How to pick the juicier 401(k) plan

  @Money September 11, 2012: 3:09 PM ET
pla 09 juicier plan

Choosing between a regular and a Roth 401(k) isn't exactly an apples-to-apples comparison but you can simplify the decision.

(Money Magazine)

Roth 401(k)s used to be fairly rare, but they're starting to crop up by the bushelful.

Two in five private-sector plans offer these tax-advantaged retirement accounts, with another 29% likely to add them this year, according to Aon Hewitt. And the federal government began offering Roths to 3.3 million of its employees in May.

When a Roth Makes Sense ...
Say you're 30 and expect your tax rates to rise:
Avg. salary for rest of career $70,000
Annual contribution rate 10%
Tax rate now 25%
Tax rate in retirement 28%
Retirement income generated
Traditional 401(k) $49,300
Roth 401(k) $56,700

... and When It Doesn't
Say you're 50 and expect your tax rates to fall:
Avg. salary for rest of career $100,000
Annual contribution rate 10%
Tax rate now 28%
Tax rate in retirement 15%
Retirement income generated
Traditional 401(k) $18,100
Roth 401(k) $16,900
NOTES: Examples assume the equivalent sum used to pay taxes for the Roth are invested in a separate account. Also assumes a 6% annual return, retirement at 65, and a 30-year retirement. SOURCE: Charles Schwab 401(k) calculator.

Yet workers have been slow to bite. Only 6% of savers who are eligible have signed up. "Part of that is employees are already in traditional 401(k)s and don't have the time or capacity to make a decision to change," says Charlotte, N.C., financial planner William Bissett. There's also the extra "cost" involved.

Just as with a Roth IRA, Roth 401(k)s are funded with after-tax dollars, while withdrawals are tax-free. The upfront tax hit, though, means stuffing $17,000 -- the annual federal max for all 401(k) accounts combined if you're under 50 -- will actually take $23,610 if you're in the 28% federal bracket.

Clearly, a Roth isn't for everyone. To see if you'd benefit, ask yourself the following questions:

Am I sure I'll be in a higher bracket later? Because workers who'd gain are those in a lower bracket now (when taxes are paid) than at retirement, Roths are especially attractive to young savers, says T. Rowe Price financial planner Stuart Ritter.

Related: Seniors, think twice before you buy an annuity

As the table shows, a 30-year-old at the 25% marginal rate today who retires in a higher bracket could generate 15% more retirement income by going with a Roth. In fact, that same person would do better with a Roth 401(k) even if he retires at the same 25% tax rate. Chalk it up to the long-term impact of tax-free compounding.

Others who stand to benefit are high earners in the top brackets who plan to maintain that level of income in retirement. If you fall into either of these groups, read on. If not, skip to the last question.

Have I weighed other complicating factors? Even if you think your tax rate will be higher later on (insert snarky comment about Washington pols itching to raise your taxes here), a Roth might still not be a slam dunk. What if you work in a high-tax state like New York but plan to retire to income-tax-free Florida or Nevada?

Also, understand it's your "effective" tax rate that matters at retirement, not your marginal bracket. Say you're single, putting away 10% of your $80,000 pay, and are planning to tap $40,000 a year in retirement. In a Roth 401(k), your $8,000 contribution will be taxed at your 25% rate. This may not seem that bad if you expect to be in the same bracket later on.

Saving for retirement in your 50s

But in a progressive tax system, not every dime of income you generate later on will be taxed at your marginal rate. In this case, the first $8,700 will be taxed at 10%; the next $26,650 at 15%; and the final $4,650 will be hit with 25%, for an effective rate of 15.1%.

Will the Roth negatively affect other taxes? Contributing to a traditional 401(k) will reduce your adjusted gross income, which in turn could lower the chances of being hit with the dreaded alternative minimum tax. Roth contributions won't.

Fail to reduce your AGI and "you may also lose tax credits and the deductibility of certain expenses," says Eric Lewis, a planner in Los Altos, Calif. Medical deductions, for instance, are limited only to those expenses that exceed 7.5% of your AGI.

Are there special circumstances that weigh in the Roth's favor? Roths appeal to those who want to pass money on to heirs, since there are no required minimum distributions starting at 70½ if you roll the account into a Roth IRA.

Related: Boost retirement income, minimize risk

They're attractive to high-income households for another reason. Married couples filing jointly begin to lose the ability to fully fund a Roth IRA once their income exceeds $173,000. Yet these IRAs can help diversify the tax treatment of your retirement funds.

Earn too much for a Roth IRA? You can get the same diversification via a Roth 401(k), says Bissett. Ideally, he says, you want "different buckets to pull money from in the future as you're taking distributions."

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