I want to go back to a pretty important concept regarding the savings vehicles I have covered. I mentioned that you can choose accounts that allow you to contribute pre-tax money (regular contributions) or post-tax funds (Roth contributions). This option gives you yet another choice to make when trying to build your retirement nest egg.
The Roth 401k has caused quite a stir in my company’s transition to our new retirement account, since we didn’t have that option before.
Pre-Tax vs. Post-Tax
The foundation of the decision rests on when you want your retirement funds taxed. Under the regular, pre-tax method, the money that you contribute to your 401k, 403B, 457, or TSP comes out of your paycheck before it’s taxed. In other words, you contribute that money as if you haven’t earned it yet.
For example, if you earn a salary of $60,000 a year, and you contribute $10,000 to your retirement account, your W2 will only show that your gross income was $50,000. (This reduction only applies to federal and state income tax. Your FICA tax – Medicare and social security – are still calculated at the $60,000 income level.) But when you take the money out of your account during retirement, you pay taxes on all of your withdrawals.
On the other hand, if you contribute that same $10,000 to a Roth account, you pay income tax on the entire $60,000 salary. But when you retire, you don’t pay any tax on your withdrawals, even money that you have earned through compound interest. (Caveat: you still have to be at least age 59 ½ and have had the account for at least five years.) In addition, you can take your contributions out at any time without tax or penalty.
So in our example, if over several years that $10,000 grows to $15,000, you can take your $10,000 back at any time. But you have to reach age 59 ½ and have the account for five years to take out the $5000 of gain (or earnings) without paying a tax or penalty.
Choosing between the two
So how do you choose? It depends on a few factors.
The first is your marginal tax rate. All things being equal a Roth account and Traditional account will produce the same results if your marginal tax rate remains the same. So you will have to figure out which one provides the biggest tax break. However, that is a difficult task since you can’t predict the tax rates of the future.
Secondly, you have to keep in mind, pre-tax and post-tax savings amounts are not equivalent. The equivalent amount depends on your tax bracket. For example, $10,000 pre-tax is actually $7,500 post tax if you’re in the 25% marginal tax bracket. Thus, If you’re able to max out each account and have the ability to pay the taxes outside of your investments, you can actually contribute more to a Roth account.
Some would argue that you can create the same benefit of a Roth by investing the tax savings from your pre-tax contribution. In other words, if your federal and state rate is 25%, you would invest that $2500 savings to cover any future tax liability. In my opinion, that type of discipline alludes most people. Additionally, you have to take into account the taxes paid on your investments in any taxable vehicle.
Tax free earning doesn’t necessarily mean that everyone should invest in a Roth account, especially for those closer to retirement. Again, if you are currently in a high tax bracket and expect to be in a lower one when you retire, you will likely want to take advantage of the tax break provide by traditional accounts. However, if you are in a low tax bracket now and expect to have a higher one in retirement, you will be better off taking the tax hit. You should also keep in mind that some believe that tax brackets in the future will rise for everyone to cover the nation’s ever increasing debt. But others argue there are other ways to do this beside raising the income tax.
Because of the uncertainty of future tax rates and growth in your accounts, you can also hedge your bets and invest equally in both. If you have access to both accounts, you can contribute to either up to the contribution limit ($17,500, or $23,000 if 50 or older for 2013 and 2014).
Alright, so you have your retirement vehicle, and you’ve decided the method you want to use to save that money. The last step involves taking determining how much you need to retire and taking those steps to get you to your goal.