You save money on your 401(k) contributions based on your current *marginal* tax rate.

When you take money out in retirement, you will pay taxes based on your overall *effective* tax rate.

It is highly unlikely that your future effective tax rate will be higher than your current marginal rate unless your marginal rate is very low now (0 or 10%).

Thank you for this, as a Canadian I was very confused when this subject would come up, but now at least I understand the basics. This is probably a good measure of how well you explained it.

If you ever need a tutorial on RRSP’s, RESP’s, RRIF’s, HBP’s, LLP’s or tax-free savings accounts (new in 2009!) let me know. :)

All the best.

Scariest words in personal finance…..

You can always go back and amend your old tax returns! Usually 3 years worth depending on when they were filed.

Good luck.

But I’m also planning for contingencies with a Roth IRA. Not contributing to the max, but probably 80/20.

As things change, I’ll reevaluate.

Thanks for explaining that stuff in “dummy” terms. I have contributed to a 401k for years but I never really have known what I am doing, so that was nice of you.

I’m with K regarding Roth IRAs; the ability to withdraw the principle early without penalty is a big plus in my book. The ability of a Roth to thus serve as a last-resort emergency fund as well as a source of early retirement money increase its value even more. (I suppose this is not an unmitigated positive, though, as there are some people who will withdraw from a Roth without having a really good reason to do so. For people who can resist such temptation, though, it’s another point in Roth’s corner.)

As for taxes (and the implications thereof), the simple fact is that with the National debt climbing as high as it is, something is going to give if the U.S. is to avoid going into default. The only options besides higher taxes are (1) dramatic across the board cuts in spending (which might work, but getting politicians to agree what to cut and doing so by enough to make a real difference, is going to require a vastly different political environment than I’ve seen in my adult life) or (2) allowing inflation to increase dramatically, eroding the real value of our current debt (and also the real value of our savings, investments, and salaries). Ultimately, it’ll probably take a mix of all three in order to get the national debt to a more manageable level, but the point remains: there’s almost no chance the post-Reagan tax rates we’re currently experiencing will remain this low, so investing in a Roth IRA/401(k) is definitely a smart idea.

Although… As Stacey mentioned, there is the possibility that our tax system could be converted to a ‘fair tax’; where the bulk of taxes would be collected through a national sales tax. In this case, unless there is some kind of compensation or allowance included in the new tax law, Roth holders will be screwed: they’ll have been taxed on the income that went into the Roth, and taxed again on the spending when the money comes out. (401(k) or Traditional IRA holders will benefit, though, in having completely dodged the income tax bullet, even if they still have to pay the new national sales tax as they withdraw their savings.)

However, while such plans do have some good points (easier to administer, decreases consumption, no disincentives to saving or investing), there are problems that (in my opinion) will keep it from gaining traction, the biggest being the regressive nature of the tax. (If I, a person making half my salary, and a person making twice my salary all spend the same amount in a given year, we’ll all pay the same amount in taxes, but the person who makes twice my salary will have paid a much smaller portion of his income than me, and I will have paid a smaller portion than the person making half my salary.) There are ways to remedy this situation (like per capita checks sent out on a quarterly basis), but without a truly comprehensive plan, I don’t see this as an issue in the near future.

401(k) and 403(b) plans are virtually interchangeable when talking about tax law, so you should qualify for the retirement savings credit if that is what you’re referring to.

Kevin

But I haven’t seen mention of one aspect that some people may find important…

Taking funds out of a 401(k) before retirement often comes with a penalty (except for rare instances), but if I recall correctly you can take your contributions from a Roth IRA at any time without penalty, you just can’t touch the gains until retirement. So…while having a separate emergency fund is always a great idea, this could serve as a secondary buffer in case of something truly tragic and expensive.

The fees are nearly impossible to find because insurance fee disclosures are state-regulated, but a typical number would be 1.3% on top of the mutual fund fees.

Further, consider that your 401(k) is locked to your job. The ONLY way to move that money to a better-performing investment company is to QUIT YOUR JOB. Quitting will allow you to move it to a rollover IRA with the investment company of your choice.

Also, if your company offers a lousy 401(k), and you’re in a high tax bracket and want tax-free contributions, you’re out of luck. You’re considered “covered by a retirement plan” and a tax-deductible IRA is only an option for those who don’t end up in a high tax bracket.

Also keep in mind the reason for employer matching. Sometimes it is because they are just nice folks. Usually it is to encourage greater participation thereby making full contributions possible for the highly compensated individuals at the firm. Participation must be balanced for everyone to contribute fully. (This is a vast oversimplification of complex IRS rules).

I decided to stick with the Roth 401k for two reasons. One, it’s the easiest thing to do. I don’t have to change anything. Two, I also think tax rates have got to go up in the long term.

Trent, Thanks for the article! I’ve enjoyed reading about your journey!

Thank you!!