9 March 2009
Traditional vs. Roth 401(k) – Complex? Of course not…
Being a financial advisor has to be one of the hardest jobs around, especially in these times. My company offers a 401(k) plan through John Hancock. Recently, they decided to add on the option of Roth 401(k) that we can contribute to as well. The advisors came in and conducted a company-wide meeting to introduce and explain the new plan. I have a fairly good undesrtanding of financial instruments, but some of the minute details of the tax benefits/detriments of the two types of plans are mind-boggling. I can only imagine that after the meeting, they had a line of twenty-somethings with questions, who did not have a good financial education and didn’t understand a word of the meeting. Let me give you an idea of what I mean and some of the information that I took away.
As many of you know, the main benefit of a Roth vs. Traditional account is that the Roth is taxed now, so that when you withdraw funds, you won’t be taxed at that time. With a traditional IRA or 401(k), you receive a tax benefit now but you have to pay the taxes when you withdraw. The assumption is that tax rates will continue to go up over the years, so it’s better to be taxed now, than when you retire. Those are the basics, but there is a lot more to it.
My company happens to match contributions, up to 5% of my salary. Even if I choose to move all of my contributions to the Roth option, the company match will continue to go into the traditional sub-account and be taxed at withdrawal. If I contribute $100 now per paycheck, I will still contribute $100 per paycheck with the Roth, but since it is after-tax dollars, I will actually have $115-120 removed from what I receive. So my paycheck will actually go down now. The company match will also be $100, but since it’s going into a taxable account, it is actually worth less when it comes to retirement time.
On major benefit is that if I contributed $100,000 over my working career and it earned another $50,000, then I won’t be taxed on the gain either. Oh, there are exceptions though. If I haven’t been contributing for at least 5 years, or if I’m not over 59.5 years old, then I’ll have to pay taxes on the gain, but not my contributions. Not to mention a 10% penalty for early withdrawal, but that’s the same as a traditional.
I say that being a financial advisor is tough because you really can’t answer people’s questsions. In general, no matter what is asked, you have to respond generically and vaguely. Their training must contain a section on these key phrases:
- “it depends on your situation”
- “we’d have to sit down with you and look at that individually”
- “only you can determine what is the best decision for you”
- “no one can predict what the market will do, but…”
- “although it looks bad now, I can say with almost certainty that the next 5-10 years will show an improvement”
Please, feel free to contribute to my list in the comments below. I’m sure there are about a dozen more of these types of phrases.
It would be so much easier to make decsisions if we could just predict the market. Also, if the tax rules were a little less complex perhaps, it would help. So if anyone out there wants to tell me what to expect over the next 30 years, then maybe I can make an informed decision regarding what to do with my funds. Otherwise, I may have to put my election form on the wall and let a dart decide my future.
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5 Comments currently posted.
Chris Sumpter says:
Ken Lanning says:
Yes, a comsumption tax seems more fair, but if not that, then a flat tax with no loop holes. I think everyone needs to contribute.
I need to you blog about how to get motivated to go see the financial planner about 529 plans.
matthew says:
My company tricked me into starting a 529 plan. When my son was born, they gave me a check for $500 that was already made out to LearningQuest. Thus, I had to open an account and set up a monthly contribution or throw the $500 in the trash. Sneaky little things aren’t they…forcing me to save for my children’s education.
Chrisitna says:
So are you going to be my financial advisor?
matthew says:
Ummmm…no. I don’t want to get sued
I’m wishing for a consumption tax instead of an income tax, but I think it’s highly unlikely. I don’t pay much tax now, but I still use a Roth IRA because I like the idea of my investments growing tax-free. I’m not planning on taking them until retirement so it’s not a big risk for me to leave them there long-term.