marginal tax bracket is 25 percent, and the 401k goal is six percent. Monthly salary is $3,000, but will rise by three percent per year. Right now you can only afford to contribute $30 a month into your 401k.

In year two, you get a three percent raise, which equals $90 a month. You put it all into your 401k, bringing your monthly contribution up to $120. That’s a lot better than where you started, but still not up to your goal. In year three, you get another three percent raise, which now is worth an additional $93 a month on top of the first $90. You only need to add $71 of that raise to your 401k contribution to get up to your goal of six percent contributions. You keep the rest. It’s not real easy to go a couple of years without a raise, but it will get your retirement savings on track.

For anyone, there is a way to get your 401k contribution up to the level that will provide for your retirement.

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