Questions and Answers
Q: My employer will be offering the option to switch all or some of my 401(k) contributions to a Roth 401(k) starting 2008. So the question is; all, some, or none?… As I understand it, the question comes down to paying the taxes now or later. Anonymous
A: First, a quick definition for our readers. The big difference between a traditional 401(k) from a Roth-401(k) is taxes. Your contributions to a 401(k) are made with pretax dollars. You pay taxes on the savings when it’s withdrawn during retirement. With a Roth-401(k), your contributions are made with aftertax dollars. But the money comes out tax free at withdrawal.
Both plans are good. The bottom line is that you can’t go wrong. Which one is better for you comes down to a combination of math and tax assumptions, although I think for most people the Roth-401(k) holds an edge. The higher your tax bracket in your old age the better the Roth-401(k) looks. For instance, young workers in a low tax brackets should look closely at a Roth 401(k). The odds are that their incomes will rise during the course of their career, putting them in a higher tax bracket. A traditional 401(k) becomes more attractive if you think your tax bracket will drop during retirement. There are a number of calculators on the web that will run some numbers for you. I’ve played with one offered by Smart Money at www.smartmoney.com/retirement and another by Bloomberg at www.bloomberg.com/invest/calculators.
One other thought: Doing both isn’t a bad idea. You’ll pick up tax diversification. After all, who knows what tax brackets will be 10 to 30 years from now?
Q: Would it ever be a good idea to forego an employer’s 401k in favor of a Roth? I’m 46, single and have been saving 15% of my income in a 401k since I was 22 resulting in about 500K in savings. My current employer doesn’t match my 401k, that is, they’re not profitable enough to match it… John
A: I get variations on this question a lot. The answer is easy when there’s an employer match. Everyone should at least fund their 401(k) up to the match. It’s the match that truly boosts your return on savings. Then if you have the money and qualify you can also fund a Roth-IRA.
But what about circumstances like yours where there is no match? I’m assuming your company offers a good mix of mutual fund options coupled with low fees. If that’s the case, next year you’ll be able to set aside a maximum of $15,500 in your 401(k) ($20,500 if you are over 50). The limits on a Roth are $5,000 ($6,000 if you’re over 50). You can set aside a lot more money every year with the 401(k), and that’s certainly attractive. So, I wouldn’t stop taking full advantage of it. Rather than forego the 401(k), how about a mix of both?
By the way, to make a full contribution to a Roth-IRA for 2008 your income must be under $159,000 if you file jointly and below $101,000 for a single filer.
The only reason to abandon your 401(k) is if your employer’s plan is a high-fee bad-choice menu of investment options.
Q: My husband’s sister has 4 kids. We have been looking into opening 529s for each of them and putting money in the accounts for them for Christmas gifts, Birthdays, etc… We were concerned that opening accounts for them would affect the later opportunities for applying for financial aid, whether in terms of grant money, loans and scholarships. But it seems to us that the money found in a 529 is not totally considered against them for these types of programs. Is that true? I guess I would like to know what the pitfalls are for opening a 529 versus doing some other type of investment for their education. Leanne
I like 529 college savings plans. The plan is funded with aftertax dollars, but the money compounds tax free. It’s also tax-free money if it’s withdrawn to pay for qualified educational expenses. In most cases, there are no income or age limits, and the money that can be set aside is substantial, up to $300,000 in a number of plans. Anyone can contribute the child’s account, including parents, grandparents, relatives, and friends. The savings plan also gets favorable treatment under the current financial aid formula. When it comes to paying for college, parent-owned accounts are assessed at 5.6% and by law 529 accounts are considered parental assets.
By the way, the plan beneficiaries are not locked into attending school in their state. The accumulated savings are available for college–public or private–and in any state. A good place to research 529 plans is www.savingforcollege.com.
The biggest disadvantage is that the government imposes steep penalties if the money isn’t used for education expenses.
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