I came across an interesting online discussion the other day, about how maxing out both a 401k and an IRA was simply a lot of over-saving. The discussion was based on some article about a single adult male who maxed out his 401ks and IRAs every year, and had another $1200/month to invest. His income was not known, but it was assumed that he could make no more than $95k. The general consensus was that anyone with that income and that savings is not having any fun in life. I almost choked when I read the discussion as I have had plenty of fun on far less money when I was single and living in the most expensive area in the country. But mostly what is missed is the brilliant tax strategy in this plan. When figuring a true savings percentage, the 25% – 50% figures people were postulating as an effective savings rate were way off. If this guy did indeed make closer to six figures, he was only saving 15% of his gross income to retirement; not exactly a stretch for a single adult whom I assume does not have a lot of commitments. Let me explain how.
The reason that it was assumed in this individual’s case that he made no more than $95k was because that is the income limit for ROTHs (if you are single). Make more than that and you lose your ability to make a full ROTH contribution. This is error number one. The $95,000 limit is based on your modified adjusted gross income. This means for most of us it is your salary, plus interest and dividends and other sources of income, minus some adjustments, and minus any 401k contributions. So in this case, you can have $110,000 in income and max out both retirement vehicles. ($110,000 income minus 401k contribution of $15,000 = $95,000 modified adjusted gross income). You probably don’t even run the risk of your investment income pushing you over the ROTH income limit if you are diverting most of your investments into tax-deferred retirement vehicles. But basically, a full $15,000 401k contribution would then be 13.6% of this guy’s income. & that is all he would have to contribute. 13.6%. Because his income tax rate is probably in the 25% range, if not more with state taxes. So his $15,000 401k contribution will save him on average $4,000 in income taxes. ($15,000 x 25% = $3,750 tax saved). He doesn’t even have to change his withholdings or do anything fancy. When you contribute to a 401k it adjusts your taxable income downward at the paycheck level so automatically less taxes will be withheld. There is the $4k contribution for his ROTH, plain and simple. It just took some tax planning rather than a lot of scrimping and saving, to come up with the ROTH portion.
Another way to look at it is that if he chose to only contribute to his 401k, he would save $4,000 in taxes. So though $15,000 is getting diverted to his 401k plan, only the $11,000 ($15,000 contributed netted against the $4,000 in taxes saved) is really coming out of his gross pay. This is in comparison to if you simply put aside $15k of your after-tax pay. That would be a much bigger stretch.
Say your income is $75,000, and you are an aggressive saver. Put 20% in your 401k (or $15,000), and you will still have the same end result. You will save about $4k in taxes that you can then deposit into a ROTH. In this case it may be more of a stretch, but I wouldn’t find it impossible or view it as an overly aggressive savings strategy either.
I also think it is great this individual is hedging his bet with two completely different retirement vehicles. He is definitely taking advantage of the tax savings now in a higher tax bracket (with his 401k). But he also has some money in a ROTH which will be tax-free when he draws it in retirement. This hedges the bet for now that his income tax rate will be lower in retirement, because really nobody knows for sure.
I think it is important for people to understand their options. With all of the different employer type plans and different IRAs it can get very complex. Overall though, if you make a high wage and are offered a 401k or a 403b or such, consider diverting most of your savings into such a plan. If nothing else, you will shelter some of your income from taxes. If you are a heavy saver, you really should use retirement vehicles to your advantage. At the end of the day it means you get to keep more of your money, particularly if you are in a higher tax bracket. More to your own retirement, and less to Uncle Sam.
FYI, the maximum you can contribute to a 401k in 2007 is $15,500. The maximum traditional or ROTH IRA contributions for both 2006 and 2007 are $4,000 if you are under 50 and $5,000 if you are 50 or over. Subject to many limitations of course, depending on your individual situation.