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Calculating the Advantage of the Roth 401(k)
Even if you are near retirement, adding this egg to your nest is a wise way to go.
September 2006
If you're still working and your company now offers a Roth 401(k), you may want to jump at the chance to open one. Although you'll be trading the up-front tax savings for a tax break later, you'll be well rewarded for your patience. By nearly all measures, a Roth 401(k) beats the regular 401(k) when it comes to accumulated savings, even if your retirement is only a few years away.
As with a Roth IRA, contributions to a Roth 401(k) are made with after-tax dollars, so if you contribute $100 to a Roth 401(k), your take-home pay drops by $100. With a traditional 401(k), contributions are made with pretax dollars, so in the 25% tax bracket, the $100 contribution takes just $75 out of a paycheck.
Although annual contribution limits are the same whether you choose the traditional 401(k) or the Roth version -- $15,000 a year, plus a $5,000 catch-up for those age 50 and older -- the Roth effectively lets you set aside more for your retirement. Why? Because Uncle Sam is not your partner. (Editor's Note: For 2007, the limit for a regular contribution is $15,500.)
With the traditional 401(k), every dime you withdraw from the account in retirement will be taxed so that the government can recoup the money you saved by making pretax contributions. And, if you're still in, say, the 25% bracket, you'll pay back not only 25% of your contributions, but also 25% of all the money earned over the years.
With a Roth 401(k), however, all withdrawals are tax-free in retirement, assuming the account has been opened for at least five years and you're at least age 59 1/2. To see how this can give you more money to spend in retirement, consider this example.
Assume a 55-year-old man intends to contribute $20,000 a year (or $1,667 monthly) to his company's 401(k) for the next ten years and that investments inside the account earn an average of 7.5% a year. By age 65, the account will hold $298,404.
Now, assume our retiree taps the account for monthly withdrawals over 20 years. Assuming the same 7.5% earnings rate, he would be able to pull out $2,389 a month. If he used the Roth 401(k), the full $2,389 would be his to spend. With the regular 401(k), though, if he's in the 25% tax bracket, Uncle Sam would demand 25% of each withdrawal, leaving him with just $1,791. Over two decades in retirement, the Roth 401(k) would provide $143,000 more spending money.
It's true that the Roth 401(k) costs more, because our investor passed up the tax break during the saving years. But even if he had set aside those savings from the regular 401(k) and the savings earned the same 7.5%, the investor would still have come out behind because tax on each year's earnings would have retarded growth.
Another advantage of the Roth 401(k) is that it "allows you flexibility in managing your tax liabilities," says Steve Doucette, a certified financial planner and vice-president of Proctor Financial, a wealth-management firm in Wellesley, Mass. The tax-free income you withdraw from a Roth account could help counterbalance the taxable distributions from regular IRAs and 401(k)s.
A Hedge Against Future Tax Rates
Like a traditional 401(k), you must take minimum distributions from a Roth 401(k) once you turn 70 1/2. But if you roll the Roth 401(k) into a Roth IRA, you're not required to make any withdrawals so the money could grow tax-free for decades.
Anyone using a Roth 401(k) is betting on higher federal tax rates in the future. But sticking with the regular 401(k) could be the way to go if you're sure your tax rate will drop significantly and you plan to withdraw money in a few years, says Stuart Ritter, a certified financial planner with T. Rowe Price.
Most taxpayers should not bet on a lower tax bracket in retirement. You'll be drawing on multiple income source -- pensions, Social Security and IRAs -- that could keep your bracket level. And it's possible that today's relatively low federal rates could disappear if budget deficits continue to widen.
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