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Reader Question: To Roth 401(k) It or Not?
By JLP | December 14, 2007
I received the following email last night from a reader looking for some help in trying to decide whether or not to contribute to a Roth 401(k).
JLP,
First, I love the AFM blog. Tell your father-in-law I loved his article and that his fans want more. =)
I have a question that maybe you can shed some light on. My employer offers the option of a Roth 401k. I’m struggling with the question of whether this is right for me or not. Currently I contribute 6% of my income to the traditional 401k, of which the employer matches 50% (up to the max of 6%). I also contribute significant amounts of my salary to my employee stock purchase plan as well as a handful of mutual funds and one REIT.
I’m 42yrs old with a plan to exit the work force at 55. My tax bracket is pretty high already and one of the decision criteria for the Roth 401k is whether you expect your tax bracket to be higher by the time you retire. So that’s not likely a match for me. One of the other criteria for Roth 401k is if you are no longer eligible to contribute to a traditional Roth IRA, which I am not.
The concept of having tax free retirement funds available to me at retirement is certainly compelling. I’m just not sure if there is an advantage. Do you have any thoughts about that? I’ve tried a couple of the calculators on the internet but I feel like they are over simplified although they do show a slight to moderate financial advantage to putting my money in a Roth 401k.
Naturally the risk is that the government could potentially change their minds in the future which I think would be unlikely. In addition, the Roth 401k is up for renewal in 2011 which means, even if I do begin contributing today I may only have 3yrs with which to contribute to one so how much would it actually accrue to by the time I could withdraw from one.
So if you can tell I’m leaning on the side of not taking advantage of the Roth 401k. The one way where I feel I could take advantage of it would be to increase my 401k contribution to its max and shift the additional funds to the 401k. But would I take better advantage of the reduction in my taxable income? Am I nuts for not maxing out my 401k?
Any thoughts would be welcome.
Thanks!
Mike
Mike,
Thanks for the email and your kind words regarding AFM. I love hearing stuff like that!
Here are my thoughts:
1. Remember that the Roth IRA, which you would be rolling your Roth 401(k) into once you retire, offers the benefit of NO required minimum distributions. This is not true of traditional IRAs, which regular 401(k)s are rolled into. So, although it is hard to quantify, it does offer you some flexibility and it could also be a great way to invest for the long haul since you don’t have to withdraw money upon retirement. It also could be a great way to pass on tax-free income to your heirs if that’s something you desire.
2. As of right now, distributions from Roth IRAs are NOT included in figuring the taxation of Social Security benefits. Again, this offers retirees some flexibility. Will this benefit still be available 15 -20 years from now? I have no idea.
3. The tax situation is also difficult to assess since there are so many variables but the general rule is if you expect you are in a higher tax bracket now than you will be at retirement, then you are better off going with the standard 401(k). Of course, the difficulty is in knowing what the tax rates will be like 15 - 20 years from now. You’re giving up dollars now in hopes of getting more dollars in the future. It’s a gamble and I really can’t tell you which way is best.
4. Are you currently susceptible to the AMT? This is something to consider since the AMT calculation begins with either line 38 or 41 of Form 1040, which is your adjusted gross income. Since traditional 401(k) contributions are pre-tax, it lowers your taxable income and could theoretically help you come in under the AMT radar. I haven’t done enough research on this to know at what point a person becomes ensnared by the AMT.
I would say you are borderline as being a good candidate for the Roth 401(k). I think it’s a much better deal for those who are young and in a low tax bracket.
Topics: 401(k), Retirement Planning, Roth 401(k) |