Pension Bill to Offer Savers More Options
Saving for retirement may soon become easier--and a lot more complicated.
The Comprehensive Retirement Security and Pension Reform Act passed the House by an overwhelming margin this month and is being debated in the Senate. Under the bill, annual contribution limits for individual retirement accounts--both Roth and traditional IRAs--would more than double to $5,000. Contribution limits for 401(k) plans would rise by more than 40% to $15,000.
In addition, the bill would create a new type of 401(k) plan that would work like a Roth IRA. The proposed “Roth 401(k)” wouldn’t provide an upfront tax break as the current 401(k) plan does, but distributions at retirement would be tax-free, as they are with a Roth IRA.
“People are going to have a lot more opportunity to save in the way that suits them best,” says David L. Wray, president of the Profit Sharing/401(k) Council in Chicago.
Yet for those with a limited amount of cash to save, that raises a vexing question: Which option would maximize after-tax income in retirement?
“It’s hard to be prescriptive about something as personal as retirement,” says Diane Savage, retirement consultant with Watson Wyatt Worldwide. “You have to step back and evaluate what you have done to this point and why, and then identify the best thing to do going forward.”
Though there are a few general rules, concocting a balanced “meal” from the complicated menu of retirement choices requires you to consider your age, assets, current income and how much you expect to earn in retirement. The terms of your company retirement savings plan also can play a pivotal role.
One thing is almost always true: If you save through a company-sponsored retirement plan--that’s a 401(k), 457 or 403(b)--and your employer matches at least part of your contribution in cash or company stock, you should always save there first.
Employers typically contribute 50 cents for each dollar an employee saves, up to certain limits, Wray says. Because the money is taken out of your paycheck on a pretax basis, saving in a 401(k) reduces your tax bill.
Consider: Each $100 contributed monthly to a 401(k), 457 or 403(b) by someone in the 30% marginal tax bracket reduces the saver’s paycheck by just $70. But if the employer matches contributions at a 50% rate, the amount going into that account each month rises to $150. Net return on this saver’s out-of-pocket cost: 114%. And that’s before the money is invested.
“Company money is better than a tax benefit any day,” Wray says. “Never leave company money on the table.”
Only about half of U.S. workers have access to company-sponsored defined-contribution plans, however, and not all employers match contributions.
If there is no employer match, other factors come into play. For instance, 401(k) plans are a little more flexible than IRAs because you can usually borrow against your account.
On the other hand, if your 401(k) plan features a roster of lousy investment options, choosing a traditional IRA might make more sense because it gives you the freedom to invest your money wherever you want.
The tougher question is whether individuals should take their tax benefits today by opting for the upfront deductions of a traditional 401(k) or traditional IRA, or whether they should take the tax benefits later by choosing the Roth IRA or the proposed Roth 401(k).
The benefits of upfront deductions are obvious--they reduce the amount of income subject to taxation and, hence, the amount of tax you have to pay.
However, Roth-style plans allow savers to withdraw principal before retirement without penalty, whereas a permanent withdrawal from a traditional IRA or 401(k) would be taxed and bring a 10% penalty.
In addition, Roth plans give savers more flexibility when withdrawing money at retirement. Participants in traditional IRAs and 401(k)s must withdraw set amounts after age 70 1/2. With a Roth account, you can withdraw your money or leave it alone--it’s up to you.
Yet the pivotal factor in determining which type of plan is the best choice is your tax bracket, Wray says.
Because traditional retirement accounts allow you to take tax breaks today whereas the Roth method makes you wait until you retire, you must decide when those tax savings are likely to be most lucrative. That’s primarily a function of the tax rate you’re paying at the time.
This is tricky, because you’re guessing about the future. But generally, if you’re young and a dedicated saver, but you’re in a low tax bracket, the Roth IRA should prove to be the better deal because you’ll get your tax breaks in the future, when you’re likely to be wealthier and paying higher taxes.
