Saturday, April 22, 2006 - Page updated at 12:00 AM

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Where to save: A new Roth on the block

Special to The Seattle Times


401(k) vs. Roth 401k)'s estimator lets you compare the after-tax amount of your retirement savings in both scenarios. For each, it estimates your take-home pay as well as the size of your nest egg during retirement.

Everything you ever wanted to know about 401(k) retirement accounts:

The buzz: ETFs

About: A new item many financial planners are promoting, called an "Exchange Traded Fund," or "ETF" — similar to an index fund (which is a mutual fund that matches its portfolio to that of a specific financial-market index, with the objective of duplicating the general performance of the market in which it invests).

Why the buzz: Investors like that the funds trade all day long (mutual funds trade at one time during the day), says Kevin Schulz, Bellevue financial planner and board chair of the local Financial Planning Association. ETFs focus on all segments of a market, giving investors additional choices. For example, you could buy a Korean ETF or Global Energy ETF instead of U.S. Energy, Schulz says.

Buying: Depending how and when you buy, ETFs could be less expensive than traditional mutual funds. ETFs can be purchased through a financial adviser or broker.

Some employees for the first time this year will have a new retirement-investment option designed to save them taxes in the future.

This new option, called the Roth 401(k), isn't being offered because employers want to be benevolent. It's actually a message from Congress to the American people that they shouldn't rely on the government — or their company pension plans — to fund their retirement.

"Congress is [encouraging] individuals to take more ownership of their retirement funding. Congress is also sending taxpayers a message that government resources may be scarce in the future," says Seattle CPA Nolan Newman.

Adds Steve Juetten, a Bellevue financial planner and instructor at City University: "Social Security will provide, on average, 40 percent to 50 percent of an American's post-retirement income. They'll be on their own for 50 percent to 60 percent of their retirement income."

The big question not only is how much money do individuals need to save before they can retire, but also how do they make sure they have enough to live on once they are retired?

Managing your money to make sure you don't outlive it is even harder than when you're trying to stockpile it, Juetten says.

Given the warnings, here are some questions those thinking about retirement savings may have — and the answers.

Q. What is the new Roth 401(k), anyway?

A. Like the traditional 401(k), a Roth 401(k) is now available to employees through their companies. Because this just began this year, only a few employers around here so far have rolled it out (Microsoft, for example, is offering it beginning this month and the Bellevue office of Invesmart, which manages employee-benefit plans for about 400 local companies, says it is making it available to its clients).

Employees who choose to invest in a Roth 401(k) must first pay income taxes on money contributed to it, so there is no up-front tax benefits like in a traditional 401(k). But the investment is allowed to grow tax-free and will never be subject to taxes again — at least under the current rules.

At age 70 ½, investors will be required to take a minimum amount out of the account. But they can avoid this by transferring the money from their Roth 401(k) into a Roth IRA, which is not subject to minimum-distribution requirements.

Q. How do I know whether to put my money into a Roth 401(k), a traditional 401(k), a Roth IRA or a traditional IRA?

A. Employees can put up to $15,000 in a 401(k) plan in 2006 and can choose how to divide those dollars within the 401(k) between traditional and after-tax Roth contributions.

Which option is best for you depends largely on three considerations: What tax bracket are you in today; what tax bracket do you expect to be in at retirement; do you believe taxes are going up?

"If you believe your tax bracket will be higher in retirement than it currently is, Roth is the way to go; if you believe your tax bracket will be lower, traditional is the way to go. If your tax bracket stays about the same, there's a slight edge to the Roth," says 401(k) consultant Rick Meigs, president of 401(k)

The answer's clearest for those early in their careers, making a fairly modest salary but anticipating being in a higher tax bracket in retirement: For them, the Roth 401(k) will be appealing.

For workers in their 40s and 50s, the choice is fuzzier, because a baby boomer in his 50s who funds a Roth might be paying taxes up front when he's in a high bracket — only to withdraw the money when he's in a lower bracket.

But — Meigs says that, while most people might assume they'll have less income in retirement, once they begin drawing retirement income from 401(k)s, Social Security and possibly pensions and other investments, that's not necessarily true.

Actually, he says, "Most financial planners will tell you you need to replace 100 percent of your income for retirement; the old 70 percent rule is being thrown out, because of health-care costs."

And even if your income is lower, you may still be in the same tax bracket.

When you add in what's likely to happen with taxes, he says, the Roth options start to look even better.

"What the studies have been saying — and Vanguard probably did the best one — is that we're in a historically low tax environment; tax brackets have come way down. The likelihood going forward that tax brackets will go down further is probably not high; more likely they'll remain the same or go up. If you believe that, the Roth IRA or Roth 401(k) has the distinct advantage."

