Retirement plans - 401k and Roth 401k

401k plan investments are limited - both by the government and by the employers who provide the plan. Yet, there are still strategies one can use to maximize the benefits of the 401k plans, and also to free the money from the 401k straightjacket. We will skip many IRS rules and details - you should check with your accountant each year, as tax laws can and do change.

While this page focuses on the retirement plans in the United States, the discussion of their benefits is applicable to almost any country inthe world, since most countries have adopted some sort of retirement program - though the specific tax advantages will differ from country to country.

Both IRA and 401k plans come in two flavors - traditional (IRA, 401K) and Roth (Roth IRA, Roth 401k). Both programs allow your money to grow tax free, but there are 2 significant differences between regular and Roth plans: Traditional IRA and traditional 401k allow participants to contribute PRE-TAX money to the plan, but when the money is taken out at retirement, it is subject to income taxes at the individual's regular tax rate - both the contributions and the earnings.
Roth IRA and Roth 401k allow participants to contribute money only after it has been taxes, but when the money is taken out at retirement, it is tax free - both the contributions and the earnings. Click here to read more about IRAs


401k and Roth 401k strategies

Basic question between traditional 401k and Roth 401k is - do you think your tax rate will be lower when you retire?
If you answer Yes - then traditional 401k is for you.
If you answer No - then you should use Roth 401k.

Robert Kiyosaki is fond of saying, that if you plan to pay at a lower tax rate when you retire, this implies that you are planning to fail - planning to make less in retirement than now. Well... we do not entirely agree. It's OK to plan to have lots of assets and income when retired, but for the time being, we want to take advantage of the available tax breaks - we prefer immediate gratification of tax savings today, instead of 30-40 years from now (and later, we will show you a strategy that gives you the best of both worlds).

So, preferred, strategy 1: fund Traditional 401k every year- currently you can put in $15500 per year (even more if you are over 50 years old). In doing so, average person will save about $5000/year in taxes (assuming 30% combined Federal and state tax bracket). So you end up with $15500 in 401k account that will grow tax free until retirement, and you get $5000 in tax saving - you could invest this in a regular investment account, or take a really nice vacation - thanks to IRS and Uncle Sam.

Strategy 2: If you cannot afford to fully fund your 401k account - then at least take advantage of the employer matching. Many employers will match your 401k contributions up to 3% of your salary (ask HR department for your company policy). Example: if you make $50000 per year, 3% of your salary would come to $1500. If your company matches up to 3%, then you should do all you can to contribute at least $1500 to your 401k each year - and you will get a matching contribution from your company of another $1500. That's a 100% return on your money - every year you contribute.

Strategy 3: if your tax rate is really low, or you think you will be in a higher tax bracket at retirement, you can contribute to a Roth 401k - your contributions are not tax deductible, but at retirement, you can withdraw both contributions and earnings tax free.

IMPORTANT: many ignorant people will tell you that you should not contribute to an 401k because you cannot get the money out before age 59 and a half, without paying an additional 10% tax penalty. They are wrong. While we do not recommend draining your 401k, if you really need the money, there are ways to get at it without paying the 10% penalty (regular taxes still apply). There are special IRS code provision that allow money to be taken out of 401k without penalty - check with your accountant. Of course, if you REALLy want to, you can read the gory 401k details yourself, in the IRS Publications on 401k plans.

As we said before, 401k plans are limited as to their investment vehicles, and the fees are often outrageous. But not all is lost - we promised you a strategy to fund both 401k and IRA - well, in addition, we will show you how to "free" your money from the clutches of 401k, so you can invest it where you want, not where your company wants. So here it is - "best of both worlds" strategy - click here to see how you can fund both 401K and an IRA.

 

 


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