In tough economic times, most of us focus on our day-to-day expenses. But if you can swing it, you also need to save money for your eventual retirement.
Today's Daily Tax Tip looks at one of the easiest retirement savings options out there, the 401(k).
On the job savings: A 401(k) is a workplace retirement plan offered by many companies. If you work for a public school or nonprofit, it's called a 403(b) plan. For state and municipal government workers, they're called 457 plans.
As you've already figured out, the names come from the section of the Internal Revenue Code that governs these retirement savings options. But despite the different names, they operate the same.
With a 401(k) and its cousins, you contribute a percent of your paycheck each pay period to the account. This saving method has two advantages.
First, the money goes to your retirement account before you ever see it. If you don't have the money to spend in the first place, you're less likely to miss it.
Second, your boss takes your 401(k) contribution out of your pay before taxes are calculated. That means your tax bill is a bit smaller.
Plus, in many cases employers match at least a portion of employee contributions.
401(k) tax considerations: While contributing to a 401(k) can help trim some off your current tax bills, the standard accounts are simply tax-deferred.
So years down the road when you do take money out, you'll owe taxes. And the distributions will be taxed at ordinary income tax rates. That means that a person taking out 401(k) money in 2013 could pay taxes at a top rate of 39.6 percent.
But there is a way to avoid paying tax on 401(k) money. If your workplace offers a Roth 401(k) -- not all do, but more companies are adding the option each year -- put your payroll contributions into that account.Like the similarly named Roth IRA, you contribute after-tax money to a Roth 401(k). That doesn't save you any taxes now. But also as with a Roth IRA, when you take Roth 401(k) funds out in retirement, as long as you've have the account for five or more years you won't owe Uncle Sam a dime on the money.
If you're just now opening a 401(k) at work and you have the Roth option, take a good long look at your personal situation and where you expect to be in retirement. Yes, this means some prognostication, or as it is more realistically known, guessing about what the future holds.
Basically, if you think your tax rate now will be lower than what it will be when you retire, then pay the taxes by contributing to a Roth 401(k).
But if you expect your tax rate to be lower when your working days are done, then a traditional 401(k) with its pre-tax contributions might be a wiser move.
The decision is yours. Talk with your spouse. Consult with your financial and tax advisers. Examine the options. Consider whether you want to worry about taxes at all in your golden years.
Roll into a Roth 401(k): What about folks who already have 401(k)? If your company offers a Roth workplace retirement account, you now can convert your tax-deferred 401(k) to the tax-free version.A provision in the American Taxpayer Relief Act (fiscal cliff bill) makes this conversion possible.
Previous law let workers move their traditional 401(k) money into a Roth 401(k) only under specific circumstances, such as when the worker left the company, retired or turned 59½. Now, however, a worker can decide at any time to shift regular 401(k) funds to a Roth 401(k).
Again, you have to do some financial soul-searching and make some future projections.
You also must determine whether you can pay the conversion taxes.
Yep, just like when you convert a traditional IRA to a Roth IRA, you'll have to pay tax on the previously untaxed contributions you move.
Converting generally is not a good idea if you don't have the money outside your 401(k) funds to pay the due taxes.
So do your retirement analyses (Morningsgstar suggests six questions to ask before you convert to a Roth workplace plan) and assess your current situation.
Then whichever version you choose, put as much as you can in your workplace 401(k).
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