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401(k), IRA… Here Are a Few Things to Consider

People who are new to investing are often overwhelmed by the number of options that they have and the technical terms that they have to deal with in order to save for retirement. We’ll explore some of the options here and the one variable that looms over your returns.

401(k), IRA… What’s the deal with all the acronyms and coded language? 401(k) plans are administered through your employer and your employer may contribute money to your plan in addition to the money that you contribute. These plans are funded with before-tax money, meaning that you are not taxed on your contributions but taxed on your future withdrawals in retirement. There are Roth 401(k) plans, however, and these are funded with after-tax money, meaning that the withdrawals in retirement are not taxed.

An IRA, an acronym for Individual Retirement Account, is an investment vehicle that you can administer yourself or through a broker or adviser. Like 401(k)s, these plans can be in the Traditional mold or of the Roth variety. Traditional IRAs are funded with before-tax money, while Roth IRAs are funded with after-tax money. As a result, Traditional IRA withdrawals in retirement are taxed, while Roth IRA distributions are not.

A major factor in deciding what plan to go with is as you would expect – taxes. What will be your tax rate in the future? Nobody can know for sure, but if you’re young, then your marginal tax rate will likely be higher in the future as you are just starting your career. A Roth IRA might be the way to go, so you pay hopefully a lower tax today instead of a higher one in retirement. On the contrary, if you are far progressed in your career and are near the highest marginal tax rate that you will ever pay, then a Traditional IRA may be the best option, so you do not pay your current rate. Instead, you get to pay a lower marginal rate in retirement.



Although future tax rates cannot be forecasted for certain, many of the issues you hear discussed in the political forum today will impact these rates. As the baby boomer generation rapidly enters retirement, they will begin to make withdrawals from Social Security and require Medicare, along with other social service programs. These programs are underfunded in the tens if not hundreds of trillions of dollars. Moreover, our population is aging and people are delaying having children until later in life more frequently. So who’s going to pay for those trillions of dollars in government benefits? It’s likely working people going forward will have to endure higher tax rates in order to fund the government’s traditional functions in addition to its social benefit programs.

Baby Boomers are rapidly entering retirement and this has implications for both them and younger investors.

You should plan for the worst and hope for the best. Most people will have higher tax rates in the future due to the macroeconomic factors discussed above but also because people usually make more money as they progress in their careers. So if you have a Traditional 401(k) plan with your employer in which you will have to pay taxes on distributions in retirement, it could be a good strategy to hedge that “tax risk” with a Roth IRA. You will have already paid taxes on the money in your Roth IRA, so your distributions in the future will not be taxed unlike your Traditional 401(k) payments.

We’ll explore some other factors affecting 401(k), IRA, and other investment plans in future articles.

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