Archives For Roth 401(k)

I’m in the process of reading John Bledsoe’s The Gospel of Roth: The Good News About Roth IRA Conversions and How They Can Make You Money
*. So far it’s a great read. As you can probably imagine, Bledsoe is sold on the Roth IRA. Reading his book, I couldn’t help but daydream about what it would be like to have $1,000,000 sitting in a couple of Roth IRAs ($500,000 in each) by the time my wife and I retire.

Then I got to thinking…

How long would it take to get to $1,000,000 in a Roth IRA(s) if I contributed the maximum amount each year to two IRAs?

The maximum contribution amount is currently $5,000 per person ($6,000 per person if you are over 50). Due to silly income restraints, I would have to first contribute to a nondeductible IRA and then convert it to a Roth IRA. Either that, or I could make Roth contributions through my wife’s 401(k).

Here is what the math looks like:

As I noted at the bottom of the graphic, the $1,000,000 goal is not adjusted for inflation.

How long will it take?


If this little exercise tells us anything, it’s that it’s best to start working towards financial goals AS SOON AS POSSIBLE. If you don’t, you are faced with either having to SAVE MORE or reach for higher rates of return (gamble).

*Affiliate Link

Reader and frequent commenter, Don, sent me this email this morning. It’s his thoughts on the Roth 401(k) vs. Traditional 401(k). I’ve included my thoughts after Don’s email (edited slightly from the original). As always, your thoughts would be appreciated.

I was reading this Marketwatch article recently:

Roth IRAs: Good for you or not?

In it they noted that, “A regular 401(k) beats a Roth for a majority of our stylized households, but both offer a significant improvement over fully taxed savings.”

I wasn’t surprised that fully taxed savings were worse, but I would have expected the regular and Roth IRAs to be neck and neck. The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.

But the article suggests something different, and eventually my mathematical mind found a reason why their claim might be true. It depends on what percentage of your income you expect to be provided from your retirement assets and the fact that we have a progressive tax system. Here is a sort of maximal example.

Consider a couple that makes $80,000 and contributes 20% ($16,000) of their income into deductible 401(k) or IRA investments. That brings them just about down to one of the tax bracket boundaries, between the 15% and 25% bracket. Because it is their high-margin rate income that they put away, they saved 25% of $16,000 in tax, or $4,000 in federal tax.

Assume they retire next year (so we don’t have to think much about inflation or the tax code changing). The maximal case, would be having 100% of their income provided from accumulated retirement assets, although it would probably be less because of social security or pensions or the like. But if next year, we draw the same salary from their retirement assets ($80,000) it would in fact be taxed progressively: the first $15,650 at 10%; and then at 15% up to $63,700; and only the top $16,300 would be at the full 25% rate. Nearly 4/5 of their income would be taxed at a rate lower than the savings they got every year when they invested it even though they are in exactly the same bracket as before.

I believe this changes the naive Traditional/Roth comparison and it would tip in the favor of the Traditional (just as the article implies).

If you are the “typical” person, your Social Security income would account for 40% of your retirement income. In that case, starting from the scenario above, you’d be drawing $48,000 from your IRA. If we allocate the low-margin tax brackets to your Social Security, you’d still have $31,700 drawn from your retirement assets that would be taxed at the 15% and again only the top $16,300 would be taxed at the full 25% marginal rate. Nearly 2/3 of your income (provided by retirement assets) would be taxed at a lower rate than the rate you saved at when you made the contributions.

It seems that the practical advice to take from the analysis is this: if you are near a bracket boundary use Traditional IRA or 401(k) savings to reduce your savings just to the boundary. Further savings should be Roth savings. It makes sense to diversify in any event against tax changes that would adversely affect Traditional or Roth savings anyway since no one knows the future.

If you can’t save down to a boundary but could at least foresee where the boundary would land in retirement, you could split your Traditional/Roth savings to match that. In the example above where 40% of your retirement income is from Social Security, a reasonable person might make 2/3 of their savings Traditional and 1/3 of them Roth. You’re not really ahead or behind mathematically in this scenario, but you get “tax diversification” as well as the potential Roth advantages (no minimal distribution, etc.) on part of the money.

The only issue I have with Don’s thoughts is his computation:

The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.

Is that really how people would contribute to a Roth? I would think most people would contribute $4,000 no matter if they used a Roth or a traditional IRA or 401(k). If they used the traditional IRA of 401(k), they would get the tax advantage up front. If they contributed to the Roth, they would take it on the chin and pay the taxes up front but still contribute the full amount to the Roth. NOTE: I’m going to run some calculations on my own and report back to you what I find.

