In 2005, Congress passed a law creating the Roth 401(k). What follows is an overview of 401(k) options as well as some thoughts to consider when figuring out which one is right for you.
How a regular 401(k) works:
Contributions to your 401(k) are pre-tax, meaning that the contribution amount reduces your taxable income. Any contributions that your employer makes do not count as income to you. At age 59 and a half, when you are able to start making withdrawals, you will pay tax on the distributions at your regular tax rate.
Current Year: You make $100,000 per year and contribute $15,500 to your 401(k) and your employer chips in another $5,000. Your taxable income for the year (from your employer) will be $85,000. This reduction in income results in is a substantial reduction in taxes – especially for those of us who live in high tax places such as NYC.
Retirement: Beginning at age 59 and a half, you start to take withdrawals from your 401(k). Let’s say you withdraw $100,000 per year. That $100,000 will be counted as ordinary income and you will pay federal, state & local taxes on the full amount at whatever your tax rate happens to be at the time.
How a ROTH 401(k) works:
Contributions to your ROTH 401(k) are after-tax, meaning that the contribution amount does not reduce your taxable income. At age 59.5, when can start making withdrawals, you will not pay any tax at all on the distributions. By age 59.5, the majority of the money in your account will not be money you put in (principal) but it will be capital gains on the principal. Thus, you will be paying ZERO tax on the massive amount of capital gains and interest that will compound in your account over the next 40 years!
Current Year: You make $100,000 per year and contribute $15,500 to your 401(k) and your employer chips in another $5,000. Your taxable income for the year (from your employer) will be $100,000.
Note: unfortunately, the employer contribution has to go into a traditional 401(k), not the Roth 401(k)
Retirement: Beginning at age 59.5, you start to take withdrawals from your Roth 401(k). Let’s say you withdraw $100,000 per year. That $100,000 will not be counted as income and you will pay zero tax on the withdrawal.
Which should I choose – the Roth 401k or the regular 401k?
There is no simple answer here – it depends upon the individual and also your belief of what your future holds. Consider this hypothetical situation for Sarah & Jane. These gals have a lot in common: they are both 25 years old, earn $100,000 per year, and can contribute $15,500 to a retirement plan this year:
Sarah: Sarah has big-time career ambitions and plans to have a much higher income in the future. She loves to work and plans to do so, either for a company or herself, until at least age 75. She is an “aggressive saver” and already has substantial non-retirement assets. She loves New York City and plans to stay there forever. Also, she expects to get a substantial inheritance from her parents one day. It is very likely that Sarah will be in the highest tax bracket when she retires.
Jane: Today Jane has the same income level as Sarah but Jane has very different ambitions for her career. Jane plans to stop working at age 65 and live off of her 401(k) and perhaps a part-time job. It is unlikely she will have substantial assets outside of her house and 401(k). Given these circumstances it is likely that her tax bracket will be lower in retirement than it is now.
In this example, Sarah’s contribution to the Roth 401(k) will only be $11,250 (because of the $3,750 in taxes she will have to pay on the additional $15.5k in income.) Jane’s contribution into her retirement plan will be for the full $15,500. All other factors equal, Sarah and Jane will probably end up in roughly the same, after-tax position when all is said and done. This is because Jane’s higher contribution now, will result in a much higher future amount due to the miracle of compounding. However, since Jane will owe a bunch of tax on the future distributions, it probably evens out.
Of course, all other factors are never equal… Since Sarah is going to have substantial assets and income in retirement, her tax bracket will likely be very high. Also, it is quite probable that Sarah can afford to pay the $3,750 in additional taxes out-of-pocket and thus not reduce her current contribution at all. In other words, Sarah will contribute the full $15,500 into the Roth 401(k) – she will find the money somewhere to pay the tax.
If she does this for the next 40 years, Sarah will have $5.3 million (assuming a 9% CAGR) – all of which can be withdrawn completely tax free. If she invests in the traditional 401(k), she could owe 40%+ of this amount to the IRS!
Bottom-line: It is very clear to me that “aggressive savers” with high future earning potential should go with the Roth 401(k). For people not in this category, the answer isn’t so clear.
Follow these links for additional resources:
There is an interesting op-ed by Bob McTeere in today’s WSJ (subscription required): Don’t Dismiss Our Dismal Savings Rate. Excerpt:
The main fallacy in monetary theory and policy is the confusion of money and wealth. Money is wealth from the individual perspective since individuals can usually exchange it for goods and services. Money — and financial assets easily converted to money — may not be wealth for society as a whole if the production of goods and services has not kept pace with claims on it. Early spenders may have some success, but inflation will dilute the buying power of others. The bottom line is that real wealth has to be produced; it can’t be printed.
The paradox of thrift says that attempts to save more in the aggregate reduce consumption spending, which, if not offset by increases in other spending, will reduce total spending and income. The paradox comes in when attempts to save more results in reduced saving out of lower incomes. The irony is that policy makers advise more saving but those who take the advice will benefit only if most of us ignore it, and policy makers are implicitly counting on that outcome.
A parallel is the farmer who hopes for a good crop year. But, if all or most farmers have a good crop year, the decline in prices may more than offset higher yields. What our farmer really needs is a good cop in a bad crop year. Then he could look for a popular restaurant that isn’t crowded.
A penny saved may be a penny earned, but it matters whether it was earned by producing more or by a rise in price of existing financial assets. A stock or housing market boom creates apparent wealth in the form of capital gains, but trying to convert it to real wealth en masse can make it disappear.
