March, 2007 Tax Tip
What Are You Having For Dessert, 401(k) or Roth IRA? Try Both
For starters, know that you can have both, so try to be greedy! There’s no reason to choose one plan over the other and risk making the wrong decision when you can have both.
Both 401(k)’s and Roth’s have their own unique benefits, but different tax treatments. One of the great non-tax benefits of a 401(k) is that it’s virtually a “no-brainer”. The money is taken directly out of your paycheck and deposited into your account. You have no documents to file or forms to fill out. In return you get an immediate tax benefit as the amount is not reported as income on your W-2 (although it is included for purposes of Social Security and Medicare tax withholdings). The money and its earnings are not taxed until you withdraw it, likely after retirement. Many employers also sweeten the pot by matching your contributions up to a certain limit, usually four to six percent. Your contribution limits are far more liberal than those of a Roth or traditional IRA. For 2007, the 401(k) maximum contribution is $15,500 (plus an additional $5,000 if you are 50 or older). Looks like an easy decision, right?
Let’s look at the Roth IRA. The maximum contribution for 2007 is $4,000 (plus an additional $1,000 if you are 50 or older). You don’t get an upfront tax deduction for your contribution but the tradeoff is that you can later withdraw your contributions and earnings tax-free, provided you satisfy certain withdrawal requirements. Due to a law effective in 2006, employers are now allowed to offer a Roth 401(k) option in their company 401(k) plans.
So, on the one hand we have the 401(k), you avoid tax on your contribution today (by not having it included in your income), but you will pay tax on the withdrawals later. Therefore, a 401(k) works best if current tax rates are higher than future rates. The flip side is the Roth where you are paying tax on your contribution today (by not being able to deduct it), but paying no tax on future withdrawals. A Roth, then, works best if today’s tax rates are lower than they will be in the future (certainly a good possibility).
Let’s say you would like to contribute to both a 401(k) and a Roth, but are concerned that you may not have the funds to do both. Which one has priority? A suggested solution is to take inventory as early in the year as possible. Prepare a budget (yes, the dreaded “B” word) in order to determine how much you can afford to save during the year (the more the better). The first step is to fund your 401(k) up to the amount where you get the full employer match. This gives you the upfront tax benefit plus the “bonus” of your employer’s matching funds. The next step is to contribute as much as you can to your Roth IRA up to the maximum. After that hopefully you will still have some leftover funds to invest to add muscle to your retirement nest egg. If so, go back to the 401(k) and fund it to the maximum, if possible. Doing this planning in advance will allow you to set your annual 401(k) contribution based on the total amount you can put into your 401(k) after allowing for the Roth.
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