Paying tax on retirement now vs. later

Diversify your nest egg by sprinkling your retirement savings across taxable and tax-deferred accounts.

EMAIL  |   PRINT  |   SHARE  |   RSS
 
google my aol my msn my yahoo! netvibes
Paste this link into your favorite RSS desktop reader
See all CNNMoney.com RSS FEEDS (close)
By Walter Updegrave, Money Magazine senior editor

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

NEW YORK (Money) -- Question: I'm 29 and I contribute 12% of my $109,000 annual pay to my 401(k). My company matches 100% up to the first 6% of salary I save. I'm concerned, though, that I could give up a lot of my 401(k) to taxes after I retire, so I'm considering diverting some of my 401(k) contributions to a Roth IRA account each year. Do you think that's a good idea and, if so, how much do you think I should be putting into the Roth? --Eric, Newark, NJ

Answer: I'm a big believer in having retirement savings in both tax-deferred (401(k)s and traditional IRAs) as well as tax-free (Roth) accounts.

The reason is that it's just too hard to predict what tax rate you'll face in retirement, especially in the case of a youngster like you who still has 30 to 40 years of work ahead of him.

If all your dough is in a 401(k) or traditional IRA and your tax rate goes up during retirement -- hardly a stretch considering our burgeoning budget deficits -- the after-tax value of your nest egg will drop.

If all your savings are in a Roth account and your tax rate goes down in retirement -- whether because the government gets its act together or your income falls enough to knock you into a lower tax bracket -- you'll still be able to pull money from Roth accounts tax free. But you will have shelled out more to the IRS than you had to because you paid taxes at the higher rate in effect during your career instead of at the lower rate in retirement.

By having retirement money in both types of accounts, you're able to diversify your tax exposure in retirement, plus take advantage of some other plusses a Roth IRA can offer.

Taxable vs. non-taxable

So how should you divvy up your contributions between your 401(k) and a Roth IRA?

Generally, the greater your chances of facing the same or higher tax rate in retirement, the more money you would want to devote to a Roth IRA (or Roth 401(k) if that option is available). But there are other factors that also come into play.

No matter how appealing a Roth is, you wouldn't want to give up an employer match in your 401(k) to fund a Roth. You've also got to weigh the fact that taking money that would have gone into your 401(k) and putting it into the Roth will increase your taxable income for the year.

Keep in mind too that with a 401(k), your contribution goes into your account like clockwork without you having to do anything (other than sign up). The onus is on you, however, to get the money into the Roth account. If you're not likely to actually fund the Roth, you're probably better off just sticking with the 401(k).

Assuming you will follow through, there's a relatively simple strategy for divvying up your annual retirement savings between your 401(k) and a Roth IRA account: First, contribute enough to get the full employer match in your 401(k); next, max out your Roth IRA contribution; then contribute whatever is left to your 401(k) until you hit the max for that account.

So let's see how this strategy would work in your case.

Crunching the numbers

You would start by having 6% of your $109,000 salary, or $6,540, go in your 401(k). That would assure that you get the full employer match of 6%, which amounts to another $6,540.

Next, you would contribute $5,000 to a Roth IRA, which is the most you can do this year, although people 50 and older can kick in another $1,000. (The income ceiling for singles wishing to make the maximum Roth contribution is $105,000 this year. But that figure refers to modified adjusted gross income, which excludes pre-tax 401(k) contributions. So contributing $6,540 to your 401(k) should drop you below that limit and allow you to fully fund a Roth.)

At this point, you would be saving a total of $11,540, which means you still have $1,540 left to save ($13,080 minus $11,540). Since you're still well below the annual contribution limit for 401(k)s this year ($16,500, plus another $5,500 for people 50 and older), you would throw the $1,540 into your 401(k), bringing your total 401(k) contribution to $8,080.

You would pull this off by telling your 401(k) plan administrator that you want to contribute 7.4% of your $109,000 salary to your 401(k). That would give you close to your target $8,080 contribution. Add the $5,000 Roth contribution, and you're at $13,080, the amount you're now contributing to your 401(k) alone. And, of course, you'll also have your employer's match of $6,540, giving you total savings for the year of $19,620, the same as now, but with one big difference: instead of having all that money in a 401(k), you'll have $14,620 in your 401(k) and $5,000 in the Roth IRA.

I'm sure at this point there are many readers saying, wait a minute, Upde. You're mixing pre-tax 401(k) dollars with after-tax Roth IRA dollars in this example. So even though you're contributing $13,080 in both cases, putting $13,080 in a 401(k) is not the same as contributing $8,080 to your 401(k) and another $5,000 to a Roth IRA.

And those alert readers are absolutely right. If you cut back your 401(k) contribution by $5,000 from $13,080 to $8,080 to free up $5,000 to put into a Roth IRA, that move would boost your taxable income by $5,000 and increase your tax bill by $1,400 (assuming you're in the 28% marginal tax bracket).

Which means that to fund your Roth IRA to the max as I've outlined here, you would have to come up with an extra $1,400 to pay for the extra taxes you'll incur. To get that extra dough, you would either have to cut back spending by that amount or dip into other savings. Or you could re-jigger the mix of 401(k) vs. Roth IRA contribution, say, cutting back your 401(k) contribution by $5,000, funding your Roth IRA account with $3,600 and using the remaining $1,400 to pay the extra taxes you would owe.

But it seems to me the goal for someone in your position is to start building that Roth balance. Given your salary and the higher contribution limits on 401(k)s, you should have no trouble fattening your 401(k) account.

So if I were you, I'd opt for keeping things simple, which is to say I'd max out the Roth contribution and then adjust my spending to pay the extra taxes.

Yes, that means you would effectively be saving a bit more than you are now. But if the last year and a half has taught us anything, it's that an extra cushion of savings can help make life more enjoyable and a lot less stressful come retirement time. To top of page

Send feedback to Money Magazine
Features
They're hiring!These Fortune 100 employers have at least 350 openings each. What are they looking for in a new hire? More
If the Fortune 500 were a country...It would be the world's second-biggest economy. See how big companies' sales stack up against GDP over the past decade. More
Sponsored By:
More Galleries
8 CEOs who took a pay cut in 2013 Median CEO pay inched up 9% in 2013 to $13.9 million. But not everyone got a bump last year. Here are eight CEOs who missed out. More
7 businesses Amazon wants to shake up From industrial supplies to educational software, Amazon is about more than just retail and books. More
Don't miss these Tax Day deals From massages and paper shredding to cookies and queso, celebrate the end of tax season with these Tax Day freebies and discounts. More
Worry about the hackers you don't know 
Crime syndicates and government organizations pose a much greater cyber threat than renegade hacker groups like Anonymous. Play
GE CEO: Bringing jobs back to the U.S. 
Jeff Immelt says the U.S. is a cost competitive market for advanced manufacturing and that GE is bringing jobs back from Mexico. Play
Hamster wheel and wedgie-powered transit 
Red Bull Creation challenges hackers and engineers to invent new modes of transportation. Play

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.