Monday, September 28, 2009

YOU ASKED FOR IT!

A list of “Latest Good Reads” at Roni Deutch’s TAX LADY BLOG (which, I am honored to say, begins with my post “A Tax Deduction Is Only Worth What It Is Worth”) led me to “401(k) vs. IRA - Which is Better For Your Extra Money?” at BUDGETS ARE $EXY – A personal finance blog of a 20-something soon-to-be millionaire, written by “j. money”.

The post introduces a question regarding 401(k)s and IRAs, provides j money’s answer, and asks the readers, “What would you guys advise?”.

Here is the question –

"I'm like you, turned 30 this last year, and getting my finances in line (I'm in the black, which is a good thing, but I can do better). Got a question for you regarding 401k's and IRA's. I currently participate in my company’s 401k program, but I am only contributing the amount that the company matches (i.e. 60% on my first 6%). However, my 6% doesn't even get me close to my annual maximum ($16,500 or so... whatever it is ).

Would you suggest hitting the $16,500 in my 401k before setting up a separate IRA account? Or would you just contribute to the 401k up to the employer match amount, and then max out an IRA each year?
"

You can read the post to find out j. money’s response. Here is mine –

Let us look at the 401(k) and IRA in two separate ways – the tax considerations and the non-tax (financial/economic) considerations.

Tax Considerations:

Employee contributions to a “traditional” 401(k) plan (there is also a ROTH 401(k) option), up to the annual maximum, are considered “pre-tax” for federal, and generally state, income tax purposes. This means that the money you contribute to a traditional 401(k) reduces your taxable income. If your gross wages for the year are $100,000 and you contribute $15,000 to your employer’s 401(k) plan the federal, and probably state, wages reported on your Form W-2 for the year will be $85,000.

This means that in addition to any employer match, the IRS, and probably your state tax agency, will also “match” anywhere from 15% to 45% of your total contributions, depending on your level of income and state of residence. I expect that the average government “match” is between 30% and 35% of the money you put into the plan. If you contribute an additional $10,000 to a 401(k) plan, and your combined marginal tax rate is 30%, your federal and state income tax liability is reduced by $3,000. That is $3,000 more in your pocket! This $3,000 tax savings can be contributed to an IRA.

There are no income thresholds to “phase-out” allowable 401(k) contributions. The maximum employee contribution is allowed regardless of the extent of your Adjusted Gross Income (AGI). The only possible restriction on employee contributions concerns “highly compensated” employees in a plan where the lower-level employees do not adequately participate.

If your employer offers a ROTH 401(k) option your contributions and distributions are treated pretty much the same as a ROTH IRA. Contributions are considered “after tax” and do not reduce taxable income. If the employee in the above example contributed the $15,000 to a ROTH 401(k) plan the taxable wages on his W-2 would be $100,000. But qualified distributions are totally tax free!

If your employer has both options you can split your contributions between the two plans in any way you choose, or as allowed by the individual plan, as long as your combined employee contributions to the two components do not exceed the annual maximum. You can contribute $10,000 to a traditional 401(k) and $6,500 to the ROTH component, or vice versa

The maximum amount you can contribute to an IRA for 2009 is $5,000 ($6,000 if age 50 or older at the end of 2009). If you also have a 401(k) plan at work your contributions may be partially or totally “non-deductible” depending on your level of income.

The phase-out ranges for an IRA deduction by an active participant in an employer plan for 2009 are:

• Modified AGI of $55,000 to $65,000 for Single or Head of Household
• Modified AGI of $89,000 to $109,000 for Married Filing Joint
• Modified AGI of $0 to $10,000 for Married Filing Separate

If only one spouse is an active participant in an employer plan the other spouse (whether a working or non-working spouse) the deduction for the non-active spouse is phased out for 2009 when AGI is between $166,000 and $176,000.

You can contribute the annual maximum amounts to both a 401(k) and an IRA, but the deductibility of your IRA contribution may be limited. So the person asking the question can contribute a total of $21,500 to retirement plans for 2009. The 401(k) contribution must be made during the calendar year, but you have until April 15, 2010 to make an IRA contribution for 2009.

The amount that can be contributed to a ROTH IRA is limited based on your AGI. The phase-out ranges for contributions to a ROTH Individual Retirement Account (IRA) are:

• Modified AGI of $105,000 to $120,000 for Single and Head of Household
• Modified AGI of $166,000 to $176,000 for Married Filing Joint and Qualifying Widow(er)
• Modified AGI of $0 to $10,000 for Married Filing Separate

A single taxpayer with AGI of $120,001 or more cannot contribute to a ROTH IRA for 2009. Neither can a married couple filing a joint return with an AGI of $176,001 or more.

So to answer the question - the best case scenario, based solely on tax considerations only, would be to contribute the maximum $16.500 to your employer’s 401(k), splitting the contributions between traditional and ROTH components if available such that you get the maximum employer match, and contribute the maximum $5,000 to an IRA, with as much as allowed going into a ROTH account.

Non-Tax Considerations:

There are many financial or economic considerations to review before deciding how much to put aside for retirement and where to put the money. I will touch on just two.

