Your 401(k): Is it still a great way to save?

We pit it against the Roth IRA and saving on your own

For years, employers, financial planners, government officials, and your Uncle Jack have harped on one piece of advice: Max out your 401(k)! Contributing to a 401(k) or a similar tax-deferred retirement plan cuts your taxes and boosts your retirement stash. So, for heaven's sake, scrimp, starve, squeeze--do whatever it takes--but put in every penny you can.

Most of those who followed this advice are probably happy they did. But a lot has changed in the almost quarter-century since 401(k)s were authorized by Congress. New tax laws and a giant federal budget deficit makes us question whether you're better off saving in a 401(k) (or a similar tax-deferred plan) or on your own.

To see how well the 401(k) works now, Consumer Reports Money Adviser asked Boston University economist Laurence Kotlikoff to run scenarios for families at different income levels and ages using ESPlanner, a financial-planning program he developed with Jagadeesh Gokhale, a Cato Institute economist ($149; www.esplanner.com).

The findings? Uncle Jack was right, but not that right. It turns out that having a decent amount of spending power in retirement depends more on your willingness to save early and often (and give up the pleasures of lavish spending in your earning years) than it does on the tax benefits of either a 401(k) or a Roth IRA. There are tax savings to be had--and the wealthier you are, the bigger they get--but they are smaller than was once the case.

What's changed

Time was, the 401(k) and the Individual Retirement Arrangement (what the IRS now calls the Individual Retirement Account, or IRA) were the only tax-saving games around. Now, however, there are significant tax breaks to be found elsewhere. Roth IRAs typically provide no up-front deduction but impose no tax on withdrawals. (Generally, joint filers may each make the full $4,000 contribution to a Roth--$4,500 for taxpayers over age 50--if their adjusted gross income is less than $150,000 or $95,000 for a single filer.)

Second, saving on your own--accumulating regular assets without a tax-deferred envelope like a 401(k)--is a much better tax deal than it was in the past, particularly if you invest your savings in stocks. The reason: Capital gains and dividends earned on stocks are now taxed at a maximum rate of 15 percent. But if you hold the exact same stocks within your 401(k), you will pay ordinary income taxes when you withdraw the money. That means that people whose taxable income is between $29,700 and $71,950 for single filers and between $59,400 and $119,950 for joint filers would pay at a higher 25 percent income-tax rate.

That difference--between 15 percent and 25 percent--doesn't sound so bad, but that income-tax rate could rise steeply in the future, when you're ready to withdraw your money from a 401(k). The ever-growing federal debt, huge unfunded Social Security, Medicare, and Medicaid obligations, as well as the costs of the Iraq war all spell one thing--much higher future income taxes. And future tax hikes do not augur well for 401(k)s and their ilk. Uncle Sam taxes every penny withdrawn from those accounts. And if he jacks up tax rates as we start taking our money out, those nifty "tax shelters" may start feeling like tax traps.

What's more, contributing to a 401(k) may cost you a chunk of your future Social Security income. Uncle Sam includes all 401(k) withdrawals, be they principal or return, in its definition of taxable income, and that in turn determines the extent to which your Social Security benefits become subject to taxes. In contrast, withdrawals from Roth IRAs are not included in taxable income. Neither are the proceeds from selling stocks or other assets. So they don't affect your Social Security.

The test

Determining whether to contribute to a 401(k), save in a Roth, or save on your own while considering all the variables is just about impossible unless you've got a Pentium IV chip embedded in your brain. So we turned to ESPlanner software. It determines a household's highest sustainable living standard--think of it as spending power or spending capacity--through time, given the number of mouths that need to be fed, the relative cost of kids, and the economies in shared living--the fact that two can live more cheaply together than two apart. This construct excludes taxes, housing, insurance, and other fixed expenses.

The program makes highly detailed, year-specific federal and state income-tax as well as Social Security benefit calculations. It can also specify future tax hikes, Social Security benefit cuts, and the share of your regular assets whose return will be taxed at the preferential 15 percent rate. All this computation finds the saving vehicle that generates the lowest lifetime taxes and, therefore, the highest sustainable living standard or spending capacity.

Kotlikoff examined single and married, low-, middle-, moderate-high, and high-income households in which all adults are currently age 35, live in Ohio, and have one 7-year-old child. Earnings are assumed to keep pace with inflation.

Each household owns a house worth three times the household's annual earnings. (Let's assume they bought the house in the pre-bubble era and live in Lima, Ohio, one of the nation's most reasonably priced housing markets, according to the Center for Housing Policy.) Added on were property taxes, homeowners insurance, maintenance expenses, and a 25-year mortgage--all scaled to the value of the house. Finally, each household spends 15 percent of its earnings on four years of college tuition for the child.

