09/01/05 - Roth 401(k) or Traditional 401(k) - Which one is right for you? Part II

By: Richard Feldman, CFP, MBA, AIF

The Roth 401K is the greatest retirement option available as long as you believe the old saying "There are only two things certain in life; death and taxes". The Roth 401(k) gives you the opportunity to defer money now into your retirement plan that will never be taxed again. The main question for most individuals is whether to defer taxes into the future or pay taxes now and have your retirement account grow and never be taxed again. The answer is very complex and depends on a number of circumstances that will change from individual to individual. I will use my own personal experience for analysis purposes since I have been toying with the idea for my wife's 401(k) account.

Tax Rates

The main driver of the analysis is an individual's current and future tax rate. Individuals will derive the most benefit from a Roth 401(k) if they are in a low tax bracket currently and will be in a higher tax bracket in the future. The reason is that you can pay taxes now at a lower rate than what you will be able to pay in the future. The difference in tax rate will need to be high enough to offset the tax deferral that you receive by deferring salary into a traditional 401(k). An individual's tax bracket is not the only issue that needs to be forecasted. Future tax rates for all tax payers must be addressed. Many economists and tax experts feel that our current tax rates might be the lowest rates we see due to the rising budget deficit. Many professionals feel that you would be better off to pay the taxes now because the government in the future will need to raise taxes because of social security and budget deficits.

The Analysis

In looking at my own circumstances my wife and I file a joint return and are in the 28% marginal tax bracket. We are both in our thirties and itemize because we just purchased a house two years ago. We will probably start a family soon so we should have more deductions coming. My tax forecast is that we will be in a lower tax bracket now due to all of our deductions than we will be in the future if we continue to save according to the plan I have established, which is approximately 15 - 20% of our gross wages.

My wife through her retirement plan has the opportunity to contribute $15,000 to either a traditional 401(k) plan or a Roth 401(k) plan. If she continues to defer salary into her traditional 401(k) she receives a dollar for dollar deduction from federal income taxes saving us or deferring us a total of $4,200 on the $15,000 saved. If she switched to a Roth 401(k) it would take $20,833 in gross wages at a 28% tax bracket to make a $15,000 Roth 401(k) contribution. The question becomes whether $15,000 pre-tax contribution into a 401(k) in addition to the $4,200 in tax savings you receive on that contribution is equal to or greater than the benefit derived from the $15,000 after tax contribution. Please see the following table for an analysis of a traditional 401(k) and Roth 401(k) over a five year period. This would bring us to 2010 when the sunset provision will repeal the Roth 401(k).

	Traditional 401(k)	Roth 401(k)
Yearly Contribution for Five Years	15,000	15,000
Total amount of funds needed to make contribution	15,000	20,833
Future Value of Contributions in 5 Years	91,847	91,847
Less Assets Forgone By Paying Taxes Up Front	0	-25,717
	91,847	66,130
Taxes on Future Value of Contributions	-25,717	0
	66,130	66,130

 

If your tax bracket remains the same in the future as it does today there is no incremental gain from contributing to a Roth 401(k). The analysis would favor a Roth 401(k) if the tax savings from the traditional 401(k) were invested tax inefficiently in a taxable account. There will be taxes owed on the investment of the tax savings ($4,200 a year). If those funds are invested in a taxable account the comparison is skewed either way by the tax efficiency of the investment vehicles used. If taxes on dividends and capital gains are owed each year as a result of the investment of the tax savings then the analysis would favor a Roth 401(k).

Estate Planning

The Roth 401(k) and the traditional 401(k) both require mandatory distributions after the participant has reached the age of 70 ½. The only difference in the distribution rules results in the opportunity to rollover the Roth 401(k) into a Roth IRA after the employee has retired from service. Roth IRAs have no rules requiring mandatory distribution after reaching age 70 ½. Funds inside a Roth IRA could enjoy twenty or thirty years of additional compounding without any funds ever having to be distributed from the account. This creates an opportunity to build up an inheritance for children or grandchildren that will be free of taxation. This might be a valuable option for corporate executives or professionals that have already built up significant estates and retirement accounts that are concerned with leaving an estate for their heirs. The Roth 401(k) is an opportunity to prepay taxes that might otherwise be subject to the estate transfer tax if they were deferred.

Conclusion

There are a number of issues that need to be addressed before you decide which retirement vehicle is right for you. The Roth 401(k) seems to be optimal for individuals who are in their thirties and have a lot of deductions or individuals who are in the fifties or sixties and have already built up a sizeable pre-tax retirement account. The main beneficiaries of a Roth 401(k) are those individuals in a lower tax bracket now than when they retire or individuals who would like to build up a tax free vehicle to pass on to their heirs. Please see my previous article for a discussion of the rules and availability of the Roth 401(k).

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