Wednesday, December 28, 2005

401k Versus Roth - A New ER Ratio!

So you are one of those people who can afford to save some money, but you are bewildered as to which investment vehicle will be your best bet... pre-tax 401k or post tax Roth IRA. I hate to break it to you but there is no 'one size fits all' answer.

Before I get into the decision discussion, I need to make sure you are ready to make such a decision. Make sure you are doing the following...
  • You should be contributing enough to your company's 401k to get the company match. This is free money and usually a great deal. My company will contribute 4% of my salary if I put 5% or more into my 401k... that's a risk free 80% return on my investment!
  • Your non-mortgage consumer debt (credit cards, car loans, etc.) should be at interest rates below the average return for the market (8-12%). If you are paying 18% interest on your CCs, use your extra money to pay-off that debt.
  • You are spending less than you earn.

OK... so we're talking about whether you should invest your money in a 401k or Roth. Let's make sure we're all on the same page as to our definitions of each account:

401k

  • employer sponsored
  • pre-tax contributions- that means no federal, state or social security taxes are withheld from your earnings if they are contributed into this account
  • tax deferred - you don't pay taxes now - but when you withdraw this money, it will be taxed like normal income
  • $14,000 annual contribution limit (more for older folks)

Roth IRA

  • you can pick one up at your broker or bank
  • income limits - if your AGI exceeds $150k (married), you cannot contribute
  • post-tax contributions - you use money from your after tax earnings to fund this account
  • tax free earnings - you will not pay any earnings on the investment gains if you wait to withdraw the money in retirement

Both of these investment accounts have a bunch of restrictions and rules which are important but won't be covered in this article. Read your plans' rule carefully, blah, blah, blah.

So... I've worked-out the math on which account is more advantageous. It's easier than I thought it would be:

x= marginal tax rate today

y= marginal tax rate when you retire

TERRAR (The Early Riser Retirement Account Ratio) = (1-x) / (1-y)

TERRAR tells you the after-tax value ratio of a tax-free Roth compared to a tax deferred 401k. If the TERRAR is <> 1, you should go with the Roth. Let's do an example...

x= today's marginal tax rate = 28%

y= retirement marginal tax rate = 15%

TERRAR = (1-0.28) / (1-0.15) = 0.72 / 0.85 = 84.7%

This would tell me that my after-tax R0th balance would be 15.3% less than my after-tax 401k balance.

Easy... right? Well, you ask, how do I know my marginal tax rate when I retire? Good question. For the older folks in the audience, you should estimate your annual retirement income and look at the current tax tables. For those of us who are 20 or more years away from retirement, you have to be a fortune-teller.

I personally believe that when I retire (2040 or so), taxes will be less than they are today. This is especially the case if you believe the Singularity is near.

Ratio - smatio you say... give me some practical advice! OK... here's where I would put my money in descending order:

  • Employer Stock Purchase Plan - slam dunk if the terms are favorable
  • 401k to get employer contribution - you should put enough in to get the employer match
  • pay off all debt is APR over 10%
  • split remaining $ between 401k and Roth

Remember, everyone's financial situation is different. There are significant estate impacts to these different investment vehicles. If you are unsure about what to do, go find yourself a fee-only financial planner to work-out the numbers.

Related Posts

Kiddie Tax 2006 , I Love Dividends , Investment Newsletter Review: Prudent Speculator, Employee Stock Purchase Plan

10 Comments:

At 9:02 PM, Anonymous Anonymous said...

For Young people,you posit too many choices. I'm 70, and not much of a typist. My wife and I have had: civil service pensions, social security, 401K's, 403 b's, 457 plans, and most importantly, ZERO DEBT after age 55...so some strictly taxable, personal, private investments.

First reduce debt - pay yourself - eye candy makes your economic condition constipated.

Second, any match is found money...an immediate return unmatched by markets and interest rates.

Third, time is on your side: 30 years ago, I put ca. 40 k total into TIAA ... it pays me that for ten years = a 10 year 10x return due to the time value of compounding. {I didn't have time to research stocks then, too busy as a non-tenured academic.)

4th, learn to use a graph paper for repeat investments: draw a trend line if repeated deposits are being made to a substantial stock/fund investment. Buy LOW.
If an average 3-5 yr rate of return for the fund is 9 - 11 %, don't buy when the price is > 15% above the trend ... as it often is when year end distributions are made. Buy when the fund is below its long term-trend. So-called dollar-cost-averaging during a run up can be very costly after a downturn. Besides, this way you might actually learn about your investment's alpha, beta and r-squared.

Fifthly, and most importantly for the next decade: Commodities are on a worldwide tear ... particularly industrial metals, coal, timber and not necessarily -gold/oil. Fertilizer is more important to poor people than iPods. There are more poor people each year than wealthy ones. Barring a meteor strike or magmatic cataclysm, try to get some real asset investments that pay dividends in your tax-sheltered accounts.

Finally, all the deferrals and advantages of sheltering are not worth it if you aren't an optimist...money market returns haven't kept up with the rise in healthcare costs, let alone gasoline. I'm not advising starting with IPO's or penny stocks, but diversify your investments out of the US economy...more than you're aware, there's a whole other world out there for really decent investments.

 
At 2:39 PM, Anonymous Anonymous said...

Great post and comment. I have maybe 2000 in cc at like 28%. Im planning on calling to get it down cause I know my credit is better than years ago. I read somewhere that the average cc is 13.9%. What can I realistic expect to be able to talk them down to, 10% is that possiblie?

I like the graph idea and getting more into the numbers? You guys accountants? Is there a tool on the web that will do that graphing? I have fidelity and vanguad accounts for iras 401ks but neither does like a graph of my personal data.

Thanks Im saving this link.

 
At 5:13 PM, Blogger Early Riser said...

A,

28%!!! Holy crap!! Call your cc company and tell them that you have a 12 month 0% balance transfer offer from Capital One in your hand. Play dumb and ask them how you can transfer their balance to this new card. Make sure to act very nice. My guess is that they may match the fictional Cap One offer.

If not, you should be able to get a card much lower... just use bankrate.com to look for available deals.

Either way, pay off that card!

Don't worry about graphing... this is called market timing and it doesn't work. Just make sure you are contributing enough to your 401k to get the employer match.

 
At 12:52 PM, Blogger Paul Paulson said...

Hi, I was on a blog carnival and saw your article. I am the webmaster of http://moneykeg.com and blog at http://moneykeg.blogspot.com. I wrote a piece on IRA accounts several weeks ago. Maybe you would like to check it out.

Also, I am looking for people to write articles under the "Recent Articles and Commentary" section on the moneykeg.com homepage. Do you have any interest?

Thanks.

PP

 
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At 1:24 PM, Anonymous PENNY STOCK INVESTMENTS said...

The roth is clearly better.

 
At 12:13 AM, Blogger Semen Rendi said...

This comment has been removed by the author.

 

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