It is very important to state upfront that the first, and most important, criteria for evaluating a transaction, strategy or technique should always be financial. Taxes are second. Remember that taxes are only pennies on the dollar.

I also feel it important to point out that I do not have any training, experience or expertise as an investment advisor. I do, however, feel strongly that the secret to investment success is simply the application of basic common sense.

1. How much can I afford to put aside?

This is perhaps the most important question. You want to put as much as possible aside for retirement, but you need a certain amount of cash flow to properly cover all your fixed and variable expenses and to have money available for contingencies and emergencies. Money you put into a 401(k) or IRA account cannot be touched until you are at least age 59½ (well you can touch it, but you should not; and there are different rules for withdrawals from a ROTH IRA).

You should have a separate liquid “emergency” fund. You should not use an IRA as your emergency fund.

You may also want to set aside money each paycheck into a “contingency fund” invested in a liquid money market or similar fund. If by year end you have not had to use this money for “contingencies” you can contribute the balance, up to the $5,000 or $6,000 maximum, to an IRA.

2. Where should I invest my retirement money?

In his response to the question j. money says –

Most 401(k)s from smaller companies usually suck as the funds to choose from aren't as good as if you had the open-sea of EVERYTHING out there like you do with IRAs. My company has a great match at that 100%, but the funds are pretty shitty from what people tell me.”

While I have not done any research or have any first hand knowledge of or experience with employer 401(k) plans, I would guess j. money is not wrong in his comments. I expect that most employer 401(k) plans have very limited and fairly generic choices when it comes to specific investment options.

Regardless of how much money you put away in a retirement plan, or how much tax you save upfront, it will do you no good if there is no significant growth, or if the investments tank.

You want to be, for the most part, conservative with your 401(k) investment choices and be sure to diversify. Don’t put all your eggs in one basket, especially if that basket is your employer’s stock.

And j.m. is correct that you have a much wider and more diversified selection of investment choices with it comes to your IRA investments. As I said you will want to be more conservative with your 401(k) money. But you can be a bit more “adventurous” with your IRA account, since it is much easier to change your investments and you have almost unlimited options.

The answer to the question, based solely on non-tax considerations, would depend on how much you can afford to put away, how good the investment options available in your 401(k) plan are, and the amount of flexibility the plan provides for changing your investment mix.

So how would you answer the question?

TTFN

5 comments:

Mary said...

I would also add that people should do their homework and read the fine print in the prospectuses about fees.

You correctly pointed out that 401(k) plans limit investment choices, and some of them do not offer a very good menu.

Other 401(k) plans, however, offer some excellent investment options with fees much lower than a retail investor could get in an IRA. That because some large employers use their bargaining leverage to give their employees access to funds with very low expense ratios, of the sort normally reserved for large institutional investors, and not generally available to small individual investors.

The Exxon-Mobil plan and the Federal employee Thrift Savings Plan are both examples of plans that offer index funds with much lower expense ratios than an ordinary person could ever get via an IRA.

Robert D Flach said...

Mary -

Thanks for the input!

It is important that you know and understand he fees for any investment before you sign up.

TWTP

J. Money said...

Wow, talk about a complete & thorough answer! Great work my friend, appreciate the link back and time spent on working this up :)

Have a great week my new friend.

Robert D Flach said...

JM-

Your post inspired me.

Any comments on my answer?

TWTP

Stacie Clifford Kitts said...

There are also self-directed 401(k) plan options where by an employee participant may choose to place a portion of their account into investments outside of the investment bucket - i.e. self-directed. However, many employers do not buy into these plan options because they are afraid their employees will make poor choices - or are warned by their 401(k) administrators of this risk.
Therefore, employers tend to opt for a fixed bucket of investment choices. Frankly, I haven’t read any statistics or seen any studies that support this fear. If anyone knows of one, I would like to look at it.

If you are not happy with your retirement plan, I encourage you to consider mentioning it to your human recourses department. Employer sponsored plans are considered "employee benefits." Certainly, these types of benefits are in part a way to attract and retain talent. If the plan is not working for the employee's, then it is not serving the purpose in which it was intended.

I agree with the analysis that has been presented. As with all investment choices, each person must judge his or her tolerance level and personal needs when choosing how to allocate funds.

My simple advice - if you are entitled to participate in a company sponsored retirement plan -you should do everything in your power to contribute something. The decision to investment in your retirement is the most important part of the investment choice - and, if your plan has a Roth option, even better. If you are to the point where you are analyzing the choices and asking questions, then you have already given your retirement more consideration than many Americans who have retirement plans available to them but choose not to participate.

Oh and Robert - I really liked your post “A Tax Deduction Is Only Worth What It Is Worth" how true, I get that all the time - particularly in regards to charitable contributions. It never fails, at least once a year; someone mentions the great tax savings they are going to get from something they have donated based on the blanket belief that donations are tax deductible. "Well, yes they are." I have to inform them, "but sorry it's not worth anything to you." "But why not?" they ask. This is where I get comfortable, because that question always leads into a long and dreary discussion regarding the intricacies of the tax rules.