Each adult has initial regular assets equal to a year's earnings, has no 401(k) balance, and earns a 7 percent return on regular and retirement-account assets. The assumed inflation rate going forward is 3 percent, so the 7 percent return represents a real return (return after inflation) of 4 percent. Kotlikoff also incorporated a 30 percent hike in federal and state income taxes starting at age 65 when the households reach retirement. That's what the freight is likely to be to pay down budget deficits the U.S. is now incurring.

Kotlikoff considered contributions to either 401(k) plans or Roth IRAs equal to 10 percent of each adult's earnings until retirement. That is below the current 401(k) limit of $14,000 for each individual considered. (The limit for those over 50 is currently $18,000.) On the other hand, it's above the current $4,000 Roth IRA limit for the moderate-high and high earnings households. But Kotlikoff considered 10 percent Roth contributions for those households as well to preserve comparability of the findings.

To maintain an apples-to-apples comparison, Kotlikoff assumed no employer match of 401(k) contributions. Yes, most employers offering 401(k)s make matching contributions. But in a competitive labor market, those who don't contribute to an employee's 401(k) have to offer higher wages, so the employer contributions would be a wash.

What we found

The tables compare the spending power per adult and the taxes of the sample households at ages 35 and 65 if the households save on their own, save within a 401(k), or save within a Roth IRA.

Let's consider the middle-income couple. If they save on their own, the household's living standard or spending power per adult in 2005 is $19,173. This is what the wife, for example, would have to spend, were she living completely alone, in order to enjoy the same living standard as she does in the household. Of course, the wife is living in the household with her husband and their child. So total spending by the household is more than $19,173. But it's not three times bigger, given economies of shared living and the fact that children are assumed to be cheaper than adults.

So what happens if the couple now sign up to make 10 percent contributions to a 401(k)? They are forced to lower their current spending capacity to $17,601 to make the contributions. This is the downside of saving a lot in a 401(k). The upside is that penny-pinching when young raises the household's spending power to $23,624 when older.

But there's a trade-off. Participating in the 401(k) lowers the couple's taxes when young by a lot--$1,385-- but also raises their income taxes when old from $0 to $3,168. But that raises another question. Over time, is there a tax savings, and if so, how big is it?

When Kotlikoff separately calculated the tax benefit, he found that the household's annual spending power would rise to $19,477 each year, only $304 higher than the original living standard of $19,173. So the 401(k) tax break makes a difference, but not a big one. Conclusion: The 401(k) tax benefit is not nearly as important in raising future living standards as is lowering your current spending to save for the future.

This no-gain-without-pain trade-off holds even more strongly if the couple contribute not to a 401(k), but to a Roth IRA. In this case, the couple's living standard drops even further at age 35 (because they can't deduct their contributions), and they enjoy even greater spending power in retirement (because they pay no taxes on their withdrawals).

Does the Roth IRA beat out the 401(k) when taking into account all the tax savings? The answer is no. Kotlikoff separately calculated that each adult in the household would enjoy a living standard of $19,310 per year, $167 less than if they'd invested in the 401(k).

The requirement of sacrificing now to have a better life when old holds for the other households as well, including those that are single. What's different is the size of the tax benefit, which Kotlikoff figured in another exercise. In the case of a high-income single person, for example, the tax break for contributing to the 401(k) is a 5.4 percent rise in living standard. In contrast, the corresponding tax break for the low-income single household is only 1.1 percent. Clearly, the 401(k) tax break is a much better deal for those with higher incomes. The same is true for the Roth IRA.

Speaking of the Roth, how does it compare, in general, with the 401(k)? It requires you to make a bigger cut in your spending capacity when young and produces almost the same tax benefit, but at the same time, the Roth insulates you from future tax hikes.

What to do

As with most choices in life, this one isn't easy. If you're a low- or middle-income working household, you're probably paying off a mortgage, feeding little faces, and sending older kids to college. You don't have a lot of free cash just waiting around to be put in a 401(k) or a Roth. The 401(k), however, does have the advantage of forcing you to put something aside for retirement. And if your employer matches your investment, your return is that much greater.

If you would like to have a hedge against future tax hikes, then you'll want to invest in a Roth; however, you'll probably have to set up your own automatic investing plan with a mutual-fund company or another institution to enforce your saving discipline. If you can make the sacrifices in your current living standard, you'll be happy you did 30 years from now.

If you are in one of two of the higher income groups, you'll probably look at our tables and figure that the Roth is a much more powerful vehicle than a 401(k). However, it may not go as far in creating spending power because you can only put in so much fuel--a maximum of $4,000 annually.

So your strategy should be two-pronged. You should invest the maximum you can in a Roth IRA. Then you should plow into your 401(k) at least enough to get the full employer match.

Contact: Consumers Union of U.S.