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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) |
December 14th, 2007 at 1:49 pm
Yes, there are many unknowns in this decision. One of the best ways to mitigate that is to diversify - put eggs in both baskets. If you interested in another 40 something’s decision process check out my recent post.
http://thefinancialengineer.blogspot.com/2007/11/is-roth-401k-better-than-tax-deductible.html
December 14th, 2007 at 4:40 pm
Here is another point to consider on an unrelated issue. He did not ask about this but I do have some concern with his comment that he “contribute[s] significant amounts of my salary to my employee stock purchase plan.”
I suggest he be careful here. While the stock of the company may be doing great at the moment he is taking a great deal of risk in tying up his salary as well as his investments in a single company.
I would counsel that he not exceed 5 - 10% of his total investments in stock in a single company, even if it is the company that employs him.
December 14th, 2007 at 6:08 pm
Al,
Good point. I completely ignored the stock purchase plan.
Having too much in any one investment is disaster waiting to happen.
December 14th, 2007 at 6:25 pm
There’s another question: do you expect the tax structure to change?
If we end up with the so-called fair tax or flat tax, you could be taxed twice on this money. You might want to take your tax discount now.
December 14th, 2007 at 6:26 pm
“I suggest he be careful here. While the stock of the company may be doing great at the moment he is taking a great deal of risk in tying up his salary as well as his investments in a single company.”
As long as there is no restriction on selling stock, he can always sell as soon as he buys it or sell at certain times. Usually, these plans come with a nice discount - often 15% of stock value. Plus you buy with payroll deduction, so you cost average over a period of time. Occasionally there is a lookback provision in which the value of stock at the time of purchase is compared to that in the beginning of the quarter with you getting the lowest price. This is free money.
Additionally, you buy via payroll deduction at different times so you cost average. If there is a restriction on sales, then it’s important to look at what the restrictions are.
Depends on the plan.
December 14th, 2007 at 8:15 pm
Remember too that when you retire, you’re supposed to first use up your taxable savings, then liquidate your tax-deferred assets, then finally start withdrawing from any tax free assets you might have. This allows maximum growth and minimum tax on your portfolio. You spend the taxable assets first and save the ones that are growing and compounding tax free.
So if you have significant retirement assets–which I assume you do since you plan to retire at 55 and you also think your tax bracket will drop (which implies most of your income comes from your job)–then your Roth assets may have much longer than 15-20 years to grow and compound. Calculators don’t account for these different withdrawal strategies, meaning your Roth advantage may be much greater than otherwise indicated.
Also, as JLP pointed out, you will be forced to make minimum withdrawals on your tax-deferred assets when you’re in your 70’s. If you don’t need those funds (because, say, you’re still liquidating taxable assets or because you’re getting so much social security/pension money that you don’t need much from that source) then it would be great to have some assets in a Roth that you don’t have to touch.
And estate planning advantages to the Roth are significant, an important consideration if you’re not planning to run through all your money before you’re time here is up.
December 14th, 2007 at 10:27 pm
Thanks for addressing my question JLP and thank you Meg for your thoughts I hadn’t considered that strategy but it seems quite sound.
As for my “significant” contributions to my ESPP. We get a 10% break on stocks and depending on where our stock is at the moment I may or may not take a quick profit. By significant I meant of my monthly paycheck, not my overall portfolio. As loyal as I am to my company, I would never trust too much of my investments to their future. =)
December 15th, 2007 at 6:14 am
I love the idea of the Roth 401(k), but it’s really hard to fund it to the maximum unless you make considerable amounts of money. I can barely do it with the conventional 403(b) (non profit equivalent to the 401(k)) and I make decent money.
December 16th, 2007 at 10:24 am
I am younger and in a lower tax bracket and as you said I believe that the Roth is a no-brainer for myself. The benefits that it provides are quite amazing and cannot be ignored.
December 17th, 2007 at 6:59 pm
One other issue: Are you currently maximizing your 401(k) contributions and also saving some in a taxable account? If so, this strongly favors the Roth 401(k). The reason that by allowing you to pay taxes now on the invested funds with money outside the $15,000 contribution limit, you effectively increase the amount of money that is growing tax free. Put another way, assuming a 30% marginal tax rate now and at retirement, a $15000 Roth 401(k) contribution is the equivalent to a $19450 investment in regular 401(k) (which is $4500 more than the law currently allows you to invest in a regular 401(k)). Admittedly, you could invest that $4500 difference in a taxable account and then use it to pay the withdrawal taxes at the end, but the Roth avoids all the interim taxes on the taxable account (and avoids the need for interim tax-deferral strategies).
it’s better to have $15,000 in a tax free account than $15,000 in an account subject only to taxes on withdrawal plus approx. $5000 in a taxable account.
December 18th, 2007 at 8:06 am
[...] Stay tuned when we take a deeper look at the pros and cons of a Roth 401k, including reader reactions. In the mean time, check out All Financial Matters. He is helping a reader figure out whether or not to use the Roth 401k. [...]
December 18th, 2007 at 12:08 pm
READER QUESTION:
What is the benefit of increasing my contribution to my 401K that has maxed out my employer contribution (75% to 6.25% of my salary) vs. investing that money in a more stable place (i.e. money market or CD?) I have 20 more years to retirement. Thanks.
December 20th, 2007 at 10:46 am
Besides all of the number crunching, you truly have to look at the political situation in the US and the bills that are coming due. Yes, you’re in the highest tax bracket, but it could be much worse. The highest bracket is very low relative to what it used to be in the past. If you plan to take the same amount of income you’re taking now and stay in the same bracket, you have to think about the chances of the brackets being changed.
Think about it, Bush has been funding the war with borrowed money and is going to stick the next president with the bill. I’m not trying to be political, but there are a lot of government expenditures waiting to be filled. We have underfunded social security, medicare, huge debt, and a war to pay for. If certain people have their way, we’ll also have universal health care. Who’s going to pay for all this? We are. We can’t afford it at the current rates we’re at. The logical conclusion would be that taxes will go up in the future at some point of time. I’d hate to see them go up right as you retire and start taking your tax deferred withdrawals and end up paying higher rates.
Sorry if it sounded political, but it is part of the big picture. Roth’s are great for long term growth.
December 20th, 2007 at 7:39 pm
[...] Reader Question: To Roth 401(k) It or Not? [...]