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| The Basics | A tax-free retirement just got closer
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What do the experts say?
I spoke with two financial planners. Scott Jensen works at Hardy and Hardy Co. in Lima, Ohio. Scott Neal is president of D. Scott Neal, Inc. in Lexington, Ky. Both of them agree that while the tax savings from a traditional 401(k) should be invested in some way, it just doesnt happen, Neal said.
Heres where they think a traditional 401(k) is best:
- If youre in the highest federal income tax bracket (35%) and believe youll be in a significantly lower bracket when you retire, the opportunity to lower your taxable income now through a traditional 401(k) might be more appealing.
- If youre a very conservative investor or if retirement is near (meaning less potential for growth), the prospect of tax-free redemptions from a Roth 401(k) might be less attractive.
Heres where they think a Roth 401(k) is better:
- If you dont plan to spend all of your money in retirement, your Roth 401(k) can be rolled into a Roth IRA and avoid minimum distribution requirements. The tax-free growth can pass to your heirs. (Neal suggests his wealthy clients pay as much attention to distributions from their nest eggs as to the building of them.)
- If youre a younger worker currently in one of the lower tax brackets, Jensen said, the Roth 401(k) is nearly irresistible. The future tax-free growth benefit of a Roth 401(k) far outweighs the current tax reduction of a traditional 401(k), Jensen said. I would build up assets in the Roth 401(k) as much as possible until Congress takes it away.
No matter which 401(k) you wind up choosing:
- Always, always contribute enough to your 401(k) to get your employers matching dollars. As Neal points out, this is free money that should never be left on the table.
- Every time you get a raise, bump up your 401(k) deduction percentage.
What will I do?
Theoretically the Roth 401(k) becomes available on Jan 1. But the IRS has not released the final regulations regarding the Roth 401(k), and it might not do so in time for your employer to be able to ramp it up for your annual benefits enrollment. If Roth 401(k)s dont even seem to be on your companys radar, now is the time to put a bug in the ear of your benefits department.
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Down the road, if Congress makes significant changes to the tax code such as a flat tax or consumption tax, all bets are off. Whether or not to choose a Roth 401(k) might then become a moot point.
I currently max out my Roth IRA and put 14% of my salary in a traditional 401(k). Early on in my research I figured that, when the Roth 401(k) became available, Id evenly split the 14% between the two 401(k) options, softening the tax hit on the full 14%. In subsequent years Id tilt more toward the Roth 401(k).
After crunching the numbers, though, I want to up the ante faster, putting at least 10% into the Roth 401(k) in 2006 and hopefully eliminating contributions to my traditional 401(k) by 2007. The Scotts and I have our fingers crossed that Congress decides to extend the Roth 401(k) beyond 2010.
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