401k contribution question
I have a general question regarding 401k funding, IRA and Roth IRA alternatives. My question is –if I have a client and he currently invests 5% of his salary into his 401K, the max amount that will be matched by the company, but would like to invest 10% would it be more effective to invest the additional 5% into a TIRA or RIRA? I am asking due to the limited investment options within the 401k and the greater access to a wider selection of mutual fund and stocks and bonds that the TIRA/RIRA offer.
Permalink Submitted by Alan Spross on Wed, 2011-05-04 19:29
The client has done the most important thing by capturing the maximum company match possible. If both the choices and expenses for making additional contributions to an IRA are superior, there is no reason not to do that. The more important issue is the selection of pre tax contributions vrs Roth contributions and that selection requires a detailed analysis of factors including the current tax rate vrs the projected rate in retirement.
If a Roth contribution is more beneficial, the client needs to be sure that his income is not too high for Roth IRA contributions, and if a pre tax contribution is better, whether his income is also too high to deduct that TIRA contribution. Either of those factors would result in using the 401k plan rather than an IRA, especially if the plan offers a designated Roth option. Of the 5 possible options (pre tax 401k, Roth 401k, deductible TIRA, non deductible TIRA, and Roth IRA) the non deductible IRA contribution is the least beneficial. But if the client has no other TIRA accounts, he could make the non deductible contribution and immediately convert it to a Roth IRA, thereby circumventing the max income limit for a regular Roth IRA contribution.
After securing the company match, the client should match his needs against the 5 options above to determine where the additional funds are best placed.
Permalink Submitted by Eric Woodfill on Wed, 2011-05-04 20:01
If he invested the 5% into a TIRA instead of his 401k would he be losing anything? For example let’s say that the 5% equates to $5k, if he invested the $5k into a TIRA and if he was eligible to deduct the total $5k on his taxes would be better, worse or indifferent as far as taxes goes.
Does the question make sense??
A college of mine seems to think that if he invested the $5 into a TIRA he wouldn’t be actually investing the full $5k – I am not sure what he is getting at.
Permalink Submitted by Alan Spross on Wed, 2011-05-04 20:33
If his modified AGI was low enough to allow the IRA contribution to be deducted, the net result would be no different than if he had the 5k in added salary deferrals to his 401k. Either way, it is 5k pre tax.
Your friend is assuming that the net cost of a 5k IRA deduction in the 25% bracket is only 3,750 and that is correct. But it is also 3,750 if he used salary deferrals for that same amount which he would contribute to the 401k instead. Using a salary deferral, that 5k would not be included in Box 1 of the W-2 as taxable income, so the result is identical. One possible exception may be a couple states that may not allow an IRA deduction when they would allow the pre tax salary deferral, so the state income taxes would be affected.
Permalink Submitted by Eric Woodfill on Thu, 2011-05-05 00:18
That is what I thought, Thanks very much.
Permalink Submitted by Eric Woodfill on Wed, 2011-05-25 11:42
I am confused, why would a person who contributed the additional 5% in their 401k only contribute $3750 instead of the entire $5000. I guess I don’t understand your point regarding the tax form and how that 5% is treated. If you would be so kind to clarify, why wouldn’t it be included in box-1 of the w-2??
Permalink Submitted by Alan Spross on Wed, 2011-05-25 18:45
The actual contribution would be 5k, but since a 401k pre tax or a deductible TIRA contribution eliminates that 5k from taxation, the net cost in the 25% bracket is 3.75k.
But a 401k contribution is handled differently on Form 1040 than an IRA deduction. For the 401k, the employer does not include the 5k salary deferral in Box 1 of the W-2. Since taxpayer is taxed on Box 1, he is not paying tax on the 5,000 of income he deferred into the 401k.
For the IRA, the 5k is deducted on line 32 of Form 1040. This results in the same total AGI for the IRA contribution as it would have for the 401k deferral. Either way, the gross income is reduced by 5k, and the taxes on the 5k would have been 1.25k. Net cost is 5k less 1.25k savings = 3.75k.
This is why a pre tax 401k contribution results in an immediate reduction in the federal (and most state) withhholding on the paychecks. The employee collects the 1.25k in tax savings gradually throughout the year. At the end of the year if he has deferred 5k into the plan, his taxes will be reduced by 1.25, making his out of pocket cost 3.75k.
Permalink Submitted by Eric Woodfill on Wed, 2011-05-25 19:08
and if the IRA contribution is not deducitble??
Permalink Submitted by Alan Spross on Wed, 2011-05-25 21:01
If it is not deductible or if it is a Roth IRA contribution, there is no tax deduction and the 5k contribution also has a net cost of 5k instead of 3.75. Since there is no deduction, the 5k is not taxed again when it is withdrawn from the IRA. Deductible TIRA contributions are taxed when distributed. Nothing is ever taxed twice, the options are whether to pay the tax up front or to pay it when distributed and to try to determine whether your tax rate will be higher at present or in retirement.