To Roth or not to Roth 401(k)
Money Magazine's Walter Updegrave explains the pros and cons of a Roth 401(k) vs. a regular 401(k).
NEW YORK (Money) -- 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.
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). (For more on the benefits of diversifying your tax exposure, or "tax diversification," click here.)
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.
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