Why Your 401K May Not Be that Great and What to Do About It

Jason — Tue, 06 Jul 2010 12:16:06 +0000

In general, the 401K is a great tool. Most people who invest for retirement start with their company 401K. And this is a great place to start. It’s easy, contributions are automatic, annual contribution limits are high ($16,500), and usually there is a company match (i.e. free money) to be had just for participating. But like any other retirement account, it has it’s flaws.

Lack of a Match

With the recent economic down turn, many companies ended the company matching contribution. For some people this meant a loss of income up to $16,500 annually. That stinks. So did people stop contributing? Surprisingly they haven’t. Studies have shown that this had little effect on whether people continued to contribute. But should it have? I say likely yes. Here’s why…

Limited and Expensive Funds

The vast majority of 401Ks have a limited amount of funds to invest in. This is because 401Ks are typically managed by one investment firm. For instance, if Fidelity manages your 401K, then you will get to choose from around 5-10 Fidelity mutual funds for your portion of the portfolio invested in stocks. Some Fidelity funds are great. But wouldn’t you rather have a choice of funds from Fidelity, Vanguard, Schwab, T Row Price, and other investment firms? Sure you would. The more options you have, the more likely it is that you will find a low cost fund to meet your needs. Review your company’s 401K expenses with BrightScope.com.

It May Not Be the Best Tax-Advantaged Account for You

Another reason to consider moving away from the 401K is because the Roth IRA exists. The Roth IRA and the 401K have exactly the opposite tax treatment. A Roth IRA uses after-tax dollars to fund the account, while the earnings grow tax free. When you do a qualified Roth IRA withdrawal, you don’t have to pay any taxes. This makes the Roth IRA a great product for young people, who will likely be in a higher tax bracket when they retire. Also, a Roth is also not tied to your employer, and can be opened at any mutual fund company, online stock broker, or even at a bank. Thus, your choice of funds and other investment products greatly increases just by using a Roth IRA.

To sum all of this up, if you have a company match with your 401K, at least contribute enough to get the full match. If, however, you are young, have limited choice with your 401K, and you don’t get a match, then strongly consider starting your retirement investing with a Roth IRA. Once you reach your annual maximum of $5,000, then go back and start putting money into the 401K. And who knows, maybe by then the match will return.

This post was provided by PT of ptmoney.com.

Convert to a Roth IRA in 2010?

Jason — Tue, 17 Nov 2009 13:03:15 +0000

Retirement planning is an important part of managing money wisely. I think it’s necessary to build retirement through a long-term investment plan once certain financial goals have been met (emergency savings, out of debt, etc.). Retirement is what I like to personally think of as what will be my elderly working years. I want to be prepared to live on less and still work either part-time or on a volunteer basis to continue my mission of helping people manage money wisely.

Roth IRA Conversions in 2010

An article in Business Week, related to Roth IRA conversions recently grabbed my attention. Starting in January of 2010 there will no longer be an income limit on Roth IRA conversions. Currently, your AGI or Adjusted Gross Income cannot exceed $100,000 if filing single or jointly in order to convert your investment. You will also be able to spread income taxes owed on the withdrawal across 2 years.

Some benefits of the Roth IRA

As you may know, the Roth IRA can be an excellent retirement investment option. The key benefit with the Roth is tax free growth. You pay taxes going in today versus when you withdraw money in your retirement years. Another benefit is you can withdraw money without minimum required distributions given certain requirements are met.

Roth IRA conversions

What is a Roth IRA conversion? A conversion is withdrawing your investment from another retirement vehicle such as a 401k or traditional IRA. You pay income taxes on the amount withdrawn, and convert your investment over to the Roth IRA to gain the advantages mentioned above.

The article asks the question as to whether or not it makes sense to dip into 401ks, IRAs, and other retirement investment tools and pay taxes now by turning them into Roth IRAs. This is a good question as the approach could help save money in future taxes.

When does a Roth IRA conversion make sense?

Based on points made in the article and a quick review of Fidelity’s IRA Center, it may make sense in the following situations:

If you have additional savings to pay the income taxes. Otherwise, if you use part of the investment withdrawn, you’re reducing the amount that can grow tax free in the Roth IRA.
If you expect your tax rate to be higher in retirement. If you expect your tax rate to be higher in retirement you would obviously want to pay taxes on your investment now.
Fidelity says if you have 10 years or more before you start taking withdrawals a conversion is likely to benefit you.

If the above aligns with your situation, one bit of advice from the article is to play with the numbers. If you only have partial savings to pay taxes, consider withdrawing and converting less.

In regards to paying the income taxes with savings, I don’t think it’s a good idea to pull this money out of emergency savings. I would keep that money in place and only use cash savings on top of 3-6 months of covered living expenses.

I recommend speaking with a financial and/or tax advisor about this new rule and how it directly affects your situation.

What are your thoughts on the new conversion rules?

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