It may be better to pay tax now on retirement savings
Why pay tax today when you can do it tomorrow? That was the mantra of financial advisers for many years as they promoted tax-deductible individual retirement accounts and 401(k)'s as a way to get big tax deductions in the here and now and defer tax on the accumulating balance to the future.
Now advisers aren't so sure. Relatively low income-tax rates and retirement plans that offer tax-free income in the future are encouraging a new strategy: Pay tax now, and enjoy tax-free spendable income and assets later.
A growing number of savers opt to pay up front and "just get the tax obligation over with," says Susan Hirshman, a planning strategist at JPMorgan Funds.
Two vehicles are Roth individual retirement accounts, first offered in 1998, and employer-sponsored Roth 401(k)'s, which became available this year. In both cases there is no deduction for a taxpayer's deposits—up to $4,000 per spouse into a Roth IRA for 2006, if at least one spouse is employed, and up to $15,000 per working taxpayer into a Roth 401(k), plus an extra $1,000 to an IRA or $5,000 to a 401(k) for individuals 50 or older.
The payoff: The savings and investment income can eventually be withdrawn tax free if various requirements are met.
The maximum you can put into these investments is the same for Roth and traditional accounts, but in another break, the income caps that limit eligibility for a Roth IRA are higher than for a traditional IRA. What's more, having a retirement plan at work doesn't disqualify you from a Roth as it may from a deductible IRA. At work, you can have both a Roth 401(k) and a regular one.
Paying tax now rather than waiting until you make withdrawals can especially benefit people who end up in a higher tax bracket when they retire. That can happen if tax rates are raised, as many fear, to cut budget deficits, or simply because of hefty retirement income.
Young people in a low tax bracket in the early stages of their career may get only a modest kick from a traditional 401(k) compared with the future tax-free income from a Roth 401(k).
Still, people who think they may end up in a lower tax bracket can make a case for deferring the payment of tax. And the lure of an immediate tax deduction remains powerful.
A way to get the utmost benefit from a Roth-style account is to maximize your future nest egg by putting in the most allowed and paying the tax on that deposited salary out of other funds—assuming you can afford to do so. A Roth in that case would return more at retirement than a deductible account even if your tax bracket didn't change and you were to also invest the tax savings from the deductible account, according to the government's Congressional Research Service.
Roth IRAs are still a small share of total IRA assets, but they have been popular and contributions are growing steadily. People with Roths contribute greater amounts more regularly, says the Investment Company Institute.
Despite employer and worker interest in Roth 401(k)'s, adoption has been slow, in part because of concern over whether Congress will extend the ability to make deposits beyond 2010. Among large employers surveyed last year by Hewitt Associates, 34 percent said they were very or somewhat likely to implement a plan. Only about 5 percent have so far done so. But analysts expect the trend to pick up, and General Motors, International Paper, the state of North Carolina, and other employers have put Roths in place.
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