Higher-income individuals aren't allowed to have Roth IRAs, so the Roth 401(k) offers them their first opportunity for an account that's tax-free after withdrawal, says Meigs; "it's advantageous to those individuals to add the Roth feature to their 401(k)."

But there are two more twists:

If your company matches your 401(k) contributions, even if you put your contribution into a Roth 401(k) option, the match will go into a separate regular 401(k) account. (That's the government's rule; it still wants to tax the match money as well as investment gains earned on that money.)

One more caveat: Older workers may find traditional 401(k)s useful for another reason: by contributing to a traditional 401(k), they can lower their adjusted gross income, which in turn can qualify them for other tax breaks.

There are several calculators that aim to help you sort out what's best for you. One, the calculator, is listed in the accompanying information box.

Q. Besides the new Roth 401(k), what else are employers doing to help employees plan for retirement?

A. Unless they are replacing a traditional pension plan like IBM recently announced, most employers aren't increasing the percentage that they match in a retirement plan, says Juetten; better benefit plans match half of an employee contribution, up to 6 percent of their salary.

However, he notes that fewer employers are matching with company stock (likely a result of the Enron debacle), and more employers are automatically enrolling workers in their 401(k) plans (you have to make an effort to opt out).

Q. I'm thinking of changing jobs. What should I do with the money I've stashed away in my 401(k)?

A. You can leave it where it is, transfer it to your new employer plan if that sponsor allows it, or transfer it to an Individual Retirement Account held at a brokerage firm. (More about those choices, p. XX).

You could also cash it out — but resist the temptation. Here's why:

You'll have to pay taxes and may have to pay penalties. Juetten explains that on a $10,000 account, you'll pay regular income taxes, which could push you into a higher income bracket, plus you may have to pay a 10 percent penalty. For many people, this could cost them 40 percent of the original balance, meaning you'll walk away with only $6,000 from your original $10,000 account.

A caution: When transferring or rolling over 401(k) funds, make sure you never actually take possession of the funds for more than 60 days. If you do, you'll have to pay taxes on a traditional 401(k) and you may owe penalties. Easier and safer is a direct transfer: You fill out paperwork and the new-retirement-account manager takes care of moving the money.

Q . Now that I'm old enough to take the money out of these accounts without facing penalties, is there a right way and a wrong way to do this?

A . Of course there is. Did you think this would be easy? First of all, you can begin taking distributions after age 59 ½. You can take a lump sum or any amount out of the account. You'll be taxed on the amount you take out of your traditional 401(k) because you never paid taxes on the money you initially invested.

There are also exceptions that would allow someone to take out the money early, if for example, they become disabled or have medical expenses that exceed 7.5 percent of adjusted gross income.

IRA withdrawals actually can be taken out earlier in a very specific way. The rules differ between IRAs and 401(ks), and can differ in various 401(k) plans, so you'll need to carefully check on yours.

At age 70 ½, you have to start taking distributions from your traditional 401(k), traditional IRA and Roth 401(k) plans. You'll be required to take a minimum distribution, which will be determined by dividing up the account into pieces to be distributed over the rest of your lifetime.

Actuarial tables are used to determine this amount. These "required minimum distribution" rules are complex and investors probably should seek the advice of a tax specialist when approaching age 70 ½ to make sure everything is done correctly.

Juetten warns, for example, that if the person who started the retirement account dies, the required distributions may be different based on who is the beneficiary of the account.

Meanwhile, if you have several retirement accounts, financial planners advise that most people should first spend down regular accounts, i.e. savings accounts and nonretirement accounts, then "tax-advantaged" accounts, like traditional 401(k)s or IRAs, in which you only pay taxes when you sell the assets.

However, the advice may be different for some couples with large retirement accounts, according to Kirkland certified financial planner Robin Tan, board member of the local Financial Planning Association.

Some wealthier couples may be able to save on income taxes, should one spouse die, if they reduce their IRA or 401(k) while both husband and wife are alive. Best to give this careful consideration or seek professional advice.

Money should stay in Roth IRA accounts for as long as possible because you've already paid taxes on the funds and they're allowed to continue to grow tax free. Juetten says that you should be able to take out 4 percent to 4.5 percent of your accounts a year without depleting them in your lifetime.

Q . Is there a trick to investing that retirement money while I'm retired?

A . Yes. Don't be too conservative. Inflation will eat away much of your earnings. For example, assuming a 3.5 percent inflation rate, $100 today in 25 years will be worth $45. So to make money you have to invest at a rate that earns more than inflation. As a general rule, Juetten suggests investing at least half of your assets in stocks to overcome the inflation problem.

Copyright © 2006 The Seattle Times Company


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