Retirement vehicles tuneup

But more options would mean tougher choices

May 29, 2001|By Kathy M. Kristof, Los Angeles Times.

Saving for retirement may soon become easier -- and a lot more complicated.

The Comprehensive Retirement Security and Pension Reform Act passed the House by an overwhelming margin this month and is being debated in the Senate.

Under the bill, annual contribution limits for individual retirement accounts, both Roth and traditional IRAs, would more than double to $5,000. Limits for 401(k) plans would rise by more than 40 percent to $15,000.

In addition, the bill would create a new type of 401(k) plan that would work like a Roth IRA. The proposed "Roth 401(k)" wouldn't provide an upfront tax break as the current 401(k) plan does, but distributions at retirement would be tax-free, as they are with a Roth IRA.

"People are going to have a lot more opportunity to save in the way that suits them best," says David L. Wray, president of the Profit Sharing/401(k) Council in Chicago.

Yet for those with a limited amount of cash to save, that raises a vexing question: Which option would maximize after-tax income in retirement?

One thing is almost always true: If you save through a company-sponsored retirement plan -- that's a 401(k), 457 or 403(b) -- and your employer matches at least part of your contribution, you should always save there first.

Employers typically contribute 50 cents for each dollar an employee saves, up to certain limits, Wray says. Because the money is taken out of your paycheck on a pretax basis, saving in a 401(k) reduces your tax bill.

"Company money is better than a tax benefit any day," Wray says. "Never leave company money on the table."

On the other hand, if your 401(k) plan features a roster of lousy investment options, choosing a traditional IRA might make more sense because it gives you the freedom to invest your money wherever you want.

The tougher question is whether individuals should take their tax benefits today by opting for the upfront deductions of a 401(k) or traditional IRA, or whether they should take the tax benefits later by choosing the Roth IRA or the proposed Roth 401(k).

The benefits of upfront deductions are obvious: They reduce the amount of income subject to taxation and, hence, the amount of tax you have to pay.

However, Roth-style plans allow savers to withdraw principal before retirement without penalty, whereas a permanent withdrawal from a traditional IRA or 401(k) would be taxed and bring a 10 percent penalty.

In addition, Roth plans give savers more flexibility when withdrawing money at retirement. Participants in traditional IRAs and 401(k)s must withdraw set amounts after age 70 1/2. With a Roth account, you can withdraw your money or leave it alone.

Yet the pivotal factor in determining which type of plan is the best choice is your tax bracket, Wray says. Because traditional retirement accounts allow you to take tax breaks today whereas the Roth method makes you wait until you retire, you must decide when those tax savings are likely to be most lucrative.

Here are two hypothetical examples, assuming the retirement bill becomes law:

Ann, 25, earns $30,000 annually. She's a serious saver who plans to retire at 65. She decides to put away $5,000 each year. If she chooses a 401(k) or traditional IRA, she'll save $750 in federal income taxes--15 percent of her $5,000 contribution. The net out-of-pocket cost of her $5,000 annual contribution is reduced to $4,250.

When she reaches 65, she will have $2.63 million in savings, assuming she earned an average of 10 percent on her savings each year. She wants to spend all her savings and figures she'll live to age 95. She will earn less on her savings while withdrawing the money; we'll assume 5 percent.

Bottom line: She can withdraw $14,145 per month, or $169,740 per year, from her savings. Assume that she'll pay tax at a 36 percent marginal rate. That will cost her $5,092 per month in federal income tax, making her after-tax monthly income $9,053.

What happens if she saves through a Roth IRA? Her out-of-pocket costs are higher because she's contributing after-tax dollars.

To make the comparison equivalent, we'll assume that means she can save only the after-tax cost of $4,250 per year. After 40 years, she has $2.24 million saved. For the next 30 years she can withdraw $12,024 per month, or $144,288 per year. All that income is tax-free.

The bottom line: Ann has $2,971 more after-tax income each month by using a Roth account.

Janet, on the other hand, is 55. She's earning more than $100,000, but she's just starting to save for retirement. Assume she can make an annual $15,000 contribution to either a traditional 401(k), getting an upfront tax break, or a Roth 401(k), deferring the tax break until retirement.

Which is better? In this case, the traditional 401(k). The analysis works the same as Ann's, except Janet is currently paying 31 percent of her income in tax. And because she has saved so little, she's likely to drop a tax bracket or two in retirement.