However, if you’re middle-age and earn a lot today, but don’t have a lot of money saved for retirement, the upfront tax benefits of a traditional IRA or 401(k) probably will be worth more to you.
Why? Your income will probably drop in retirement, which would put you in a lower tax bracket. Meanwhile, the upfront tax breaks are worth more to higher earners and may, in fact, make it possible to save more.
Here are two hypothetical examples, assuming the retirement bill becomes law:
Ann, 25, earns $30,000 annually. She’s a serious saver who plans to retire at 65. She decides to put away $5,000 each year.
If she chooses a 401(k) or traditional IRA, she’ll save $750 in federal income taxes--15% of her $5,000 contribution. The net out-of-pocket cost of her $5,000 annual contribution is reduced to $4,250.
When she reaches 65, she will have $2.63 million in savings, assuming she earned an average of 10% on her savings each year. She wants to spend all her savings and figures she’ll live to age 95. She will earn less on her savings while withdrawing the money--we’ll assume 5%. Bottom line: She can withdraw $14,145 per month, or $169,745 per year, from her savings.
Any company pension or Social Security income she receives will come on top of that. Assume that she’ll pay tax at a 36% marginal rate. That will cost her $5,092 per month in federal income tax, making her after-tax monthly income $9,053.
What happens if she saves through a Roth IRA? Her out-of-pocket costs are higher because she’s contributing after-tax dollars. To make the comparison equivalent, we’ll assume that means she can save only the after-tax cost of $4,250 per year.
After 40 years, she has $2.24 million saved. For the next 30 years she can withdraw $12,024 per month, or $144,283 per year. All that income is tax-free.
The bottom line: Ann has $2,971 more after-tax income each month by using a Roth account.
Janet, on the other hand, is 55. She’s earning more than $100,000, but she’s just starting to save for retirement. Assume she can make an annual $15,000 contribution to either a traditional 401(k), getting an upfront tax break, or a Roth 401(k), deferring the tax break until retirement.
Which is better? In this case, the traditional 401(k).
The analysis works the same as Ann’s, except Janet is currently paying 31% of her income in tax. And because she has saved so little, she’s likely to drop a tax bracket or two in retirement.
Assuming she contributes $15,000 to a traditional 401(k), her after-tax income declines by just $10,350 because of the upfront tax deduction.
When she retires at age 65 she will have $256,056 (assuming a 10% average annual return). That sum will allow her to withdraw $1,374 in monthly income over a 30-year period, again assuming a 5% rate of return in retirement.
That income is taxable, but even after assuming that she gets some Social Security, she still lands in the 15% federal income tax bracket. That means she keeps $1,168 a month after tax.
If Janet instead invested in a Roth 401(k), and she can afford to save only $10,350 per month (her after-tax cost in the above example), at retirement she will have $176,679.
With the same return assumptions, her tax-free monthly income over 30 years would be $948--about $200 less than if she used the traditional 401(k).
As these examples indicate, “There is no one-size-fits-all answer,” Wray says. “It’s about finding the right answer for you.”
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Retirement Savings Bill
Formal name: Comprehensive Retirement Security and Pension Reform Act of 2001
Sponsors: U.S. Reps. Rob Portman (R--Ohio) and Benjamin L. Cardin (D--Md.)
Status: Passed the House May 2; awaits hearing by the Senate Finance Committee.
Main Provisions
* Boosts yearly contributions limit for IRA and Roth IRA accounts to $5,000 from $2,000.
* Raises annual contribution limit for 401(k) plans to $15,000 from $10,500.
* Allows persons 50 and over to make bigger “catch-up” contributions to retirement plans.
* Makes 457 and 403(b) plans more flexible. (These plans are available to public employees, teachers and employees of nonprofit organizations.)
* Makes it easier for companies to offer retirement plans and for workers to roll one type of retirement account into another.
Source: Times research *
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