This is a pretty complex topic because not only are we talking about the here and now, we are also trying to get a grip on the future. Adding to the complexity is the fact that there are benefits to the Roth that aren’t easily computable like the ability to NOT HAVE TO TAKE required minimum distributions and the ability to pass the Roth on to relatives, which gives them the opportunity for tax-free withdrawals. One other advantage to the Roth is the fact that distributions from the Roth DO NOT count towards the income threshold for computing taxes on Social Security.

My concern with the Roth are that the politicians may decide to tax withdrawals at some point in the future. Could it happen? Yes. Is it likely to happen? I have no idea. All I can say is that if times get tough and our politicians are looking for money to pay for their programs, and they see a bunch of tax sheltered assets sitting in Roth accounts, I wouldn’t put it past them to tax them “for the greater good.”

Anyway, there’s more on this topic to come. I’m working on a spreadsheet as I write this post. If I find out anything interesting, I’ll be sure and let you know.

Thanks to Don for his thoughts.

Tax diversity has become a more common discussion among personal finance experts in recent years. This is due not only to the plethora of tax-free, tax-advantaged, and taxable investment options that people have today, but also to the uncertainty of our future tax system.

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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).


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 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.

I found out yesterday that my wife’s company will begin offering the Roth 401(k) in January, 2008. Immediately I started thinking about whether or not it is a good deal for us. Believe it or not, it’s not a simple decision because there are numerous variables to consider.

NOTE: It’s important to keep in mind that I am NOT a tax expert. So, if some of my thought processes don’t make sense here, that’s why.

So, here are some PROS and CONS (if I missed any, please let me know by leaving a comment) of the Roth 401(k):

PROS to the Roth 401(k):

1. Roth 401(k) offers the ability for tax-free income at retirement.

2. Roth 401(k) can be rolled into a Roth IRA. For those who make a lot of money, this could be an easy way to move money into a Roth IRA.

3. As of right now, income received from a Roth IRA during retirement does not count when figuring the taxation of Social Security benefits.

4. Unlike other accounts during retirement, there are no required minimum distributions with a Roth IRA.

5. Tax rates could be higher in the future, which would make tax-free income in the future, more valuable.

CONS to the Roth 401(k):

1. A Roth 401(k) is funded with after-tax money, which means higher tax bills now and could possibly subject you to the dreaded Alternative Minimum Tax. I did a quick calculation and figured that our tax bill for 2006 would have been around $2,000 higher had we gone with the Roth 401(k).

2. Along the lines with number 1, Roth 401(k) contributions will mean higher taxable income now. This could affect deductions.

3. There’s really no guarantee that lawmakers won’t change their minds and begin taxing Roth IRAs at some point in the future.

4. The employer match is put into a separate account, which will then be fully taxable at retirement. This is a wash since you don’t pay taxes or get a tax benefit from an employer match.

Those are the pros and cons that I can think of. I’m sure there are lots more that I just haven’t thought of. If I missed some, let me know and I’ll add them to the list.

For me, the jury is still out on whether this is a good deal for our family. I’m thinking about going half and half and trying it out.

I don’t have time to go into details right now, but read Trimming Your Taxes: Why Roth 401(k)s Often Beat Conventional 401(k) Plans by Jonathan Clements. It’s an interesting take on the Roth 401(k) and definitely something to think about. I’m going to go into more detail later today. Right now I have some other things to take care of.

According (NOW FREE!) to the Wall Street Journal:

The Pension Protection Act, which is under consideration in the U.S. Senate this week after passage in the House late Friday, would let 401(k) providers like mutual funds, brokerage firms and insurance companies help workers choose specific funds for their retirement accounts.

Here’s the concern:

Some independent financial advisers see a conflict of interest for firms that could recommend their own funds.

I’ll second that! I think offering advice is fine and probably much-needed. However, there’s a huge conflict of interest if that advice is coming from the very people who are administering the plan. Do you think a representative of Merrill Lynch is going to recommend anything other than a Merrill product? I also see lots of potential for retirees to be directed into high-fee annuities, which will be a boon to the advisor but most likely not in the best interest of the retiree.

Here’s one last quote from the article that stresses my concern:

“Everything that has happened in the securities industry the last five years, all these scandals, at the heart of it was a conflict of interest,” says David Kudla, chief executive of Mainstay Capital Management, a Grand Blanc, Mich., firm that manages about $500 million in retirement assets for individuals. “Given the regulatory track record, how can anyone think this is a good idea?”

I think companies should beef up their education efforts and make it an annual requirement FOR ALL EMPLOYEES to go to. I also think that EVERY employee should receive a statement telling them how much they have, how much they should have, and how much they will need at retirement, which would make it more difficult for them to bury their heads in the sand. Kinda like that seatbelt light in your car that keeps flashing until you buckle your seatbelt.