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Author: xraymd Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 308674  
Subject: Re: Retirement vs. Snowball Date: 9/14/2005 6:43 PM
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Hey, question.... Why do you need a Roth IRA if you're contributing to a company 401K??? Is this so you can contribute to the max on both each year allowing more saving?

Greetings, mew5280, here's how I would answer your question:

You need to do more than just pay off debt - which represents funding yesterday at the expense of today, since yesterday you bought stuff you did not already have the money to pay for when the bill came due. That's the debt side of the equation.

Then there's the savings side. Savings represents funding tomorrow with today's earnings. I don't know how old you are now, but how old will you be 10 years from now? 25 years from now? 45 years from now? When you get to be the YOU whom you will be at those points, where will your largesse come from? Yep, from the dollars that you whom you are right now will (have) already tucked away for yourself for THEN.

Most people are sort of hazy about the THEN. It's kind of like being in elementary school and not having a tiny clue what it would be like to be a TEENAGER. So project forward: remember 10 years ago? Could you ever have believed that you'd get to be your age and stage today? And could you believe then, looking back, that you don't feel so gol-darn different from then; just a little bit older? Well, take it on faith that this is EXACTLY how you will feel in the years to come. Simply exactly the same, but just a little bit older. And once this gets into your head and awareness dawns, it becomes a lot easier to start saving today, because it isn't so hazy after all. The YOU you are now is going to be responsible for the YOU you will be then. And your financial actions today are going to determine the future that your future self will have.

That said, paying off debt is like disinfecting. I've made comparisons in the past to how debt is like mildew (I can even search for that post if you like). Right now, the debt you have has coated your finances with stinky mold that dumps sewage upon it in the form of interest you pay to have spent money you did not already have. I know you know this; otherwise, you would not be posting here, and strategies for paying off the debt are akin to attacking mildew with bleach. A dollar paid off for good cannot any longer raise a further stink in the form of interest that it generates against you. I'll leave the discussion of paying down debt to others.

And this leads us to the other side of your financial house. If debt is akin to infestation, then savings LEFT TO GROW are akin to securing your foundation, and shoring up your financial house for a strong foundation of support with each passing year. This is why becoming savvy about savings is just as crucially important as getting out of and remaining out of debt. Every dollar you turn loose towards building your foundation is going to ADD to itself in the form of interest it earns.

And here's one very good way to do this:

Consider which types of savings plans you have available for your future (retirement) savings. Typically, there are some tax-favored vehicles you can put your money in, paycheck by paycheck, even, that reduce the tax drag against your saved dollar. These are tax-deferred plans and tax-exempt plans. A common tax-deferred plan would be a 401(k) (or if your company is a non-profit, a very similar 403(b)). This is a retirement savings plan SPONSORED BY YOUR EMPLOYER that lets you put in a dollar now while deducting that dollar from your taxable income when you save it. The tax will still be OWED on that saved dollar (and on its earnings) but will not be DUE until years and years and years from now when you go to withdraw it from the plan. At that point (and mandatory withdrawals must begin by age 70-and-1/2), the presumption is that you would be in a LOWER tax bracket than you'd been in during your working life, so that the eventual taxes would be less than what they would have been had the tax been levied against that saved dollar at the time it was saved, and that the deferred-tax saved dollar would have had a chance to accrue the maximal interest in earnings. The employer-sponsored 401(k) has generous contribution limits and allows you to save (if you so chose) a pretty generous percentage of your salary, up to a particular ceiling. That percentage is also determined by your employer and could change from employer to employer. The ceiling is determined by the federal government and is the same everywhere. Also determined by your employer is whether or not they will pay a match against some percentage of the contributions you DO make - not all employers do this but should they do, you'd want to take it since the match is FREE MONEY.

