Parking extra retirement cash

NEW YORK (Money) -- Question: I'm considering contributing after-tax dollars to my 401(k), but I'm wondering whether it would be better to put this money in a traditional deductible or Roth IRA. What do you think? - Richard Smarz, Dallas, Texas

Answer: The short answer is that the option you seem to be leaning toward - putting after-tax dollars into your 401(k) - is the least attractive of the three options you're considering.

As for deciding which of the two remaining choices is best, well, that depends on several factors, among them whether you expect to be in a higher or lower tax bracket in retirement than you are now, how much flexibility you would like in managing your tax bill in retirement and whether you might like to leave a tax-free legacy to your heirs.

So just for fun, how about we throw together a few numbers to see how the various options shake out.

Let's assume that you're talking about investing $4,000 in after-tax funds, which is the max you can put in an IRA this year (unless you're 50 or older, in which case you can throw in an extra $1,000). Let's also figure that you're in the 25 percent tax bracket and that you'll earn an 8 percent annual rate of return on that four grand for 20 years.

And to keep things simple, let's just focus on that $4,000 of after-tax money and not worry about other funds you have invested in your 401(k). I say this because in reality, if you've added after-tax dollars to your 401(k), your subsequent withdrawals, with rare exceptions, would be considered a pro rata mix of the after-tax dollars you contributed (which aren't taxable, since you've already paid tax on them) and pre-tax dollars and investment earnings (which are taxable).

For the purposes of our example, we'll ignore this complication (which ultimately doesn't affect the outcome anyway) and just focus on the subsequent value of your original $4,000 after-tax investment (which I'll also assume isn't subject to any early-withdrawal penalties when you pull your money out).

Finally, while we're the subject of assumptions, I've got one more. I assume that you're talking about making after-tax contributions to a plain old 401(k), not after-tax contributions to a Roth 401(k), which a relatively small number of employers have begun offering.

Okay, now that we've got all that straight, let's crunch a few numbers, starting with the option of investing after-tax money in your 401(k).

If you invest $4,000 in your 401(k) and it earns 8 percent a year, at the end of 20 years it will total $18,644. When you withdraw that money, you'll owe taxes at ordinary income rates. Not on your original $4,000 - Uncle Sam already collected his share of that - but you will owe tax on the $14,644 gain. Assuming a 25 percent tax rate, you'll pay $3,661 to the IRS, leaving you with $14,983 after taxes.

Not bad, but what if you do the Roth IRA instead?

That's a simple one. As in the 401(k), your $4,000 grows to $18,644 over 20 years. But, assuming you follow the Roth withdrawal rules, you won't owe a cent in taxes when you pull that money out. So you get to keep the entire $18,644 - clearly a much better deal than the after-tax 401(k).

Now how about the traditional deductible IRA? Well, the $4,000 in the IRA will also grow to $18,644. But since you've gotten a tax deduction on your $4,000 contribution, all the money in the deductible IRA is taxable. Deduct $4,661 in taxes - assuming a 25 percent rate - and you're left with $13,983.

But wait a minute. What about that tax deduction you got for your contribution to the deductible IRA? It would be unfair to the deductible IRA to ignore the value of that deduction. So if we assume you took the value of deduction - which, assuming a 25 percent tax rate, is $1,000, or 25 percent of $4,000 - and invested it at 8 percent, in 20 years it would be worth $4,661. Add that to the $13,983 you have after-tax from the IRA itself, and you end up with $18,644. Hey, that's the same as you would get from the Roth, so these two choices must be equal, right?

Alas, no. Even if you earn 8 percent a year on that $1,000 deduction, it won't grow to $4,661. Why? Because you're not getting 8 percent tax-free as in the Roth. And because you've already maxed out your IRA contribution at $4,000, you're not even getting a tax-deferred return. You're getting a regular old taxable return. Which means at an 8 percent annual rate before taxes, your $1,000 will be worth something less than $4,661 in 20 years. How much less? That depends on how much of those 8 percent gains are in the form of interest and dividends, which are taxable each year, and how much are in the form of unrealized capital gains, which aren't taxed until you sell.

But even in the best-case scenario - i.e., none of the gains are taxable until you sell the investment after 20 years and your gains are taxed at a long-term capital gains rate of 15 percent - the most your $1,000 will be worth is $4,112.

Which means the most you'll have by doing the traditional deducible IRA, including investing the tax deduction, is $18,095. That's more than the $14,983 with the after-tax 401(k), but less than the $18,644 in the Roth.

So, the winner and our champion is...ta da! The Roth IRA!

Not so fast. In this example, I've assumed that your tax rate at the time you invest the money and the time you withdraw it are the same.

But what if you face a lower tax rate when you withdraw the money? Well, that would tilt things in favor of the deductible IRA option because less of the return from your deductible IRA (and the earnings from investing your tax deduction) would be siphoned off by taxes. And, in fact, if you dropped from the 25 percent at the time you made the investment to the 15 percent tax rate by the time you pulled out it, the deductible IRA would come out ahead of the Roth IRA.

And if you moved into a higher tax rate? That, of course, would be an edge for the Roth. And, indeed, if you went from the 25 percent to the 35 percent tax rate, the Roth would romp over the deductible IRA. (Alas, the after-tax 401(k) finishes last every time. Of course, this might not be the case if your employer matches after-tax contributions to your 401(k), but except for cases where an employer offers a Roth 401(k) that's usually not the case.)

Of course, it's difficult to predict what your future tax rate will be. Which is why I think it's a generally a good idea to put some money into a Roth IRA or Roth 401(k) even if you think you might be a lower rate. For one thing, that expectation could be wrong, either because your retirement income is higher than expected or because Congress raises rates (or both happen).

Besides, most of us will have the bulk of our retirement nest egg in 401(k)s and IRA rollovers, which means most of our savings will be taxed at ordinary income rates. So it makes sense to hedge your bets a bit by creating a stash of retirement savings that aren't at the mercy of ordinary income tax rates - or any tax rate for that matter. Having access to a pot of tax-free cash can give you more flexibility for managing your tax bill in retirement, a time when you'll probably be much more sensitive to every dollar you must shell out to the IRS.

And there's one more Roth advantage worth noting: unlike with 401(k)s and regular IRAs, you're not required to start making mandatory withdrawals the April of the calendar year after you hit age 70 1/2. Indeed, you don't ever have to make withdrawals from your Roth if you don't want to, which makes the Roth a nice vehicle for passing along money (tax-free money at that) to your heirs.

So assuming you meet the income eligibility requirements, I'd say go ahead and do the Roth. You'll clearly end up with more money than doing the after-tax 401(k) option, possibly wind up with more than by doing the deductible IRA and you'll certainly hedge your bets against higher tax rates in the future and likely give yourself more flexibility in managing your tax bill in retirement.

Start late, retire rich

401(k) to IRA? A rollover dilemma

The right way to tap into your 401(k)

Ask Walter a question: Click here or e-mail us at asktheexpert@turner.com.