Is Your 401(k) Still the Best Savings Vehicle for You?
Congress began 401(k) programs almost 25 years ago. In that time, many people have worked, saved, and pinched in an attempt to contribute as much as possible into this tax-deferred investment program. However, along with changing times, new tax laws and an increasingly dismal federal fiscal outlook might make your 401(k) investments less than optimal. Saving through a Roth IRA, or even on your own, might be better, depending upon your personal financial situation.
A recent study has suggested that a bright retirement outlook depends more upon your willingness and ability to save more money sooner than it does upon the tax benefits afforded through work-related retirement savings programs. While tax benefits are still an attractive feature of these programs, the wealthy will realize more tax savings than the not-so-wealthy, and for both, tax benefits are not nearly as strong as they were in the past.
Tax benefits gained from tax-deferred retirement programs have dwindled
At one time, the 401(k) and the IRA were the only retirement savings programs offering significant tax breaks; however, additional players have since joined the game, for example, the Roth IRA. While the Roth IRA does not offer any tax breaks upon contribution, it does allow you to withdraw funds, upon retirement, on a tax-free basis. Contributions to a Roth IRA can be made up to $4,000 per annum ($4,500 for over-fifties) by those with an adjusted gross income under $150,000 joint or $95,000 individual.
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In addition to the Roth IRA, saving on your own has become increasingly more attractive. If you invest your savings in the stock market, you can expect to pay a fixed rate of 15 percent in taxes on capital gains. Compare this figure to the approximately 30 percent you will pay in regular income tax on any withdrawals from your 401(k), even if identical stocks are held in the 401(k). With the income tax expected to increase substantially in the future owing to the present large deficit and the war in Iraq, this gap could easily widen. In fact, the predicted future tax hike could mean financial loss for any assets invested in your 401(k), whether stocks or cash.
While we're discussing taxation as it applies to your 401(k), we should also mention that withdrawals from your 401(k) will count as regular income in your retirement. If you are looking forward to social security payments, consider that an increased income will result in heavier taxation of your social security benefits. However, withdrawals from a Roth IRA are not considered income; your social security payments would be left, for the most part, alone.
Study results suggest savings strategies
A recent study comparing low-income, middle-income, upper-middle-income, and high-income families with statistically average financial obligations (mortgage, child, suburban residence, etc.) using a 401(k), a Roth IRA, or private efforts to save suggests that your income level might dictate the best savings strategy for you. In general, the study found that while contributing to a Roth IRA will diminish your spending power now and will provide similar tax benefits as a 401(k), you will be shielded from the tax increases predicted for the future. At the same time, contributing to a 401(k) will give you more spending power during your younger years.
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The study also suggests that your income might determine the best means of saving. For example, for middle-income households, the 401(k) and the Roth IRA are comparable barring future tax hikes, but the 401(k) has the benefit of making saving less cumbersome through automatic payroll deductions. For higher-income families, the Roth IRA seems to be the better option all around, except for the low maximum contribution.
The choice is yours, but make it an educated choice. Better yet, consider maxing out on your Roth IRA and then contributing as much as you can to your 401(k) so you can cash in on your employer's matching contribution.