Tuesday, November 27, 2007

Is Roth 401(k) better than tax deductible 401(k)?

About a year ago I sent an e-mail to my employer’s benefits office to inquire about when the company was going to provide a Roth 401(k) option. The response follows: “At this time the corporation is not planning any implementation as the Roth plan would only appeal to an extremely narrow part of the employee population, which does not justify the additional administrative cost”.

Extremely narrow population? That was worth a chuckle. Fast forward to today when the same employer announced with great fanfare that a Roth 401(k) option has been added to the company savings plan. Glad they came around to my narrow viewpoint.

Unfortunately, as I review the details I struggle to declare the best route. Too many unknowns in this equation: will tax rates increase, will my tax bracket change in retirement, will Uncle Sam eventually take away the Roth tax free distributions?? Yikes.

In a nutshell, the Roth means paying tax now, instead of later. IMHO, It’s a safe bet, based on the current financial state of America (see out of control national debt and growing entitlement programs) that taxes are going up. So paying now when I am young, healthy and bringing in a robust salary sounds intriguing.

What’s wrong with paying now?
Every dollar going to tax is one less dollar earning money. In other words, not only do we give up that tax dollar today but also all future earnings of that dollar. The old adage that a penny saved is a penny earned is an understatement.

What about that tax deduction?
Going with the Roth, means giving up a maximum of 15,500 tax deduction! Given a 28% tax bracket, that equates to $4340 in tax relief. Now that’s a tax deduction! Because of the tax expense, it will take many years for the Roth 401(k) to catch up to the traditional 401(k) (including the gains from dollars not paid in taxes). So going with a Roth is gonna hurt today, but feel good in 30 years. Ahhhh. Delayed gratification.

Tax Diversification
There is one other important feature that is seldom touted by the Certified FP community - the Roth provides tax diversification. Since distributions from 401(k) retirement funds will be taxed at your future income rate, it could prove to be very beneficial to have an additional revenue stream that is not taxed at all – the Roth 401(k). This strategy mitigates some of the risk and uncertainty over future tax rates.

The clincher
I already have a Roth IRA external to my 401(k) plan. Because of IRS income limitations, I can no longer contribute to my Roth IRA. So I have created a traditional IRA that I fund with after tax money. Given the current tax laws, in the year 2010, I will be allowed to convert my traditional IRA holdings to the Roth IRA without any income limitations. This approach results in the tax diversification benefit while still maintaining the 401(k) tax deduction.

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