Take a Hint

The government is really trying to help us out. Actually, it's probably trying to help get itself out of a pinch, but we benefit as well. I am talking about the various tax-advantaged savings plans that are out there: 401(k)s, Roth 401(k)s, Roth IRAs, HSAs, etc.

Many of these savings vehicles, such as the 401(k) and Roth IRA, are for retirement. But doesn't the government provide Social Security benefits? I am no authority on the Social Security system, so it will make things much easier on both of us if we just pretend Social Security is not there. If you realize that and take the necessary steps to fund your own retirement, in all likelihood you will be much better off in the long run anyway.

These plans are tax-advantaged, not tax free. So the government will take their cut, and how they do so is one of the main differences between a "Roth" account (e.g., Roth IRA, Roth 401(k)) and a regular account (e.g., 401(k), 403(b)).

Your money goes into a regular account (e.g., 401(k)) before any taxes are taken out. Uncle Sam is very patient in this case. Taxes are not assessed until you withdraw this money during retirement. More often than not, the money will have grown, so he gets more taxes. And don't try to beat the system by not making withdrawls -- there is a certain amount that you have to withdraw once you reach retirement age (specifically, April 1 of the year after the later of: the year you turn 70 1/2 years of age, or the year you retire).

With the "Roth" versions, you first pay taxes on your income. Then you put the after-tax money in your account. From that point on, that money -- and the gains it produces -- is tax-free.

With the Roth IRA you are never required to make a withdrawl. Because this is such a good deal, only people making below a certain income limit are even allowed to contribute to a Roth IRA. (in 2007: adjusted gross income below $166K married filing jointly, $109K single). And, each person can only contribute a maximum of $4000 for 2007.

Let's add to the confusion. With your employer, you can have both a Roth 401(k) and a 401(k). The combined contributions cannot exceed $15,500 in 2007. Plus, the adjusted gross income (AGI) limitations do not apply to these plans. This allows those whose AGI excludes them from a Roth IRA to benefit from tax free growth in the Roth 401(k). But, with the Roth 401(k), you are required to take the minimum distributions.

There is some of strategy involved with regard to taxes; namely, do you want to pay taxes now or later? If your retirement income will be low, then you will have a lower tax rate. Thus, you will pay a relatively small amount of taxes on 401(k) distributions, so the pre-tax contributions (not to mention your company match) here may be more valuable than having tax-free withdrawls.

On the other hand, if you expect to have a large retirement income, one of the Roths may be better for you since your higher tax bracket won't come into play.

We are taking advantage of these plans as much as we can. My wife contributes to a 403(b), and I contribute to a Roth IRA. Ideally, we would start a Roth IRA for her, but we still need some money to live on!

With all these ways the government graciously lets us slide without paying taxes, you would think they're trying to tell us something...and it's not just retirement. Next time: health care.