Maximize the value of a Roth IRA or Roth 401(k) account – pre-tax saving may be great now, but you need to maximize spendable income in retirement

Traditional IRAs and 401(k) plans allow you to save on a pre-tax basis for retirement. A Roth IRA or Roth 401(k) allows you to save on an after-tax basis but to receive all the accumulated earnings from your account on a tax-free basis.  Which is best for you?

Take a look at the likely future in America; growing debt, health care costs still out of control, increased taxes in various forms a virtual certainty (and not only on the wealthy) and inflation on the horizon. Taken together it means one thing for future retirees; you are going to need as much money as possible just to maintain your standard of living.  That’s no great revelation, but what strategy are you using to deal with the future?

Assuming you are a prudent saver (hopefully that is a correct assumption); the next question is where should you put your money? Do you use a standard tax-deferred IRA and/or contribute to your company 401(k) plan or do you use a Roth IRA?

For most financial experts the answer is easy, you use a Roth IRA or Roth 401(k) account.  Both Suzie Orman and Jane Bryant Quinn recommend this strategy.  Why a Roth, because when you need the money, you can take out all of the earnings on your account tax-free (subject to certain early withdrawal rules).  While you get the benefit of not paying taxes on traditional IRA (or 401(k)) contributions when they are made, your contributions and earnings on your account are taxed when withdrawn.  Also, keep in mind that even though your earnings may have come from gains in the value of stocks or even dividends, your withdrawals are taxed as ordinary income, not at the lower capital gains or dividend rate. 

So, if you have $500,000 in your account and you make your first withdrawal when required at age 70 ½ you will withdrawal approximately $32,000 (actual amount varies based on marital status, month of your birth). Because you must pay taxes on this money, you don’t have $32,000 to spend, but something much less depending on your income tax bracket and any state income tax.  

Note this important fact, the minimum distribution rules do not apply to Roth IRAs (you do not have to make a withdrawal while you are alive).  However, the minimum distribution rules do apply to Roth 401(k) accounts.

Here is a handy calculator to help you determine your eligible IRA contributions  and also a link to Roth rules 

In addition, experts recommend contributing toward your 401(k) up to the maximum of the employer match and then switch to a Roth IRA if you are eligible.  Let’s say your employer matches all or a portion of your 401(k) contribution up to 6% of pay.  Make sure you grab that employer contribution, but any additional contributions you make should go into a Roth account.

For some lucky workers including some government employees, Roth contributions are available within the 401(k) plan. Participants can place contributions in the Roth portion of the plan up to the same amount each year allowed as a pre-tax contribution.  That’s not in addition to pre-tax contributions but in place of them or in combination with them if your plan permits.  Here is a link to the qualified plan contribution limits for 2011.

If you have a Roth 401(k) available you don’t need to use an IRA which may save you a bit on fees.  In addition, a Roth within a 401(k) plan allows you to use the same investment vehicles as pre-tax contributions.  If you are using the Roth within your 401(k) plan make sure that any employer match is made on either pre-tax or Roth contributions.  If not, always max out your contributions that are matched by your employer.

Here is the deal, save on a pre-tax basis today and pay taxes tomorrow or save on an after tax basis via a Roth IRA or 401(k) plan and pay taxes today, but not tomorrow.  In this case we assume “tomorrow” is when you will be retired and need as much income as possible (and tax-free income is a good thing).  We also assume that saving in an IRA or a 401(k) plan is saving for retirement, not a new car or great vacation a few years from now.

Here is what you need to think about doing:

1. Make sure you are saving to maximize any employer matching contribution.
2. If you do not have a Roth 401(k) available, consider a Roth IRA once you received the maximum employer match in your pre-tax 401(k).  If you are able to continue with your pre-tax 401(k) and open a Roth IRA as well, so much the better.
3. If you have a Roth 401(k), consider saving via the Roth account instead of on a pre-tax basis (but always make sure you receive the maximum employer match)

The goal is to maximize the amount of spendable income you have in retirement.  Check out all the helpful links in this article and read the related articles below.  You can also go to IRS.gov for all the rules on these plans and a comprehensive set of questions and answers.

The choice is yours, but please take the time to make an informed choice.

Related Articles

• Roth 401(k) and Roth 403(b) Plans (turbotax.intuit.com)
• 5 Reasons to Love the Roth IRA (money.usnews.com)
• 4 Reasons Why a Roth IRA May be Better Than Your 401(k) (wisebread.com)