Advice on Retirement Plan

[parafly]

Hi All,

I graduated college last year, and now that I have been with my company for almost a full year, I will be eligible to take part in their 401(K) plan in a couple of weeks. Unfortunately, my company's 401(K) program is pretty bad, and they only match a maximum of $250 / year.

So, here is my plan. I want to contribute 1% of my earnings (pre-tax) to an agressive fund within my 401(K). This will allow me to earn the $250 match provided by my company. At the same time, contributing only 1% toward my 401(K) will allow me to save more money to put towards a Vanguard Roth IRA (specifically, the 2045 Retirement Fund).

Would this be a good way of investing toward my retirement? Or should I put more towards my 401(K) and bring more balance between contributions to Roth IRA and 401(K)?

Thanks.

[sweeps]

My $.02, your strategy is right-on. If your 401(k)'s funds stink, put in enough to get your match and devote all you can to your Roth.

[bama20]

very good strategy. free money is free money.

[TBH]

I concur. Your strategy is great, unless you think you might not be disciplined about funding your Roth. If you think you're likely to be more consistent with the 401k, put more money there. But if you can set up direct deposit or an automatic monthly transfer to your Roth, put all retirement savings there after you've put enough in your 401k to get a match.

Once your Roth is fully funded, you may want to consider beefing up the 401k contributions.

[CRFSaver]

Ughhh!!! No No No! Do the math before you decide on a Roth or non-roth IRA. And you might not qualify for either if your company already provides a 401K plan. Either way you get the tax benefits from the 401K that benefit you infinitely more since you are probably very young and that extra cash that is not taken out in taxes will grow over 30 or 40 years. I am a firm believer that a Roth should only be used as suplemental to the tax deferred retirement plans, not as the main one given that the future value numbers favor the tax advantaged account.

What is it that makes your companies plan bad? Because they only match 250 a year? Thats pretty good as its free money. Many places dont match at all? Bad funds? What funds do they have that are bad? One advantage of a 401K plan is you can many times get into funds that are closed to new investors. An example is the dodge and cox funds that have been closed for 2 years.

[parafly]

Originally Posted by CRFSaver

Ughhh!!! No No No! Do the math before you decide on a Roth or non-roth IRA. And you might not qualify for either if your company already provides a 401K plan. Either way you get the tax benefits from the 401K that benefit you infinitely more since you are probably very young and that extra cash that is not taken out in taxes will grow over 30 or 40 years. I am a firm believer that a Roth should only be used as suplemental to the tax deferred retirement plans, not as the main one given that the future value numbers favor the tax advantaged account.

What is it that makes your companies plan bad? Because they only match 250 a year? Thats pretty good as its free money. Many places dont match at all? Bad funds? What funds do they have that are bad? One advantage of a 401K plan is you can many times get into funds that are closed to new investors. An example is the dodge and cox funds that have been closed for 2 years.

I would say that the main negative factor of my 401(K) plan is the fact that they only match $250/year. So there is absolutely no difference between contributing $250/year and $5000/year because the match would be exactly the same.

The funds in the plan are provided by Merill Lynch, and from what I've seen my company offers only the basic funds. I am completely new to investing, and it would be difficult for me to diversify myself correctly. I like Vanguard's 2045 Retirement Plan because it would automatically diversify my portfolio, and I wouldn't have to worry about switching funds all the time.

Also, I know that these funds are meant for retirement, but I plan on buying a house in the next few years. Having the Roth IRA would give me the option of taking money out tax and fee free IF I chose to do so.

[sweeps]

parafly, since you're fresh out of college and will presumably earn more as you move forward in your career, it's almost certain that a Roth IRA is the right choice for you.

And you are definitely allowed to contribute to both a 401k and a Roth. Please read this article for some additional info.

[parafly]

Originally Posted by Sweepsplayer

parafly, since you're fresh out of college and will presumably earn more as you move forward in your career, it's almost certain that a Roth IRA is the right choice for you.

And you are definitely allowed to contribute to both a 401k and a Roth. Please read this article for some additional info.

Thanks for the info. But can you please elaborate on why a Roth IRA is better since I will presumably be making more money in the future?

[sweeps]

In a 401k or traditional IRA, your contribution is made before tax. In a Roth IRA, your contribution is made after tax. All things being equal, they are equivalent in the end. I've used this example before:

Assume: You will contribute $1,000 to your retirement plan this year. Your effective tax rate is 20%. Your investments will grow to 10 times their original size sometime in the future.
Scenario 1 (401k or a traditional IRA): Your contribution is pre-tax so you put the full $1,000 in your plan. It grows to $10,000 in the future. At that time you pay taxes on that amount (20% * $10,000 = $2,000). This leaves you a net return of $8,000.
Scenario 2 (Roth IRA): Your contribution is post-tax so you only put in $800 ($1,000 - ($1,000 * 20%)). That amount grows to $8,000 in the future. The amount has already been taxed though, so you have a net return of $8,000.

