Many company 401(k) plans have added a Roth 401(k) option. I believe most people should NOT use the Roth 401(k) option. The Roth feature seems very appealing since withdrawals from a Roth account can be made tax-free in retirement. However, these FUTURE tax-free withdrawals come at a high up-front cost since the employee must pay more taxes right NOW. Let me go through an example and provide an alternative strategy.
Take a married couple, 40 years old, with taxable income of $85,000. This couple would be in the 25% Federal Income Tax bracket and the 7.75% North Carolina State Income Tax bracket. Let's assume the couple contributes $15,000 per year to a Roth 401(k). This means the couple is paying an extra $4,912 in income taxes than if they contributed to a traditional 401(k) plan (15,000 x 32.75%). So, the couple is paying an extra $4,912 for the privilege of placing $15,000 into a Roth account.
My suggestion to this couple is to stop making contributions to the Roth 401(k) and instead switch back to the traditional 401(k). By switching from the Roth 401(k) back to the traditional 401(k) this couple will have an additional $4,912 in take home pay due to the lower income taxes. The couple should then take that $4,912 in additional take home pay and contribute that money into a Roth IRA (I suggest doing this at Vanguard and use only low-cost index funds).
In other words, the couple can enjoy the exact same amount of after-tax spending money in the two scenarios above. In Scenario 1, the couple invests $15,000 toward their retirement and gives almost $5,000 away to state and federal governments. In Scenario 2, the couple gets to invest almost $20,000 towards their retirement. Why would anyone chose to pay $5,000 for the privilege of putting $15,000 into a Roth account when you can put $5,000 into a Roth IRA and you don't have to pay extra tax to do it? (I should note that BOTH the husband and wife could each put $5,000 into a Roth IRA in 2012. In 2013 the IRA limit rises to $5,500 for each spouse).
Many folks are probably thinking that the money in the Roth 401(k) is going to compound over time so the tax savings must be bigger later. To simplify our analysis, let's isolate that one year contribution in our example above, and assume that one year contribution of $15,000 today will be used to fund one year in retirement 20 years from now when our couple is 60 years old.
Using our example above, the $15,000 contribution could become roughly $58,000 if it averages 7% investment return over 20 years. You might be thinking paying tax on $15,000 now makes sense if you can avoid income taxes on $58,000 20 years from now. But, you would be wrong. In Scenario 1, the couple would have $58,000 tax-free to live on in their first year of retirement at age 60.
In Scenario 2, the couple would amass the same $58,000 in the traditional 401(k) but also approximately another $19,000 in the Roth IRA. However, the couple would have to pay state and federal income taxes on the $58,000.
So, let's calculate how much tax they would owe. Under the current tax code, the couple won't pay a dime of tax on the first $19,500 (standard deduction for married couple = $11,900 and two personal exemptions of $3,800 each). However, the standard deduction and exemptions are tied to inflation. If inflation were to average 3% over the next 20 years, the standard deduction and two personal exemptions might be roughly $35,000 when the couple retires at age 60. So, the couple won't pay a dime of income tax on the first $35,000. That means the couple will only pay income tax on $23,000 (58,000 - 35,000 = $23,000).
However, the tax brackets are also indexed to inflation. So, the lowest tax bracket today of 10% is charged on the first $17,400. In 20 years this lowest tax bracket would rise to $31,400 if inflation averages 3% per year. Thus, this couple will be in the lowest tax bracket in its first year of retirement.
Estimated Tax Calculation 20 years from now
The first $35,000 is tax-free due to the standard deduction and personal exemptions
The next $23,000 is taxed at 10% Federal Income Tax = $2,300
North Carolina state income tax is 6% on the first $12,750 = $765
North Carolina state income tax is 7% on the remaining $10,250 = $718
Our couple would pay total state and federal income tax of $3,783 in that first year of retirement. Thus, our couple would have roughly $54,000 after-taxes from their traditional 401(k) but also $19,000 tax-free from their Roth IRA for a total of about $73,000 after-tax to live on in their first year of retirement.
The answer is clear, the Roth 401(k) option in Scenario 1 produces a tax-free income of $58,000 for the first year of retirement, while Scenario 2 with the traditional 401(k) combined with the Roth IRA produces about $73,000 of after-tax income to live on in the first year of retirement. Our couple will have about $15,000 more each year in retirement by switching from the Roth 401(k) back to the traditional 401(k) and investing the tax savings in a Roth IRA each year.
Another way to look at it is that the couple pays $4,912 in extra taxes NOW in order to avoid paying $3,783 in taxes 20 years from now. This makes no sense!
Note: If the Bush-era tax cuts are allowed to expire, the couple's Federal Income Tax 20 years from now would be higher by $1,150. So, even if tax rates go up, the analysis above does not change much. In fact, the lowest tax bracket would need to rise from the current 10% to over 82% for our hypothetical couple to come out ahead using the Roth 401(k).
I believe the Roth 401(k) option will likely NOT work well for most people. However, over the next few weeks, I plan to post different scenarios comparing the Roth 401(k) to my alternative strategy of using a traditional 401(k) and investing the tax savings into a Roth IRA. For example, what happens when our hypothetical couple above begins to draw Social Security and might be pushed into a higher tax bracket in retirement? What if our couple also will be receiving a pension and might be pushed into even a higher tax bracket in retirement?
One might think the added income from a pension or Social Security might swing the analysis in favor of the Roth 401(k). But, keep in mind, that over 20-40 years of traditional 401(k) and Roth IRA investing, an individual will amass two large accounts - one taxable, and one not. By drawing from the taxable account during low income years the retiree can save the Roth IRA for later years when Social Security kicks in. Stay tuned for more scenarios in the coming weeks.
If you need further help with your investments, I hope you will take a look at one of my books on Amazon.com by clicking here.