If your goal is to put as much money as possible into your 401k then you best bet is to fully fund your Roth 401k. The IRS set the contribution limit for your 401k in 2009 to $16,500 and a $5,500 catch-up contribution if you are over age 50. The funny thing is that the IRS doesn’t differentiate between Traditional and Roth contributions. They are not equal.

With a Traditional 401k contributions are pre-tax which means that you don’t pay taxes today. So if you were to max out your Traditional 401k then you could contribute $16,500 or $22,000 if you are over age 50. Simple enough right?

Now is the fun part. If you were to contribute to a Roth 401k the limits are the same. Remember though, that this is post-tax contributions which means you pay taxes today before the money goes in.  So if you were to contribute the maximum of $16,500 you would really be putting aside even more income depending on your tax bracket. Let’s say you are in a 25% federal tax bracket. That would mean you would essentially be putting aside $22,000 of your income for retirement. If you were over age 55 that number would be about $29,333. My point is that it’s not apples to apples so make sure you are realizing how much you are contributing.

To take this one step further. You max out your 401k. Either way $16,500 goes into the account correct? It grows at about 7% for 30 years. Using the Rule of 72 we know that it will double every 10 years. So it doubles once to $33,000, twice to $66,000 and a third time to $132,000. Are you with me so far? Good. Here’s the key. If you have $132,000 in a Traditional 401k you still owe taxes on it, at 25% worst case scenario you really only have $99,000. Where as if you have $132,000 in a Roth 401k you really have $132,000.

If you goal is to put away as much money as possible for retirement then you should be taking advantage of the Roth 401k. If it’s not an option for you go to your HR or the owner of your company and ask them to make it an option. In most cases it can be added at no cost. If there are any questions please direct them to me.

One more side not, whether you contribute to the Traditional or Roth portion of your 401k, any employer match will be pre-tax so it will show up in the Traditional portion.

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I was talking with a teacher about this the other day so I thought I would share.  The teacher told me that him and his wife are no longer eligible to contribution to a Roth IRA so he figured he should start a 403b.  So then I mentioned a Roth 403b to him.  He then asked me what that was.  So I proceeded to tell him it works like a Roth IRA except that there are no income limits, higher deposit amounts and the school had an approved vendor list from which you had to choose.

This is a normal conversation I have with teachers.  I usually hear one of two things.  I was told to do a 403b and so I started funding one or that they contribute to a Roth IRA.  The Roth IRA can work great if you are eligible and you don’t want to exceed the contribution limits ($5,000 under age 50 in 2009).  So then let’s look at alternatives that especially come into play when a Roth IRA isn’t available.

Before we get there let’s look at what most people seem to do.  They hear from other teachers that they should contribute to a 403b and they do.  What they don’t realize is this decision might be hurting their pension.  Let’s look at it.  I’m going to use Massachusetts numbers because that’s what I am most familiar with.  The concept should work with most pensions.  So in Massachusetts teachers are contributing 11% of their salary into the pension program.  These contributions are made pre-tax so the teacher doesn’t pay taxes on the money that goes into the pension.  What this means is that when a teacher receives their pension the money is taxed as ordinary income.  A Traditional 403b works the same way, pre-tax contributions, fully taxable withdrawals.

Before January 1^st, 2006 the only other payroll deduct plan available to teachers besides their pension was a Traditional 403b.  So when people wanted to save for retirement that was the only option they knew about so they thought it was best.  Now times have changed.  There are more options available.  The biggest of these is a Roth 403b.  The biggest benefit of this is that the withdrawals are tax-free.

The great thing about the Massachusetts teacher’s pension is that they are probably going to receive 80% of their income in retirement.  You take that number and take away their extra tax deductions they might have today; they probably end up in the same tax bracket in retirement.  If on top of this you add a Traditional 403b then you are adding more taxable withdrawals.  This could cause you to be in a higher tax bracket if you are not careful.  This could hurt your pension income.  So learn about your Roth 403b options.  Ask your employer for their approved vendor list and which ones offer a Roth 403b.   Learn your options and more importantly ask questions.

Related posts:

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