As you may know, I'm a big fan of 401ks (because of all their great advantages) and I've noted a few times that I max mine out each year (and have been doing so for years). Along the way, I pick up a good amount of free money because my employer does give a company match to employee contributions. But what if an employer didn't match? Would a 401k still be a great deal?
That's exactly the question a reader asked Money magazine. The reader's employer didn't match contributions and he didn't expect to be in a lower tax bracket when he retired, so he was questioning whether or not a 401k was worth it. Money runs the numbers and says that a 401k is a great deal even without a company match. Here are some of their comments:
Granted, a company match makes a 401(k) a better deal. But I wouldn't be so quick to dismiss a 401(k) without the match. The long-term tax-deferred compounding of gains you get in a 401(k) alone may be enough to make it a better bet than the alternative you're suggesting. It really comes down to how big a jump in tax brackets you're likely to make and how tax efficiently you can invest outside the 401(k).
When you consider that the 401(k) is such a simple way to save - I mean, all you've got to do is sign up and the money is deducted from your paycheck before you get your greedy little lunch hooks on it - I think it would be a mistake to forego the 401(k) just because you might end up in a higher tax bracket.
Good advice and I would agree.
Then Money goes a step beyond the question and recommends a Roth IRA for the questioner. Their thoughts:
I think it would also be wise for you to contribute to a Roth IRA. Why? Well, with a Roth you pay tax on your contribution, but you get to withdraw the money from your account tax-free later on (assuming you meet certain conditions). That's a big advantage if you end up in a higher tax bracket because you're effectively arbitraging the tax system in your favor - that is, paying taxes today when you're at a lower rate and avoiding them in the future when you would be in a higher tax bracket.
Actually, if you invest the max in a Roth it's a better deal if you stay in the same tax bracket and possibly even if you fall into a slightly lower one because doing the max in a Roth effectively allows you to earn a tax-free return on more dollars.
There are a couple of other benefits to doing the Roth. You'll have a pot of money in retirement that isn't subject to income tax, giving you a benefit I call "tax diversification," which is a fancy way of saying your entire retirement stash isn't at the mercy of wherever income tax rates happen to be after you retire. And you can also leave your money in the Roth the rest of your life if you wish. With a 401(k) or traditional IRA, you've eventually got to start making required withdrawals, which means some of your money is no longer sheltered from taxes.
Good stuff. I often recommend the 401k/Roth IRA combination (more on that later). It's a powerful duo that can really super-charge your retirement planning.
Finally, Money makes the bottom line recommendation for this reader:
So max out on the Roth, then put as much as you can in your 401(k) and if you still have savings left over, then go ahead with your tax-efficient investing plan. This three-pronged approach would really make you a model of tax diversification.
This is a bit of a different order than for someone who does have a company match (In that case, the order would be: put money in the 401k to get the entire match, invest in a Roth IRA, put any remaining amount into the 401k until you reach the maximum contribution), but since this reader doesn't have a company match, this seems like good advice to me.
For more information on 401ks, Roth IRAs, and retirement, see these links from Free Money Finance:
FMF,
I am finding, increasingly, a number of my clients who are well...pissed off...because they are shocked at how much they are paying in taxes on all this money they saved in "tax deferred" retirement vehicles.
They assumed that they would be in a lower tax bracket when they retired. Now, many of them are finding themselves in high tax brackets at retirment and when Uncle Sam gets the first 33%, they are shocked, upset, and very frustrated that "no one told me!".
A agree with your comments. I just think it is imperative that people calculate reality at the end. No one does it...the big surpise at the end is devastating to some!
Your life gets turned upside down when you are 65 and have a certain amount of money to retire on and THEN you remember that Uncle Sam has his hand out. It can create a HUGE hole in peoples plan.
Posted by: David Porter | August 09, 2006 at 12:14 PM
David brings up an excellent point, but I believe it is incumbent on advisors and go-it-alone investors to factor the following sink holes in retirement:
1) cost of living changes
2) health costs in later years
3) inflation
4) taxes
Squirreling away funds is a great habit, but a plan which doesn't address the above issues barely qualifies as planning. Some of the above items are hard to estimate and the tax code is certain to change, but I find estimating income low and expenses high is a good way to hedge.
Posted by: Duane Gran | August 09, 2006 at 01:34 PM
Well, remember, this government's spending priorities will probably mean an increase in taxes for most people in the future.
But that's not what I am here to talk about. There's a marginal question with the 401(k) contributions that needs to be considered. If you have income of say $115K gross annually, you cannot contribute to a Roth. But if you max out your 401(k) to the tune of $14K for the year, your AGI is now $100K for tax purposes. At this level, you can make some other above-the-line deductions to get you below an AGI of $95K. Now you fall under the IRA single earner phaseout AGI level, so you can put $4K into a Roth.
Match or no match, that's a good deal IMO. At the margin.
And how can you not like tax diversification?
Posted by: Khyron | August 10, 2006 at 04:07 AM