‘My Two Cents’ On Your 401k Retirement Plan Options
By CHM on Feb 27, 2008 in Featured, My Two Cents, Roth 401K, Traditional 401K
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There is a never ending debate about where you should direct your retirement contributions - into a traditional 401k, Roth 401k, a little of each? a portion into a regular taxable account?
I know this to be true because I’m constantly getting involved in this debate, sometimes on my blog, sometimes elsewhere. Here’s a Roth 401K vs Traditional 401K thread over on All Financial Matters (from yesterday) - that I commented on this morning - dealing with this subject. (Please keep in mind, there are some well informed people chiming in.)
Roth 401k retirement plan option
With the growing popularity of the Roth 401K plan, you get yet another option in the universe of possibilities; as if American investors weren’t confused enough with all their choices. Keep in mind, the income limitations that make investors ineligible for a Roth IRA do not exist with a Roth 401K contribution.
Left scratching your head
It seems to me, when it comes to planning the future, people don’t know where to begin. It’s the same type of overwhelming feeling you get when walking down the cereal aisle of the super market. It almost makes you want to turn around. I know I put the blinders on and just think Lucky Charms, find the Lucky Charms, lol.
But seriously, I get calls from friends all the time asking me for advice because they’re just not sure what they need to do, where to do it, how to do it, why they’re doing it; and these are well educated people.
Do I have the magic solution?
No I do not. (Here comes the cookie cutter answer) Each person is different and each situation is unique. BUT with that said… I’m going to list some of my thoughts on the many issues and get you going in the right direction.
My strong opinions (not to be confused with facts) when it comes to 401k retirement planning:
The general assumption I am making here is you are not riddled with unsecured consumer debt. If you are in debt, read Dave Ramsey’s book Total Money Makeover and get committed to getting yourself out of debt, before making any retirement plan contributions.
If your employer matches your 401K contribution, then before anything else take full advantage of your employer’s match.
When it comes to Roth 401k’s vs Traditional 401k’s, I’m not going to take as firm a stance here, as I did with deciding on a Roth IRA vs Traditional IRA.
Because you’re dealing with a bigger potential contribution (that could have a larger impact on your current year tax return) more consideration is needed, I defer to more of a tax diversified approach, and firmly believe this decision is unique to your situation.
With that said, I would still advocate putting a good portion into a Roth 401k, especially if you’re not eligible to make a Roth IRA contribution.
How much is a good portion? Well that has a lot to do with whether or not your employer offers a 401k match or even offers a Roth 401k alternative, as well as, your personal beliefs and risk profile.
Many pundits advocate ‘tax diversification’ when it comes to retirement planning- a phrase popping up more and more these days.
The basic premise here is no one knows how future changes in the law and taxation will effect existing retirement plans, so diversify your tax risk by investing in all the different accounts. Although I agree that tax diversification is key - I also believe when it comes to your 401k - prioritizing your Roth 401k contribution should be at the top of your TO DO list.
- The future tax rate of a Roth account (401k or IRA) will be 0%… hard to beat!
TIP: In life and with your money, whenever the word RISK is present, the word DIVERSIFY is your friend.
Some argue that the laws surrounding Roth distributions will change and the Roth could be taxed in the future. Here’s my response to that in this morning’s thread over on AFM:
If they change the rules for Roth’s you will be grandfathered or fairly compensated in some other way (anecdotally speaking). It’s unfathomable to me that everything you would have done properly is taken away (this isn’t Checnya)… you will be grandfathered.
Eventually, after you roll your Roth 401k into a Roth IRA, there are NO required minimum distributions (RMD’s), and a Roth becomes a very effective estate and legacy planning tool.
When it comes to subjective topics like the one being discussed here, you can use a financial calculator to prove out your bias, much like you see done on the AFM thread I references at the beginning of this post.
What’s important to keep in mind (that can’t be mathematically quantified) are the positive psychological effects of contributing to an account where no future tax is due, an account where you will have a heck of a lot of flexibility down the line.
People get jazzed up by the prospect of ‘Tax FREE‘ and IMHO are more likely to staying committed to the process over the long haul.
In conclusion
There are many different pieces to the retirement puzzle and every situation differs, there are no right and wrong answers, although I think it’s plain to see where I stand on Roth related issues. To quote myself once again from this morning’s thread:
It seems this debate will rage on… the good thing is if you’re diligent towards putting money away for retirement (however you do it) you’re on the right path…
Tags: My Two Cents, Roth 401K, Roth IRA Conversion, Traditional 401K
kentuckyliz | Aug 23, 2008 | Reply
People’s individual situations could take into account: do you have a pension? existing pre-tax savings (401k-403b-traditional IRA etc)?
If yes to either of those, depending on the size, it’s nice to emphasize the Roth IRA and Roth 401k-403b because there’s a core pre-tax part of the investments that are going to have RMDs at 70 1/2 and be the income stream; then the Roth never has to be touched if you don’t need it and it becomes an incredible family-tree-changing estate tool.
It’s also easier mentally to invest in the Roth IRA and go large with it, because beyond the fully funded emergency fund, it can serve as the mega emergency fund. You don’t want to treat it that way of course, but you can break the glass in case of emergency (assuming the account is aged 5 years).
In my situation, my required retirement contributions and the employers are pre-tax (and the employer requires this); I have significant pre-tax investments built up already, and just a little Rothiness. So I Roth IRA (greater choices and flexibility) then go back and Roth 403b (the discipline of payroll deduction and LBYM). Works for me, and I dare say anyone in a similar situation.
YMMV (as in all things)