Help a Reader: Retirement Investing

Here's a question I just received from a reader:

My employer doesn't do a match, rather we have profit sharing. So, I receive a lump sums (Usually 5-7% of my income) in my 401k every year regardless of what I contribute to the 401k. However, this money is profit sharing so it is possible that the company would do so bad I won't see that one year (it hasn't happened yet though). Right now I am also contributing 12% of my income to my 401k. I like this arraignment because it is easy and money I don't see is money I don't miss. However, I have been wondering if I should reduce my 401k contribution and put money in a ROTH. I have a traditional IRA from past jobs and other investments but no ROTH. I am 31 years old, so it is so long until I will be taking out this money that I just don't know what the tax situation would be when I can start withdrawing it.

What are your suggestions?

Comments

[JACK]

I realize that sometimes people are really at the limits of what they can devote to savings. But the first instinct should NEVER be "What investment activitity can I reduce, so that I can start this other investment activity"? I'd first look at the question, can you afford to start a Roth while still keeping up with your other investments? 12% is a great number, but these days, most will tell you that the 10% rule is by no means a "guarantee for success". You don't have to fully fund a Roth IRA to start one. So I'd look there first.

Are you maxing out your 401K? That could be a factor to look at too. Because one has the advantages of tax deferral on the front end and the other on the back end. Not knowing what 12% translates into it is hard to tell how much money we are talking about and whether it makes all that much of a difference.

Keep in mind, also, that there are opportunities to convert from an IRA to a Roth IRA. You have to be able to pay the tax liability upon conversion (I don't know the rules, but you might be able to spread it out over a couple years), but that may be another option.

Another thing to ask is whether you are close to the phase-out on Roth IRAs. I focused on a Roth early on in my career because I knew that I might have limited windows of time to invest in them.

[Stephen]

Just wanted to quickly second Jack's note about the importance of maxing Roth IRA's while you're still below the income limit. However, if you're likely to hit the limit within the next 3 or so years, I'd recommend against investing in the Roth and instead up the 401k contribution.
Another option to look into is if your company is willing to provide the option of a Roth 401k. They just became an option and, having the higher 401k max annual contribution, allow you to store up a lot more money that will be tax free in the future. Of course, the drawback is that you pay more taxes now, but even at 31, I'd guess that your current tax level is at least likely to be lower than when you retire.

[7million7years]

I can't comment on the tax situation, but I can say this:

I've run some numbers on your situation (and made some assumptions: Let's say that you are currently earning $50k a year and that you have already socked away $30k in your 401k.

Let's also say that you continue to save 12% + an average of 6% profit share = 18% of your (3.5% increasing) salary every year.

THE GOOD NEWS

That puts you WAY AHEAD of most Americans. If you continue doing this until you retire at age 65, you will have saved just over $2.5 Million (assuming that your 401k averages 8% returns over that period)!

THE BAD NEWS

If inflation averages just 3%, by the time you reach 65 your $2.5 mill. will 'shrink' to just uner $1 mill. in today's dollars (i.e. a $2.50 loaf of bread will cost you around $7 by then!).

In other words you will have SAVED yourself to a retirement of just $37k today (plus whatever government handouts you can get).

Is that your 'dream retirement'?

If not, you want to ACCELERATE by INCREASING YOUR INCOME (actively invest OUTSIDE of your 401k) and save at least 50% of the additional income (over and above the incredible 18% you are already putting away ... short of winning the lottery, it's the only way.

[Kevin]

Does your company's plan have a Roth 401(k) feature? If so, that could be a way to do it and still get the match. The match is still pre-tax however, so when you start withdrawing, your portion would be completely tax free and the employer portion would be taxable. If they don't have it, ask about it. I did, and my employer added it to the plan.

[Bertine]

Kevin and Stephen, I will request a Roth 401k. It would be an easy solution to my concerns.

Jack, I looked into converting my IRA into a Roth IRA and it didn't really seem to gain me anything. However, I didn't check if I could spread the tax liability over a few years. If things go as they are I'll be in the phase out of the Roth IRA in four or five years. I don't really want to put more money into my retirement right now because I have other things I want to use that money for, so it really is a question of where I should put that retirement money.

7million7years, thanks for running those numbers.

[beastlike]

Max the Roth while you can.

[aa]

401k match->Roth->401k

So, for the reader, he/she should go for a Roth IRA and buy some low-cost ETFs that the 401k plan doesn't offer.