Friday, May 6, 2011

Q&A Series: Roth 401(k) Plans - the Best of Both Worlds

This week's question comes from Monica, a young reader who is just starting her career and has questions about saving for retirement.

Q: I graduated from college in December and finally landed my first “real” job. My employer offers a 401(k) plan, but is that the way for me to go? Or are there better ways for me to save for my retirement? Should I have other savings besides what I save for retirement?

A:
Congratulations on graduating from college, Monica! You should be proud of yourself for this great achievement and for finding employment relatively quickly in today’s job market. It always pleases me to hear of a young person taking responsibility for his or her financial life – especially when it comes to retirement savings. This isn’t a typical priority for many people your age, although it is essential to your financial well-being.

The Basics

There are many types of retirement savings plans available to individuals, but you should definitely take advantage of an employer sponsored 401(k) plan if it is being offered to you. Why? Because most companies match a percentage of employee contributions, which is basically free money if you contribute at least up to the matching amount. Also, since 401(k) contributions are taken directly out of your paycheck, you probably won’t miss the money. Lastly, and most importantly, contributions are tax deductible and earnings are tax-deferred until you start withdrawing the money after age 59½. So, a 401(k) plan is a great place to start saving for retirement.

I’m assuming from your question that your employer offers a traditional 401(k) plan, but some employers are now offering Roth 401(k) plans, which are a combination of a Roth IRA and a traditional 401(k) plan – and is really the best of both worlds. I’ll explain why below, but you should inquire with your company’s human resources department to find out if the Roth 401(k) option is offered and to obtain information about the investment options they provide.

Roth IRAs are a definite consideration for those of you whose employers do not sponsor retirement plans and whose income is below the current threshold of $107,000 for single filers and $169,000 for married filing jointly filers. Contribution limits above those thresholds reduce or completely phase out above certain income amounts. Roth IRAs allow for earnings to grow tax-free, although contributions are made with after-tax dollars so you receive no tax deduction. Furthermore, withdrawals are tax-free after age 59½, which is a remarkable benefit since you’ll likely be in a higher income tax bracket by then.

Similarly, in the case of Roth 401(k) plans, your contributions are not tax deductible and withdrawals after age 59½ are also penalty- and tax-free. But unlike a Roth IRA, there are no income restrictions for Roth 401(k)s. Most young people can expect for their tax rate to be the same or higher than it is now in retirement, and as such, they are typically better off paying the taxes now (i.e., less take home pay) by contributing to a Roth 401(k), if that option is available. On the other hand, individuals in their peak earning years who will likely be in a lower tax bracket in retirement will likely benefit from traditional 401(k) contributions. You should also bear in mind that if you leave your job, the balance in your Roth 401(k) can be rolled over into a Roth IRA. Rolling over your 401(k) to an IRA when you leave your job is always a good idea and it is not a taxable transaction.

Keep in mind that you are allowed to contribute to an IRA – whether Roth or regular – even if you contribute to a 401(k) plan. The current limits are $16,500 to a traditional or Roth 401(k) ($22,000 for individuals 50 or older) and up to $5,000 to a Roth and/or traditional IRA ($6,000 if you are 50 or older). And, if you contribute to a Roth 401(k), you can also divide your contributions between a traditional and a Roth 401(k), although your total contributions to both cannot exceed the $16,500 limitation. So, as you can see, there are a lot of potential retirement savings options available to you, each providing opportunities to save with different tax treatments.

For someone in your age group, Monica, I’d suggest deferring 10% of your annual salary for your retirement savings, whichever option you choose. For individuals in their thirties who are just starting, I’d suggest boosting the contribution amount to at least 20% of annual compensation (and increasing the percentage even more for older individuals) until you reach the maximum contribution.

Other Savings

There are other important items to save for outside of retirement, like an emergency fund in the event you become ill or lose your job. A good goal for an emergency fund is to have the equivalent of at least three- to six-months of your monthly expenses in an account that you can easily access. If you have an emergency fund in place and something unexpected happens, it shouldn’t completely ruin your hard work in financially preparing for your future.

Those items are the necessities, but of course, there will surely be things that you will want for yourself – like a vacation, a car, or even a down payment on your first home – that will require some planning. After you’ve got your retirement savings plan in place and your emergency fund is completely financed, you can start planning for those goals. And an excellent way to do that is by putting your expendable income to work for you by opening an investment account.

Monica, if you keep on this current path, you will be better set financially than most individuals your age, and almost assuredly, better set for your retirement years. Best of luck to you in achieving your next set of goals!

We encourage our clients and readers to send us questions for our Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

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