To Roth
or not to Roth 401(k)
by Walter Updegrave
January 17,
2008
Money
Magazine's Walter Updegrave explains the pros and cons of a Roth
401(k) vs. a regular 401(k).
Question:
My employer will begin offering a Roth 401(k) this year, and I'm
considering taking advantage of it. As I understand it, the Roth
401(k) is much more advantageous than a regular 401(k) because
even though I pay income tax on the dollars I contribute to the
Roth, I don't pay tax on withdrawals, which potentially saves
me millions of dollars in taxes I would otherwise have to pay
on gains. Is my understanding correct, and do you think I should
contribute to the Roth? - Danny Pisarcik
Answer:
After getting off to a slow start, Roth 401(k)s are beginning
to pick up momentum.
Like
your employer, more companies have started to offer Roth 401(k)s
since they were allowed to start doing so two years ago, and many
firms that don't yet provide this option are considering adding
it in the future.
To
paraphrase Martha Stewart, I think that's a good thing.
But
it's important that you - as well as anyone else mulling the Roth
401(k) - have a good understanding of how it works and what its
pros and cons are.
So
I'm happy to give a quick rundown, as well as offer my thoughts
on who ought to consider contributing to this version of the 401(k).
Apples
to apples
Let's
start with one basic but often misunderstood fact. Although they're
effectively mirror images of each other -with a regular 401(k)
you invest pre-tax dollars and pay taxes at withdrawal, while
with a Roth 401(k) you invest after-tax dollars and pay no tax
at the end -in a pure economic sense there's really no difference
between the two.
For
example, let's suppose you're in the 25 percent tax bracket and
you contribute $15,500 - the maximum for 2008 - to a regular 401(k).
(People 50 and older can throw in another $5,000, but we'll ignore
"catch up" contributions for this example.) And let's further
assume that you earn 8 percent a year on your contribution.
At
the end of 10 years, that contribution to your 401(k) account
would be worth $33,463. If you withdraw that amount and pay taxes
at the 25 percent rate (for simplicity's sake, we'll assume you
don't have to pay the 10 percent penalty for premature withdrawals)
you would be left with $25,098 after taxes.
One
subtle difference
Now
let's see what would happen if you instead did the Roth 401(k).
Well, since that $15,500 isn't going into a regular 401(k), you'll
have to pay tax on it. Assuming a 25 percent tax rate, that would
leave you with $11,625 in after-tax dollars to invest in the Roth.
Assuming an 8 percent return for 10 years, that contribution to
your Roth 401(k) would have a balance of $25,098, tax free - the
same as you would have after taxes in your regular 401(k).
In
short, you end up at the same place whether you avoid taxes upfront
and pay them at the end (i.e., do the regular 401(k)) or you pay
the taxes upfront and avoid them at the end (i.e., do the Roth
401(k)).
But
there's one little wrinkle about the Roth that gives it an edge.
The example above shows that investing $11,625 in after-tax dollars
in the Roth 401(k) is the equivalent of making the maximum $15,500
contribution of pre-tax dollars into a regular IRA. But you're
not limited to contributing $11,625 in after-tax dollars to the
Roth. Congress made the maximum dollar contributions the same
for both the regular 401(k) and the Roth 401(k).
The
golden years
You
can invest up to $15,500 in after-tax dollars to a Roth. Which
means that as long as the dollar amount you can contribute to
a regular 401(k) and a Roth 401(k) are the same, the Roth 401(k)
effectively gives you the chance to sock away more money on a
tax-advantaged basis for retirement, assuming you're willing to
part with the extra bucks.
Of
course, you do reap tax savings from your regular 401(k) contribution.
And if you're disciplined enough to invest those tax savings and
you're able to duplicate the Roth's tax-free returns on those
savings, then the amount you end up with after taxes in a regular
401(k) and the Roth 401(k) would be the same.
But,
really, are you going to be meticulous enough to invest the tax
savings you get from making a regular 401(k) contribution? I doubt
it. So as a practical matter, I see the Roth as a way for people
to effectively boost the amount they save for retirement.
Tax
rate
I
should add that tax rates also play a role in the deciding between
a regular 401(k) and a Roth 401(k). The example I've given assumes
that you pay the same tax rate at the time you make your contribution
as you do when you withdraw the money.
But
if that's not the case, then the scales would tip in favor of
either the regular or the Roth version.
For
example, if you happened to drop from the 25 percent to the 15
percent bracket by the time you withdraw the money from your regular
401(k), then you would deduct less in taxes, leaving you with
more than in the Roth.
Conversely,
if you climbed into a higher tax bracket - say, 33 percent - then
you would owe more in taxes on your regular 401(k), leaving you
with less than in the Roth.
So
what's all this mean for someone like yourself trying to decide
between a regular 401(k) and a Roth 401(k)?
Well,
generally the Roth 401(k) is a better deal if you think you'll
end up in the same tax bracket or a higher one in retirement,
and the regular 401(k) if you think you'll end up in a lower bracket.
Trouble
is, it's hard to know what tax rate you'll face once you retire.
That will be determined by a variety of factors that are difficult
to sort out in advance, including how much money you'll be drawing
in retirement from taxable sources like pensions and regular 401(k)
and IRA accounts, the amount of interest and capital gains you'll
generate in taxable investment accounts after you retire, how
much you earn from part-time or other work in retirement and,
of course, the extent to which the guys and gals down in D.C.
decide to play around with the tax laws after you've retired.
The
best of both worlds
That's
one reason I think it's a good idea for most people to contribute
money to both a regular 401(k) account and, assuming they have
the option, in a Roth 401(k).
Now,
you may want to favor one account over the other depending on
your circumstances and your outlook. If you're just starting out
in your career and likely to move into a higher tax bracket later
on, then you probably want to do more in the Roth.
Ditto,
if you're such a diligent saver that withdrawals from retirement
accounts are likely to keep you in the same tax bracket as during
your career, if not push you into a higher one.
If,
on the other hand, for whatever reason you think it's more likely
you'll face a lower tax rate in retirement than you do now - perhaps
you're at your earnings peak and you expect you'll shift into
a lower tax bracket in the final years of your career and during
retirement - then you may want to contribute more to a regular
401(k). (Remember, too, that any employer-matching contributions
go into a regular 401(k) account, even if you contribute to the
Roth.)
Social
Security benefits
There
are other reasons you'll probably want to have at least some money
in both types of accounts. Although Roth 401(k)s have the same
withdrawal requirements as regular 401(k)s, by rolling over your
Roth 401(k) into a Roth IRA, you can avoid having to make required
withdrawals in retirement. And unlike withdrawals from a regular
401(k), withdrawals from a Roth 401(k) don't count when determining
whether your Social Security benefits are subject to income taxes.
Bottom
line: I don't think of this as a digital decision - do the
regular 401(k) or do the Roth 401(k). You can contribute to both
(or, if the Roth 401(k) isn't an option, then a Roth IRA, for
which the case is similar). The more important issue, as I see
it, is that one way or another you accumulate at least some money
in both tax-deferred and tax-free accounts. This strategy won't
guarantee you the cushiest retirement. But it will allow you to
hedge your bets and give you more maneuvering room for managing
your tax bill in retirement.
The
opinions in this publication are not necessarily those of Mutual
of America Life Insurance Company and are not intended to provide
specific advice or recommendations for any individual. Consult
your attorney, accountant, or financial tax adviser with regard
to your individual situation.
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