Your goal is to cut taxes. There are many gov programs to reduce/defer tax exposure. There is one that eliminates taxes entirely! This topic is pretty complicated. Make sure you play by the rules (qualify etc) the penalties are steep. Certain people do not qualify for certain plans, there are max limits, withdrawal rules etc to be aware of. It is hard to judge which programs are best, The following is a rough guess for most people. IF you don't want to read any further (this is pretty boring) the take away is that post tax is most likely the best (Roth, Roth 401k) and if you are a real cracker jack and young and taxes go up, 401k pretax contributions could end up being not so hot for you (think tax rate goes way up for everybody) but there is a fix. It is also possibly for some(under $100,000) and soon (year 2010) for all of you to roll over your traditional IRA into a Roth and this is something to look at. You pay the tax bill when you do this, (best to do it with cash) but the pain will probably pay off big time. https://calcsuite.fidelity.com/rothconveval/app/launchPage.htm will spit out a number for you. Terms: I am not going to talk about individual accounts. Pretax is a traditional IRA or 401k, post tax is a Roth 401k or Roth IRA
In order, the way to fill up from best to not best
1. 401k match
2. Roth IRA (post tax $5,000) make sure you dont make too much money for IRAs
3. 401k post tax (if your employer had this I am going to assume your 401k is pretty god (low fee funds available)
For steps 4 and 5 may be a good idea to get em going and then roll em over to a Roth.
4. Traditional IRA (traditional is pretax contribution, do not use if contributed to above Roth.)
5. 401k pretax (young, aggressive, crackerjack savers beware but get going and plan rollover to roth)
there are also other programs which may work well for you such as
6. Health savings account (no taxes period!)
7. 529
Whenever you quit your job or get laid off, rollover your 401k
This is a rough best guess but is probably accurate. Be pretty curious if somebody else is coming up with a better idea or shuffles em around.
Why is 401k match best? Free money rules. you put in a dollar and so does the company. You wouldn't turn down a raise would you? (if they put it in w company stock sell as soon as possible, while avoiding any fees. You do not want to hold company stock )
Post tax (401k or Roth) rules. for more reasons than i am going to mention. these are defiantly #2. It is easier to pull contributions out than most people realize (no fees or penalties) but you don't want to do this anyway because Roth's are so great. they are also a great thing to hand down to kids when you are dead. Very flexible. I love these.
Why is post tax usually better than pretax when it comes to tax advantaged accounts? Even thought paying less taxes now may be very immediately gratifying, I think it is a better idea to contribute whenever possible post tax rather than pretax for a couple of reasons. You can contribute "more", your tax rate now is probably less than it will be in retirement, the more time you have the more a roth makes sence, and finally you reduce your tax risk.
For super savers-you can effectively contribute "more" post tax as the limits are the same for both. Try to max out your contribution and you will see why post tax is "more" than the same figure amount pretax.
Your tax rate in retirement will probably be higher than you are in now. This is one critical piece of the puzzle. You have to guess what tax rate you will be in retirement. If it is higher than the tax bracket you are in now, It makes no sence to defeer your taxes, so Roths can not be beat. It is almost impossible to guess what may happen to your tax bracket. Taxes are pretty low right now. deficit is high. I think the highest rate now is about 32%. rates have been as high as 87% in the past. I personally suspect that taxes in general are going to go up. I am also giving you credit for planning your retirement well (you have read this far). If you are likely to have a pension or other income in retirement, this is even more true. For these reasons I think it is a good assumption that your tax rate will stay the same or be going to go up in retirement. If you are 5 years from retirement and have just started your retirement savings, you are in a very different boat and post tax is not for you.If you are young you probably aren't getting taxed real heavy right now anyway, why deffer taxes that are already low?
later, when you are at your max tax bracket(say in your 50s or when you are getting a massive one time pay spike say win lotto) and are confident you will be in a lower tax bracket in retirement it may make sense to then go pretax.
The longer your money sits the more obvious the Roth advantage becomes.
Pretax (traditional) disadvantage. You are required to withdraw a certain amount at around age 71. this forced withdrawal could be big enough to bump you into a high tax bracket and wipe out some of the 401k advantage ( tax rate in retirement that is higher than the tax rate you could have payed when you were young) What is worse is since you deffered taxes, now you gotta pay taxes on the forced withdrawal, which could force you to pull more money out of your 401k.
Finally future increases taxes are a big risk to your retirement. paying taxes now eliminate that risk. pay tax now (Roth) and you know what you got. What are taxes gonna be in the future? who knows? Go to this link and see what i mean (how does a 87% tax rate sound? It happened.) http://www.truthandpolitics.org/top-rates.php it has max tax rates over the last century
Pre tax is risky. If you end up in a significantly higher tax bracket in retirement than you were when you deferred your taxes, you could live to regret the day you deferred your taxes. This can happen if you are good (start young max contributions and have a high rate of return, a crackerjack, or a little cracker jack and a fat pension) The stars would have to line up a little for this to happen (say capital gains stays at 15% future tax rate goes way up). I am not saying that if your only choice is a trad 401k that you shouldn't do it(remember rollover trick to weasel out of this), but that Roths are way better.
want the cold numbers? Here is a calculator that should give you an idea. http://www.ifa.com/401k/calculator/RothConvertCalc.asp
or
https://calcsuite.fidelity.com/rothconveval/app/launchPage.htm
The neat thing about running these is you can make up your own assumptions and come to your own conclusions. If you monkey around with your tax rate in retirement you can make the numbers dance and do what you want with em.
Why are 401ks slightly worse than IRAS? the bad deal is that 401k plans are typically have a limited investment choices that have higher expense ratios. This more true for some 401ks than others. I hear school teachers have terrible 401ks choices. You can fix this sometimes and is not a good excuse to not contribute to one. the work around or fix?
When you change jobs, rollover your 401k. This is a great deal (Get more low cost mutual funds to choose)Make sure they do not cut you a check
Some places have brokerage link accounts.
Letter campaign to your employer tell em you want better options.
Health savings accounts. This is new. If you have a "high deductible health insurance" you may qualify. If you don't use it at the end of the year you still get to keep it. money is never taxed. I say again never. you can invest it. You can use the money immediately on most health related expenses (Dr visit medicine and more importantly down the road health insurance) You can use it for your spouse or child. the bad, the money can only be used for health related things and you got to keep records and the investment options are sometimes not great(low choices high fees) It takes a year to build up enough money to invest. This can be a great deal for people who plan to pay for their own insurance once retired.
529's i don't know much about. other than pay for higher ed, can change name of kid. something to look into at some point. IF somebody would like to comment feel free.
By the way all these retirement accounts have the added advantage of litigation protection. (think OJ going golfing even though he has got a huge settlement against him) which may be a reason in and of itself to do em.
Are you still awake? congradulations! you are the only one who made it through this blog entry.
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