Employers are slowly shifting more responsibility for retirement savings onto you, the employee. This means you must educate yourself by exploring your retirement savings options, weighing the benefits and drawbacks of each as they pertain to your personal financial situation and choosing which options are the best for you.
Traditional 401(k)s and 403(b)s
With both traditional 401(k)s and traditional 403(b)s, a company contracts with a third party to manage the retirement plan for its employees. Employees elect to have a portion of their payroll deducted before taxes are taken out, and this amount is deposited into their account. Contributions and earnings grow over the employee’s career and are taxed when withdrawn from the plan at a later date.
The deposits to the account are invested in mutual funds, annuities, Real Estate Investment Trusts, or any other investment vehicle offered by the plan provider. 403(b) plans can only be offered by non-profit institutions like schools, hospitals, charities, and research institutes.
Roth 401(k)s and Roth 403(b)s
Newcomers to the slate of employer-offered retirement plan options are the Roth 401(k) plans and the Roth 403(b) plans. Both are hybrids of a Roth IRA and a traditional 401(k) or 403(b). Unlike the traditional plans, the Roth plans enable participants to contribute after-tax salary dollars. Contributions and earnings then grow and are not taxed when withdrawn from the plan (subject to certain restrictions). Unlike Roth IRAs, Roth 401(k)s and Roth 403(b)s do not limit participation based on income.
After getting off to a slow start a couple of years ago, the Roth 401(k) and 403(b) plans are beginning to pick up momentum. More companies have started to offer the Roth plans and many firms that don’t yet provide this option are considering adding it in the future.
General Benefits of Employer Plans
One of the benefits of all these employer plans is that contributions move out of your paycheck and directly into your savings plan, avoiding a dangerous stop in your checking account where, all too often, money is spent elsewhere instead of saved.
Another benefit of employer plans is that most companies offer matching of the employee’s contributions. It is important to note: any employer-matching contributions go into a traditional 401(k) or 403(b) account, even if you elect to contribute to the Roth 401(k) or 403(b).
The Role of Tax Rates
Another rule of thumb to consider is whether you expect to be in a higher or lower tax bracket upon retirement.
- If you expect to be in the same tax bracket or higher at retirement, you would want to pay the taxes now – so the Roth 401(k) or 403(b) would make sense.
- If you expect to be in a lower tax bracket at retirement, you would want to pay taxes then – so the traditional 401(k) or 403(b) would make sense.
However, it is worth noting that your actual situation in retirement may differ from what you expect, due to a variety of possible factors, including how much money you may be drawing in retirement from taxable sources, the amount of interest and capital gains generated in taxable accounts after retirement, how much earned income you continue to generate, and the effects of ever-changing tax laws.
Roth IRA Estate Planning Benefits
One of the biggest benefits of a Roth Individual Retirement Account (IRA) is you never have to pull the money out and it can be passed along to your heirs income tax-free. While required minimum distributions must be taken from Roth 401(k)s and Roth 403(b)s beginning at age 70½, you can avoid these by instead rolling the money accumulated in the Roth plan into a Roth IRA and leaving it there. This is easy to do.
Upon your passing, the assets can be merged into your spouse’s name and the spouse will not be required to take draws during their lifetime. Upon the spouse’s death, the assets can go to the next generation. At that time, heirs will be required to draw the assets out of the account, but on a schedule based on their life expectancy. By following this path, a dollar saved today could potentially grow undisturbed and free of taxation for a very long period of time.
Split the Difference, or All In?
If you think the Roth 401(k) or 403(b) sounds attractive, but you’re not ready to go all in, consider splitting your contributions. If you contribute the maximum amount for 2008, you might put half of that amount into both plan options, or favor one account over the other, depending on your circumstances and your outlook. This strategy allows you to hedge your bets and gives you more room for maneuvering as needed in retirement to best manage your taxes.
In the end, the Roth 401(k) or 403(b) option may be attractive to:
- Younger savers in lower tax brackets
- Those who currently have Roth IRAs and want additional after-tax savings growth
- Savers wishing to maximize flexibility when drawing on retirement savings in the future
- Highly compensated employees
- Savers wishing to diversify potential taxes in the future
As with any significant financial planning decision, contact your personal tax professional, accountant or financial advisor for more information.