abcInvesting Blogs

February 2008

February 27, 2008

Roth 401k or Regular 401k? (Part 1)

There’s a new kid in town: the Roth 401k. Your company may give you the choice of a regular 401k or a Roth 401k, causing you to wonder what your better choice would be.
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 has added another possibility, the Roth 401k. 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.

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. Through a few more examples, we'll figure out when it might make a difference for you.

February 18, 2008

The Gradual Option to Building Up 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 marginal tax bracket is 25 percent, and 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.

Year	Monthly Pay	Target Contribution (6%)	Actual Contribution	Pay after Contribution
1	$3,000	$180	$30	$2,970
2	$3,090	$185	$120	$2,970
3	$3,183	$191	$191	$2,992

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 $93 a month. 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.

February 4, 2008

Contribute to Your 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. You will be expected to put all the money in a college savings plan into college expenses. 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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