Q. Assuming you take advantage of all of your employer's retirement benefits, are there circumstances under which it would be advisable to take your salary today and invest a post-tax portion in taxable funds rather than place the pre-tax amount in a 401(k)?

I am working in a state that has no income tax but wish to retire to one that does. It would seem that, in some cases, it might be better to pay now and take advantage of lower taxes.

---D.R., by e-mail from San Antonio, TX


A. That's a very important question. It's a question that will be getting more and more attention in the future as retirees start to realize how the taxation of Social Security benefits impacts their retirement savings.

There are three major factors to consider when deciding where to invest your retirement savings:

•       The employer match, if any

•       The cost of the employer's plan compared to alternatives and

•       Your anticipated future tax rate.

When your employer matches 50 or 100 percent of your contribution there is every reason to participate fully. If you don't, you are walking away from free money. Even when the match is in company shares it is still beneficial to "capture the match."

If your employer provides no matching funds the decision is more complicated because you have to weigh the convenience, ease, and higher limits of a 401(k) or 403(b) plan over alternatives you can find on your own. Most public school teachers, for instance, could do far better than the investment options they are offered through their 403(b) plans because most teacher plans are loaded with variable annuity products that have annual expenses greater than 2 percent a year. If they will do their own homework they can invest independently and have annual expenses of less than 0.2 percent a year.

While the current limit on 401k and 403b plan contributions is $14,000 plus an additional $4,000 for those age 50 and over, IRA plans are limited to $4,000 plus an additional $500 for those age 50 and over. For many workers the $10,000 plus difference doesn't matter--- saving $4,000 a year is difficult enough. An average worker, for instance, earns about $35,000 a year so $4,000 a year would be 11.4 percent of gross income, a hefty amount.

Given a choice, many younger workers should opt for a low cost Roth IRA plan over an unmatched employer plan. Since a Roth IRA has the same dollar contribution limit as a traditional IRA but is funded with after-tax money, the effective contribution limit is higher. If you are in the 25 percent tax bracket, for instance, the $4,000 you contribute to an IRA will be subject to taxation in the future. To contribute $4,000 to a Roth IRA you will need to have paid taxes on $5,333 of income but will have no taxes to pay in the future.

Most people assume they will pay income taxes at a lower rate when they are retired than when they are working. This may not be true for those planning to move from a no tax state to a state with an income tax. It may also not be true if you are a middle-income worker whose qualified plan withdrawals will trigger the taxation of Social Security benefits.

Suppose you are in the 15 percent tax bracket while working. If you put your money in a traditional IRA, all later withdrawals will be taxable. If they trigger the taxation of Social Security benefits, your effective tax rate on withdrawals will be 22.5 percent.

You would be better off paying the 15 percent tax today and putting the same money in a Roth IRA. Since withdrawals from Roth IRAs aren't taxable, the taxation of Social Security benefits won't be triggered and you'll pay no taxes at all.

So it's 15 percent now or 22.5 percent later.

Because the formula for the taxation of Social Security benefits isn't indexed to inflation, workers in their 30s and 40s should favor Roth IRAs over traditional IRAs. (An earlier column that demonstrates this is available on my website, www.scottburns.com)

And what if you just put the after-tax money in a taxable account?

That won't be particularly beneficial if you are in the 15 percent tax bracket (taxable income in 2005 of $14,600 to $59,400 on a joint return) but it is likely to be beneficial if you are in the 25 percent tax bracket and receive your future income in dividends and capital gains.


Because if you save tax deferred, all withdrawals will be taxed as ordinary income, probably at 25 percent. In addition, they will probably trigger the taxation of Social Security benefits, increasing the effective tax rate to 37.5 percent or 46.25 percent. Take the income from a taxable account as dividends and capital gains taxed at 15 percent, however, and you may trigger Social Security benefit taxation increasing your effective tax rate to 22.5 percent to 36.25 percent. Either way, it's a big difference.

Bottom line: For young workers, saving a few tax dollars today can be "penny wise and pound foolish."