Four Ways to Save for Your Retirement

Until now, you typically faced a three-way choice in how to save your earnings for retirement: you could put money away in your 401(k), you could use a Roth IRA, or you could opt for a traditional IRA. Beginning in 2006, your employer might begin to offer a fourth means of saving through the new Roth 401(k) plan.

Investing in a 401(k)

No doubt, your 401(k) has some attractive incentives. By contributing pretax dollars, you reduce your total taxable income. In addition, if your employer matches your contribution, you are getting "free money" that should you not turn down. Also, contributing through a payroll deduction makes it easy to save.

Your 401(k) gives you an immediate tax break. The money you contribute now saves you on taxes paid now. However, you will be required to pay taxes on any money withdrawn in your retirement.

Investing in a Roth IRA

In contributing to a Roth IRA, you contribute post-tax dollars; you pay taxes on your income as usual, and then you set aside a portion of your net earnings. It may prove to be more difficult for lower-income workers to set aside an equivalent amount of post-tax dollars as they could pretax dollars, and employers do not typically match Roth IRA contributions. These considerations aside, Roth IRA funds are not taxable when withdrawn during retirement. Every penny in your Roth IRA account is yours to spend once you reach age 59.5, assuming that your account is at least five years old. Therefore a Roth IRA gives you a tax break when you retire.

Investing in a traditional IRA

Traditional IRAs are, overall, an inferior product to a Roth IRA; they are often used as an account into which money from a 401(k) is rolled over when a worker leaves an employer.

When should I use a Roth IRA, and when should I use my 401(k)?

The answer to this question depends on three factors:

1. Your current tax rate
2. Your expected tax rate at retirement, and
3. The length of time for which you have been investing. It also depends upon your own preferences for investing.

If your tax rate remains steady from now through your retirement, investing in a Roth IRA makes sense and will provide you with more disposable income than will investing in a 401(k). However, tax rates rarely remain stagnant, and your best bet is to take your tax break when your tax rate is at its highest: if you will be in a higher tax bracket now than at retirement, invest in a 401(k); if you will be in a higher tax bracket at retirement than you are now, invest in a Roth IRA.

Of course, the problem with this simple solution is that it is next to impossible to predict your future tax rate. While you might be tempted to assume that you will find yourself in a lower tax bracket in retirement for the simple reason that you are earning less, think again. Any money withdrawn from your 401(k) will count as income, as will any money earned in a part-time job, should you choose to have one. Additionally, even if you do earn less income, there is no way to predict what Congress will do with the tax rate. A hefty increase in future taxes could put you firmly in a higher tax bracket than you are now, even at a lower income level.

Tax rates aside, as a general rule, the longer you plan to invest, the better of an option a Roth IRA becomes because any long-term growth is yours to keep.

If you are looking for options, a Roth IRA is more your style. While any options in 401(k) plans are determined and controlled by your employer, Roth IRAs can be established with a multitude of investment companies, and funds can be invested in an almost limitless array of bonds, certificates of deposit, stocks, mutual funds, and real estate, commodities aside. In addition, with a Roth IRA, you will not suffer mandatory withdrawals. In contrast, with a 401(k), you will be required to withdraw a certain amount annually once you turn 70.5. If you do not need the cash, mandatory withdrawals could be a problem when you find yourself entering a higher tax bracket because of them.

Finally, if you plan on receiving social security benefits, remember that any withdrawals from a 401(k) will count as income and might qualify you to pay tax on your social security benefits. In contrast, Roth IRA withdrawals do not count as income.

At this point, you might be asking why you should contribute to your 401(k) at all. The 401(k) does have some advantages over a Roth IRA, first and foremost of which is your allowable contribution level. Beginning in 2006, if you are under 50 years of age, you can contribute up to $15,000 to your 401(k). Those over 50 can contribute up to $20,000. Compare this to contribution allowances of a Roth IRA: $4,000 for under-fifties, and $4,500 for over-fifties. In addition, funds in a 401(k) can be borrowed at no interest, while any funds withdrawn from a Roth IRA cannot be replaced.

Investing in the new Roth 401(k)

Prior to 2006, this discussion would have ended here. However, in January, some companies will begin to offer a fourth retirement option: the Roth 401(k). The Roth 401(k) is, in a sense, a combination of the 401(k) and the Roth IRA, and it takes the best features from both.

Like a traditional 401(k), a Roth 401(k) allows contributed earnings to grow tax-free, but like a Roth IRA, contributions come from post-tax dollars, and therefore any withdrawals made upon retirement are not taxable. While contributions are not matched, the maximum you can contribute to a Roth 401(k) is much higher than what you can contribute to a traditonal Roth IRA: $15,000 if you are under age 50, and $20,000 if you are over 50.

So now, in which plan should I invest?

The rules remain largely the same. If you believe that your tax bracket will be higher in retirement than now, invest in the Roth 401(k). If you believe that it will be lower, stick with your traditional 401(k). However, the uncertainty remains the same as well.

Most experts agree that the simplest solution to this dilemma is to not put all your nest eggs in one basket. Maximize your traditional 401(k) matched contributions (don't turn down the free money) while also contributing to a Roth 401(k).