So a 401(k) is one vehicle for saving for your future. Another separate vehicle which you may be eligible for depending on your 401(k) participation is to fund a portion of your retirement savings YOURSELF (not employer-driven) in an IRA. The IRA comes in two flavors - a traditional IRA which has terms fairly much like contributing to your 401(k) in that it is also a tax-deferred plan and does reduce your current-year taxable income in the year you fund it. Or a Roth IRA, which has only been around since 1998, that has some unique and generally greatly favorable features. The Roth is more of a tax-exempt plan in that the dollar you put into it THIS YEAR is taxed (no reduction on your taxable income) BUT EVERY PENNY THAT DOLLAR EARNS GOING FORWARD REMAINS ENTIRELY FREE OF TAXATION. Read that twice, a third time, even. This means that for foregoing today's tax benefit, you wind up with savings later that are not only FREE of tax but by the rules of a Roth are not required to be distributed (withdrawn) by any specific age, may be inherited by your beneficiaries without their having to owe any tax on it and which is open for continued contributions so long as you have the income to support it beyond the traditional IRA deadline of age 70-and-1/2. The sum of your traditional IRA contributions plus your Roth contributions together must not exceed the annual limit ($4000 in 2005, $5000 in 2006 for a single person) BUT nothing says that you can't decide to make your IRA contribution 100% Roth and not contribute to a traditional IRA (which is essentially duplicated by your 401(k) contributions).

So, to sum up so far, assuming you are single and this is 2005, you could put up to x% of your salary in a 401(k) (where x is determined by your employer, usually up to 20%) - with the hard limit on 2005 being around $14,000 of contributions PLUS you could contribute another $4000 to your Roth ON TOP OF THAT. Or reverse the order with the Roth contributions coming first: read on.

Okay, I hear you saying that you can't possibly make this level of contribution because you owe so much to debt. Well, here's where you want to set your future security planning into motion: decide that making your retirement contribution is a BUDGET ITEM, akin to rent and utility bills. DO NOT WAVER FROM PAYING IT. It is an expense towards YOURSELF and if you short yourself now, where will you be later? And to make it easy, easy, easy to be sure you have paid it to yourself, have the contribution autodeducted from each paycheck. If you don't touch what you have decided to set aside for your future, if you don't even DIRECTLY RECEIVE it, then it is truly the most painless possible way to save. A mindset towards earnings that understands the cruciality of PARTITIONING each dollar that you bring in is what leads to your preferred result. You don't really get to spend 100% of what you bring in. Accustom yourself to thinking that each time you receive money that some portion of it is payment to your future self that your present self MUST caretake. That way, you won't err on the side of acquiring stuff that you can't afford, since that portion of your present income actually belongs to your future.

So should you get a Roth? Yes, indeed. In your case, since your 401(k) has no match, then you don't have an advantage where your employer is handing you free money and so you may wish to put your first contributions towards funding your Roth and then fund your 401(k) once you hit the Roth annual limit. If, after checking it out, you decide there is some previously-unconsidered benefit to funding your 401(k), you might even want to do so SIMULTANEOUSLY with funding your Roth, and divvy up your paycheck to stream your preferred amount towards the Roth and the other preferred amount towards the 401(k). Given that you have debt, you MUST also stream a portion of your paycheck to debt repayment. But even as stinky as $32K of debt may be, if you have stopped using the cards and are not adding to it, eventually you WILL get it paid off and then all the snowball proceeds that went towards debt retirement can then come back to you for you to decide how much you want to be putting into your retirement coffers.

"The Richest Man in Babylon" is a great little parable book written a long time ago and whose overall message is to try to think of every dollar that comes in as 70% for current expenses, 10% towards retirement savings and 20% towards debt. That's a pretty good recipe. You would then pay debt off at twice the rate you'd be setting aside for savings - but at least you ARE setting aside for savings even while you are paying off debt. And remember that along with good payback behavior comes better and better offers to lower your debt interest rates, making owing the money decreasingly costly. So the snapshot of your current net worth picture would change (favorably) as your savings accumulate and your debt shrinks.

Hope this helps. Obviously I am totally persuaded that there is no reason to delay regular savings unless your debt interest rates are high enough to smother you. I am also persuaded that the easier you make it be to save, the more likely you ARE to save. And that once you look anew at what your earnings represent for your future, your attitude towards falling again into debt is likely to shift markedly away from what made it so bewitchingly easy to spend money before that you did not already have banked.

xraymd

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