As you can see, there is no difference in the end. Now, what can change things is your effective tax rate. When you're young (or disabled or semi-retired), your income is typically low, which means your effective tax rate is low. This is the time you want to pay taxes up front, so a Roth IRA is a better deal. Later in your career when you're making a lot more money, you want to shelter that high income from taxes which means a 401(k) or traditional IRA is a better choice. In that case you'll pay your taxes later when your income goes back down.

[parafly]

Originally Posted by CRFSaver

Either way you get the tax benefits from the 401K that benefit you infinitely more since you are probably very young and that extra cash that is not taken out in taxes will grow over 30 or 40 years.

I see your point concerning the taxes, and since the money would be contributed to my 401(K) pre-tax, my earnings would be taxed less. But I also have to take into account that when it finally comes time to retire and withdraw from my funds, my 401(K) funds will get taxed at that time. And if I assume that tax rates are much higher in 40 years, my tax benefits now will lead to tax negatives in the future.

Again, I am no investing expert, but tell me if my thinking is wrong...

IMO, having the ability to withdraw my retirement funds in the future tax free is worth the $10/week I would be saving in taxes now.

[parafly]

Originally Posted by Sweepsplayer

In a 401k or traditional IRA, your contribution is made before tax. In a Roth IRA, your contribution is made after tax. All things being equal, they are equivalent in the end. I've used this example before:

Assume: You will contribute $1,000 to your retirement plan this year. Your effective tax rate is 20%. Your investments will grow to 10 times their original size sometime in the future.
Scenario 1 (401k or a traditional IRA): Your contribution is pre-tax so you put the full $1,000 in your plan. It grows to $10,000 in the future. At that time you pay taxes on that amount (20% * $10,000 = $2,000). This leaves you a net return of $8,000.
Scenario 2 (Roth IRA): Your contribution is post-tax so you only put in $800 ($1,000 - ($1,000 * 20%)). That amount grows to $8,000 in the future. The amount has already been taxed though, so you have a net return of $8,000.

As you can see, there is no difference in the end. Now, what can change things is your effective tax rate. When you're young (or disabled or semi-retired), your income is typically low, which means your effective tax rate is low. This is the time you want to pay taxes up front, so a Roth IRA is a better deal. Later in your career when you're making a lot more money, you want to shelter that high income from taxes which means a 401(k) or traditional IRA is a better choice. In that case you'll pay your taxes later when your income goes back down.

Thanks again. I see your point, and it makes sense. Of course, this example assumes that tax rates will remain the same over all these years. If you assume that tax rates will go up in the future, absorbing the tax hit now is better than absorbing it later.

[Ima saver]

I have to agree with most of the others, put your money into a roth Ira.

[CRFSaver]

Originally Posted by Sweepsplayer

In a 401k or traditional IRA, your contribution is made before tax. In a Roth IRA, your contribution is made after tax. All things being equal, they are equivalent in the end. I've used this example before:

Assume: You will contribute $1,000 to your retirement plan this year. Your effective tax rate is 20%. Your investments will grow to 10 times their original size sometime in the future.
Scenario 1 (401k or a traditional IRA): Your contribution is pre-tax so you put the full $1,000 in your plan. It grows to $10,000 in the future. At that time you pay taxes on that amount (20% * $10,000 = $2,000). This leaves you a net return of $8,000.
Scenario 2 (Roth IRA): Your contribution is post-tax so you only put in $800 ($1,000 - ($1,000 * 20%)). That amount grows to $8,000 in the future. The amount has already been taxed though, so you have a net return of $8,000.

As you can see, there is no difference in the end. Now, what can change things is your effective tax rate. When you're young (or disabled or semi-retired), your income is typically low, which means your effective tax rate is low. This is the time you want to pay taxes up front, so a Roth IRA is a better deal. Later in your career when you're making a lot more money, you want to shelter that high income from taxes which means a 401(k) or traditional IRA is a better choice. In that case you'll pay your taxes later when your income goes back down.

There is a flaw in this logic. Your assuming the extra 200 dollars you put in doesnt compound. RUn a simple future value of an annuity over 30 or 40 years and the difference is huge. The closer you get to retirement the more a Roth makes sense but at 22 years of age I think you do a diservice by telling someone to put a majority of their money in a Roth. The math just doesnt make sense.

Now mind you wanting money for a house is a different story though. I still think you should contribute that cash to a 401K because lets face it, it is for retirement. Just my two cents.

[sweeps]

Originally Posted by CRFSaver

There is a flaw in this logic. Your assuming the extra 200 dollars you put in doesnt compound. RUn a simple future value of an annuity over 30 or 40 years and the difference is huge. The closer you get to retirement the more a Roth makes sense but at 22 years of age I think you do a diservice by telling someone to put a majority of their money in a Roth. The math just doesnt make sense.

CRF, trust me, it doesn't make any difference.

Let's say your $1,000 is in your retirement plan for 10 years earning 10%. It grows to $2593.74. After 20% taxes, $2075. $800 that grows for 10 years @ 10% becomes, guess what, $2075.