Is It Foolish to Invest in a 401(k)?
Dear Dr. Don,
It looks like retiring workers who invested pretax dollars in their retirement accounts and who need to tap the 401(k)/IRA for income will probably pay more in taxes than they avoided by investing with pretax dollars.
What is the best strategy for people still working? For example, should they invest no more in their 401(k) than the employer match in pretax dollars?
-- Michael Morass
That's an interesting question. Conventional wisdom has you investing pretax dollars in IRA and 401(k) accounts, then later taking qualified distributions from these accounts. At that time, you'd pay taxes on the distributions at ordinary income rates expected to be lower in retirement.
A retirement planning strategy of investing in a 401(k) up to the limit of the company match, then investing in other retirement accounts can provide a measure of tax diversification. For example, even if you don't qualify to contribute directly to a Roth IRA, you can make nonqualified (after-tax) contributions into a traditional IRA and then convert the account to a Roth IRA.
The uncertainty lies in what your marginal tax rate will be in retirement. With the current concern over budget deficits and expanding federal programs, the worry is that marginal tax rates will be higher in retirement than when the money was contributed to the account.
Another variable in the mix is how probable it is that you'll need the money in retirement. Roth IRA funds aren't subject to required minimum distributions from the account during your lifetime.