Alan Greenspan has been one of the few economists to explain these matters correctly and understandably, usually in the context of entitlement reforms. He frequently pointed out that any solution to the problem had to include real economic growth. With claims on output growing rapidly, output has to grow equally rapidly or the claims are bogus. Any solution — to entitlements or the savings rate — must include a bigger, more productive economy in the future…
The problem goes beyond government entitlement programs. Consider the baby boomers whose IRAs, 401(k)’s and personal investments helped drive the stock market to record highs. What happens when cash-in time comes? There will be a mountain of paper claims on output, but will there be an equally tall mountain of output?
This simple thesis helps to explain a lot of what confuses me about all of this new “money creation” we hear about constantly. For years now global money supply has been increasing much faster than the rate of global growth. Of course, defining “money” has become so much more difficult because of the velocity effects of increased global trade, not to mention derivatives. This is partly why the Fed has stopped publishing the M3 measure of money supply – it’s just too hard to quantify the broad monetary base.
Nevertheless, most of this new money has sloshed into assets, pushing up their prices. I have commented before that rising asset prices are not good for most people. For lower and middle class people who don’t own a lot of assets, they have not benefited much at all. Many of these people are actually worse off because they borrowed a ton of money against an overvalued asset.
Yesterday — Thursday, July 12, 2007 — the Trois Pistoles were defeated by a construction company team whose name escapes me. Aside from the first inning, where we had a miserable showing, we played very well. Alas, the damage done in Inning #1 was too great to overcome. Follow this link for the softball set in Flickr!
I know that I’m way late to the party but I have accidentally (or not?) just realized how cool YouTube is. Anyway, it seems that someone using the camera yesterdayrecorded a video on the camera. So…. here it is…. my first YouTube video!
I have been investing in stocks for about 7 years. Until 2007, I have absolutely no idea what my rate of return was and whether I under/over performed the market.
Many of us (myself included) believe that we are better investors than we really are. We vividly recall the success of winning stock picks but somehow forget about the losers. In my case I like to think of all the money I made in PetroBras stock over the last few years. But what about the small fortune I lost trading gold futures in 2006? I almost never think about that – I have subconsciously blocked it from my memory. While it can be fun to live in a fantasy world, it is important to know the truth so that we can make smart decisions.
Why is it so hard to figure out my return? Because I’ve been continuously adding money to my brokerage accounts…. Sure my account is going up in size, but how much is a result of savings and how much from positive returns? I use Excel and the formulas below to easily track my portfolio returns. Now that everything is setup, it takes less than 5 minutes per month.
Each month I compute the time-weighted-return of my portfolio. This tells me the return of my portfolio for the month and takes into account any deposits or withdrawals:
Rate of Return = Change in Mkt Value / (Beg Bal + (Net Contributions * Factor of days in Month)
For example, if I contribute $1,000 into my account on the 20th day of June, I would multiply the contribution by .33 (10/30). This is done because the $1,000 contribution was only in the account for 1/3 of the days in June.
Calculating Compounded Monthly Return:
Use this formula to calculate the compounded monthly (or any period) return in your portfolio:
Return for the Year = (1 + R1)*(1 + R2)……(1 + R12) – 1
In the above formula, R1 = rate of return for January, R2 = rate of return for Feb, etc.
Q1 Update: In my Q1 portfolio review, I said the following:
Notwithstanding the benefits I have derived thus far, it is not smart to put money in the stock market which you will need in the next 1-3 years. So today I liquidated the stocks and bought a Short Term New York AMT-Free Municipal Bond Fund which pays about 3.1%. I have to completely segregate the money into a separate account so that I’m not tempted to trade with it!
As it turns out, this statement was a lie. When I wrote it, I had indeed planned to move the cash into the Short Term New York AMT-Free Municipal Bond Fund the very next day. Instead, I bought a bunch of Japanese Yen. I own the Yen as kind of a contrarian investment. That’s irrelevant though. Point is, I do not have self control – if I have cash in my brokerage account, I just have to mess with it.
Q2 Review: As a result of all this, I am starting to think a lot more about asset allocation and organization. Up to now, my approach to allocation has been haphazard at best. By the Q3 ’07 I want to be treating my accounts as follows:
Taxable Brokerage Account(s):
* In this account I want to have “great” stocks which I hold for long periods of time. Every year, I should sell anything with a short-term loss. Hopefully I will generate $3,000 in short-term loss per year. I will only take long term gains, and only if there is a very compelling reason. In my taxable account I am doing way too much trading!
* Here is where I should do all of the trading. By Q3 ‘07, anything that I own in here that deserves to be a core holding should be sold and purchased in the taxable brokerage account.
* Today I am invested in international/emerging markets growth mutual funds. I fully expect and hope for lots of volatility in these funds. No action needed here.
* The goal for this account should be to maximize my after-tax return. Living in NYC, it probably makes sense to put free cash into a muni-fund, but I have to crunch the numbers to be sure.
This is not a perfect setup but I think it will be an improvement over the current arrangement. Now that I have a good system in place for accurately tracking the performance of my accounts, it’s something that can be objectively evaluated at some point in the future.
Here is the YTD performance of my portfolio (which includes the above-mentioned accounts):
|2007||My Return||S&P 500|
Got back to NYC yesterday from a week in Provincetown. It was the best trip ever…. Follow this link for my public Flickr photos (Flickr friends can see pics with people, not just scenery).