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Roth retirement decisions

By Barbara Whelehan ·
Friday, August 27, 2010
Posted: 3 pm ET

In an opinion piece appearing in today's Wall Street Journal, Gov. Arnold Schwarzenegger complains that the state of California is saddled with $550 billion of retirement debt, "thanks to huge unfunded pension and retirement health care promises ... and also to deceptive pension-fund accounting that understated liabilities and overstated future returns."

If the professionals don't get pension fund accounting right, how are individuals supposed to manage? After all, we have to make a lot of assumptions when we do our own retirement planning. We have to guess how many years we will live and what kinds of returns we can expect on our investments going forward, among other things. ...

After the last 10 years, it seems optimistic to hope for even meager positive returns.

Gov. Schwarzenegger desperately wants pension reform because the state of California may fall into the Pacific Ocean if things keep going the way they are. I'm using poetic license here; he doesn't say that exactly. But he does make this startling statement:

"Few Californians in the private sector have $1 million in savings, but that's effectively the retirement account they guarantee to public employees who opt to retire at age 55 and are entitled to a monthly, inflation-protected check of $3,000 for the rest of their lives," he writes in the editorial.

Roth vs. traditional 401(k) contributions

Individuals are left to their own devices as they plan for retirement. For instance, what's better? Deferring 401(k) contributions on a pretax or aftertax basis? Should we get the immediate gratification of a tax break now, or delay gratification and get a tax break later?

The answer is not immediately obvious. But in a column that appears in, Fred Reish, managing director and partner of the Los Angeles-based law firm of Reish & Reicher, points out that the first $20,000 of income that you take from a tax-deferred account, such as a regular 401(k) plan or traditional IRA, will be free of tax. So why pay tax upfront with a Roth?

I asked Bankrate's Tax blogger Kay Bell how Reish came up with that tax-free $20,000 number. After all, the 2010 tax bracket rates for married couples filing jointly indicate we get taxed 10 percent up to $16,750, 15 percent above that to $68,000, etc. Kay answers, "Because at filing time, a couple gets a $3,650 personal exemption each plus the standard deduction amount of $11,400. That comes to $18,700 that gets deducted from income."

Oh yeah. That approaches the $20,000 figure Reish alludes to.

So, assuming a 5 percent withdrawal rate during retirement, it makes sense for people to save at least $400,000 in a non-Roth account before stashing any money in a Roth 401(k) or Roth IRA, since they save tax money going into the account as well as going out.

Of course, this forces us to make yet another assumption -- that our tax system won't change in the future.

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Barbara Whelehan
September 04, 2010 at 12:31 pm

Adam -- Nobody's playing around, and yes, we do try to be helpful. On Tuesday I plan to post a blog that supports Fred Reish's case. It turns out he did take Social Security into consideration when coming up with his numbers. The blog will explain further and will link to a work sheet that shows how the IRS calculates Social Security and other income for the purpose of determining taxable benefits. I think you will be surprised by it. Thanks for writing.

Adam Earle
September 03, 2010 at 11:36 pm

A statement of the first 20,000 dollars not being taxed should not have been printed with an understandable explanation. You know, some folks will not search for any details. Of course, the first $20K will not be tax free. You will figure your deductions just as you have been doing forever and what ever amount that comes to is the amount that you want have to pay taxes on. Just the same as you have always been doing. I hate it when somebody slips something in like that. It's somewhat misleading. Are not these articles supposed to be helpful? Stop playing around, then.

August 31, 2010 at 5:19 pm

Agree, that is why you don't ask an attorney to give financial advice.

August 31, 2010 at 4:38 pm

Greg is absolutely right. The strategy proposed of not converting a traditional IRA to a Roth unless you already have $400K saved makes no sense except for a very very small group of people who will have no other income.

August 31, 2010 at 10:24 am

If U all think IRS is giving U $20K tax free I have bridge to sell U. There is no free lunch people....if I have reduced my taxes by taking 2 exemptions and standard deduction and ADD $20k back with a withdrawl.....I WILL PAY TAXES !
Gezzus go back to school on the short school bus.

August 30, 2010 at 5:13 pm

This is actually very hard to come up with the correct roth/non-roth equation for a person. You can do elaborate retirement calculations but the problem is we have no idea what the tax outlook will be in the future. It is not just about rates but, deductions, exemptions, your age, outlook, etc.

Two constants:

1) You need to put at least a $1 in the roth 401k to start the 5 year clock.
2) You need to have some non-roth assets at retirement so you don't lose the ability to offset some deductions, adjustments, etc. in retirement.(home mortgage is one example but who knows in 2020, etc.)

I recommend people seek professional advice and integrate this question into their overall financial plan.

Barbara Whelehan
August 30, 2010 at 9:57 am

Thanks for pointing that out, Greg. I did wonder how Social Security figures into the equation, and plan to look into it for a possible future blog post.

Greg McBride
August 30, 2010 at 9:52 am

One point I’d like to make is that the $20,000 figure assumes that the retirement withdrawal is the ONLY source of income. It doesn’t account for any income received via Social Security, part-time work, interest earnings and capital gains on taxable savings, or pensions from previous employers or military service.