Six common money dilemmas solved

As you invest your money, shop for a home or tackle any one of the many financial decisions you have to make over your lifetime, do you sometimes wish you'd paid more attention in math class? Do you find yourself having to “run the numbers” and wondering how? To help, “Money” magazine has taken six common financial quandaries and done the math for you. Use this guide to walk you through the caveats and calculations as well as to navigate some of your financial life's trickiest questions and come up with your best call.

1. Pay off a credit card or fund your 401(k)?
You should do both. If you can't, pay off the plastic first.

In an ideal world, you'd wipe out your costly debts and save for retirement. But in the real world, you may not have enough cash to do both at the same time. Of course, you must pay at least the minimum on your credit card every month. So the question is, Do you put the rest of your available cash in your 401(k) or devote it all to your credit card?

Strictly by the numbers: By paying off credit-card debt, you get a guaranteed rate of return equal to your interest rate (the average is 14 percent today). But if your employer matches your 401(k) contributions, that's a 50 percent return (assuming the typical 50¢-to-the-dollar match on the first 6 percent of your salary).

Hard to beat. Or is it? The 50 percent match is a one-time gift; the 14 percent interest will compound every year. At some point the cost of that interest will overtake 50 percent. So if you have a big credit-card balance, attack that first.

Here's how that could play out if you're deciding what to do with $250 a month. With a $5,000 credit-card balance at a 14 percent rate, your minimum payment is $125 a month.

Suppose you put the rest in your 401(k). Because you don't pay taxes on that contribution, you can actually invest $174 a month (assuming a 28 percent tax rate). Keep paying $125 a month on your credit-card balance, and you'll need 55 months to wipe it out. During that time if you earn 8 percent annual returns and get the standard 50 percent match you'll amass $17,271 in your 401(k).

If you ignore the 401(k) for a while and instead plow your entire $250 toward the credit card, you'll pay it off in just 23 months. Then you could devote all your spare cash to your 401(k). By the end of the original 55 months, you'd have $18,515 in your plan. The one-at-a-time approach beats splitting your money because 55 months of paying 14 percent interest outweighs the 50 percent match.

But wait: Suppose your credit-card debt isn't that big, and you can pay it off in just a couple of years even if you split your cash. Great. Go ahead and fund both goals. You'll get the benefit of the 50 percent match.

You do the math: To see how long it would take you to pay off your credit cards, use the calculator at Bankrate.com.

Beyond the math: Good savings habits are important, too. If by putting off funding your 401(k) you'll never get around to it, work on both goals at once.

The bottom line: If you have a big credit-card balance, wipe it out before you open a 401(k)

2. Save in a Roth 401(k) or a regular 401(k)?
Don't miss this new chance to lock in tax-free retirement income.

Wish you could forever shelter your retirement savings from taxes, but you make too much to contribute to a Roth IRA? With the recent arrival of the Roth 401(k), you may have, or may soon be getting, a second chance at tax-free income.

Grab it. With a traditional 401(k) you invest pretax dollars and pay taxes when you withdraw your money; with the Roth version you pay taxes on what you put in but nothing on your withdrawals.

About a quarter of employers have rolled out this option, and a majority of plans will likely offer it by 2009. Unlike a Roth IRA, which is off-limits in 2008 once your modified adjusted gross income hits $169,000 (as a couple), a Roth 401(k) has no income caps.

Strictly by the numbers: Let's say that you contribute the maximum of $15,500 to your 401(k) and you're in the 28 percent tax bracket. Assuming an 8 percent annual return, you'll end up with $72,245 tax-free in 20 years with a Roth.

If you go with the traditional 401(k) instead, you'll also end up with $72,245 in 20 years, but you'll pay taxes on the withdrawals. At the same 28 percent tax rate, you'd be left with $52,016 you could actually spend.

When you fund the traditional 401(k), however, you shelter $15,500 from taxes. But even if you invest that $4,340 tax savings outside your plan, you'd have to earn well in excess of 8 percent a year to equal your Roth total after taxes.

But wait: Won't your tax bracket drop once you're no longer working? Don't count on it. If you're just starting your career, you'll almost certainly be earning more in 40 years. Even if you're mid-career, you can't assume your tax bracket will plummet. With federal tax rates currently at their lowest levels in decades and the federal deficit growing, it's not hard to imagine Congress raising taxes between now and your retirement. Assume a lower bracket only if you're near retirement and know your tax rate will fall.

You do the math: Use the Roth 401(k) calculator at Dinkytown.net.

Beyond the math: A regular 401(k) has one thing going for it: the up-front tax break. That's why you'll see your disposable income shrink if you switch to a Roth. But for the regular 401(k) even to come close to the Roth as a savings vehicle, you'd have to invest the extra cash that it put in your pocket. Would you?

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