YOUR FRIENDS' ACTIVITY

    To Defer or Not to Defer; The Ultimate Pre-Retirement Question

    By | Work + Money – Thu, Apr 7, 2011 7:27 PM EDT

    To Defer or Not to Defer; The Ultimate Pre-Retirement QuestionTo Defer or Not to Defer; The Ultimate Pre-Retirement QuestionBy: John D. Buerger, CFP®

    Should you fund your retirement plan (401(k), IRA and Roth IRA), or not? Which plan? How much?

    As a financial planner, these are the most common questions I am asked by clients, workshop and Webinar attendees. Ask three people and you'll probably get three different answers. Here's my answer (and it is sure to be different as well):

    No Simple Answer

    To start, every case is different so there is no single one-size-fits-all answer.

    The solution for your specific case depends on a number of variables: your age, current income, chances you will earn more later in life, best guess of your retirement income sources (pension? social security? inheritance?) and best guess of tax rates in the future. They're all critical to the answer of whether or not to put money into an IRA, a Roth IRA or some kind of non-qualified retirement savings account.

    Basic Rule of Thumb

    The general objective of good retirement and tax planning is to always pay the least amount of taxes whenever those taxes must be paid. Note that I didn't say, "Always pay as little taxes today as possible."

    Example: If Susan is young (in her 30s, let's say) and in the early part of her career and earning cycle, putting money into a 401(k) plan will help her save taxes at a low rate (maybe 15 percent) in order to potentially pay taxes at a much higher rate later on (when she retires and has grown used to having more income to work with). This works against the principle of paying the least amount of taxes whenever those taxes are paid.

    So if you think your nearer the bottom of your lifetime pay scale, then don't defer taxes and fund a Roth-type or regular retirement investment account - at least for any dollars beyond a company match (more below).

    Calculator Fail

    This is the problem with most financial calculators for IRA contributions and much analysis done by tax professionals and CPAs. The calculations use static data and assume that tax rates and your income will stay the same for the rest of your life. Neither are valid assumptions for most people in real life.

    Advantage of 401(k) Plans

    401(k)-type plans have two major advantages. The first is that the company may match any contributions you make to the plan (up to a limit). This is "free" money being offered to you as an incentive for you to use the program. No higher tax rate in the future can make "free" money in the present undesirable. You should always contribute to your plan up to the match limits.

    The second advantage of 401(k)-type plans (including 403(b) and other deferred compensation plans available through your employer) is that they are automatic forced savings. You never see the money so never realize it's gone.

    "Out of sight, out of mind" is a very powerful financial concept for building wealth.

    A Different (and Easier) Way to Answer the Question

    Look at your lifestyle, income and expenses today (hopefully you're spending less than you earn). If that lifestyle is about what you expect to enjoy in your retirement years, then you defer the taxes and make the contribution to your 401(k)-type or IRA plan. If you expect that your retirement lifestyle will require more income than you're earning today, then save the money in a Roth-type or regular savings account.

    Furthermore, if you think tax rates are going to go up in general before you retire, then you will want to trim how much goes into tax-deferred savings and put that money someplace else.

    No Pass on Savings

    In order to build a more secure future for you and your family, you simply must start saving. Ten percent of your income is the minimum and really 20 percent is preferable. That may mean cutting back on current expenses and/or lowering your quality of life, but I'd rather make a few small sacrifices when I'm young than have to make huge ones when I'm old and set in my ways ... or risk running out of money before I run out of life.

    So if you choose not to defer compensation today (don't use your 401(k)-type program), you still have no excuse to not save money. I know that is a bitter pill to swallow for many people, but if you don't want to rely on handouts from others in the future, it is acting responsibly.

    John Buerger is a Certified Financial Planner™ professional licensed with a registered investment adviser that provides personal financial advice online for a fee. John is a wealth coach and an online advice pioneer who teaches his clients to make better money choices.

    Related articles: