Why I told a gen-x friend to slow contributing to his 401k, and what I told him to do insteadAugust 28, 2013 12:00 am
Over dinner a few weeks ago, a friend of mine announced to no one in particular that he had no intentions of working past 65. Since we’re the same age, I was shocked at his confidence in his current financial situation to make such a proclamation. We’ve been friends for a long time so I didn’t hesitate to start peppering him with questions. I started asking him about his finances, how much he makes, what his current expenses are, what he has saved for retirement so far, and finally where that retirement money is saved.
In his case, it turns out he saves over 10% of his salary in his company’s 401k. He’s single, owns his own home, has very little debt and makes just below six figures. His emergency reserve was well funded, and in fact he acknowledged that he is sitting on a little too much cash. Years ago he had an advisor put together a financial plan, the two of them review it annually and he is still on track to achieve his goals. From the sound of it, I had to agree that he certainly has put himself in a position to succeed at his retirement goal of 65.
As our discussion continued, he confessed that he had recently received a raise and was contemplating raising his 401k contribution. When he asked me what I thought, I asked if he had a ROTH IRA. I got a puzzled look for an answer.
“I’ve heard of a ROTH IRA, but what is the difference again?” he asked.
Traditional IRA’s and 401k accounts are funded with pre-tax contributions. As the account grows, the taxes are deferred. When you start withdrawing the funds in retirement, your withdrawals are taxed then, at whatever your tax rate is. In simple terms, you avoid the taxman now when you make the contribution, and then he arrives when you start taking your money out.
ROTH IRA’s are the opposite. Contributions are made with after-tax dollars. The account still grows tax deferred like Traditional IRA’s and 401ks, however in retirement withdrawals are made tax free. So you pay the taxman today, for the benefit of avoiding him in retirement. Another difference for ROTH’s is that the amount you may contribute each year depends on your MAGI (modified adjusted gross income). As of 2013, if you make over $127,000 as a single filer, or $188k as married couple filing a joint return, you are ineligible to use a ROTH IRA. Note: these levels change year to year, so be sure to contact your advisor or accountant to determine if you are eligible.
My friend laughed at the current limits because they are so much higher than his current salary. However, with a few more raises and if the current income limit remains the same, he may find himself prevented from using the ROTH. Like most decisions about retirement, the sooner he decides and starts saving, the better off he may be.
“OK, so how would a ROTH IRA potentially help me in retirement” he asked.
For gen-x, and even most baby-boomers, the largest pool of retirement funds is in their 401k or 403b accounts. Every withdrawal made from these accounts in retirement is taxed as regular income. Obviously to maintain your lifestyle in retirement you will have to start to draw down your savings. Take out too much and you could push yourself into a higher tax bracket, costing you savings. Another reason to keep an eye on withdrawals is that monthly Medicare premiums rise as your income level rises so every withdrawal made from an IRA moves the retiree closer to a higher premium.
For my friend, the ROTH IRA could be a great option for his retirement planning. Obviously we have zero way of knowing what the tax laws will be when he reaches retirement, however a ROTH IRA provides him with tax diversification. Tax diversification is achieved by having various sources of savings, which are taxed differently when the funds are withdrawn. This flexibility will allow him withdrawal and spending options in his retirement that he is currently missing. A ROTH still allows his savings to grow tax-free while he’s working, and then in retirement will provide a source of savings that can be used to manage his tax exposure in retirement.
Keep in mind that there are some other factors that need to be considered prior to deciding on saving extra income in a ROTH versus using a 401k or Traditional IRA. Besides looking at your current situation, one also has to have an idea of what the future may hold as well. The decision to use a ROTH over another retirement account does not need to be complex, but we do recommend speaking with a financial advisor to make sure your current factors and future assumptions are realistic. As for my friend, he spoke with the advisor who created his retirement plan and then decided to start funding a ROTH. That dinner we had may end up being the best thing that happened to him all summer!
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Derek’s opinions and comments expressed on this site are his own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.