The tax break 89% of eligible Americans are missing

A Roth 401(k) may make sense if you pass these simple tax rate tests

May 28, 2014 @ 1:00 pm

By Carla Fried

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There are some easy decisions around 401(k)s. Contributing enough to trigger the highest possible matching contribution from your employer, for example, is one of them.

Contributing to a Roth 401(k) should be another. But it's not. Eight years after retirement savings plans were allowed to offer the option, which can help many people boost their retirement funds, more than half added it. Yet just 11% of savers with access to the account use it, according to benefits consultant Aon Hewitt.

Roth 401(k)s are much like your garden variety 401(k). The big difference is that you contribute after-tax money, not pre-tax dollars like with the standard 401(k). Later in life when you want to tap that Roth money you won't pay income tax on it — not a penny, as long as you've held the account for five years and are 59½.

The conventional wisdom is that the Roth 401(k) makes the most sense if your current income tax rate is lower than what you expect to pay in retirement. Opting for the Roth 401(k) essentially prepays your tax bill. Granted, deciding if the Roth route makes sense for you is tougher than deciding whether to contribute enough to get the company match. But the lack of broad buy-in suggests many 401(k) savers are missing out on an important way to build retirement security.

With a traditional 401(k), you delay the tax bill and your money compounds over time. You get an upfront break that reduces taxable income. The tradeoff: Your later withdrawals get taxed as ordinary income. Stands to reason that prepaying — as you do with a Roth account — makes sense when you're in a low tax bracket, especially for younger workers yet to reach peak earnings.

An analysis by T. Rowe Price Group Inc. found that a 30-year-old saving in a Roth 401(k) would have 17% more spendable income in retirement even if his pre- and post-retirement tax rates were the same. If his retirement tax rate is 5 percentage points higher, the Roth 401(k) will generate 25 percent more income than the after-tax money from a traditional 401(k). A future tax rate 10 percentage points higher will generate nearly 35 percent more spendable income in retirement compared to the traditional, courtesy of the time factor of tax-free (not tax-deferred) compounding.

While the young get the greatest benefit, even middle-agers who anticipate a lower tax rate in retirement would likely be better off saving via a Roth 401(k). “Unless you're planning for a steep lifestyle change in retirement, what's likely is that at best you might drop into a tax rate a few percentage points lower,” said Stuart Ritter, a senior financial planner at T. Rowe Price.

For example, the tax bracket for a 45-year old married couple with taxable income of $200,000 is 28%. If they retired today, that income would have to drop below $74,000 to fall into the 15% tax bracket. More likely, they'd be in the 25% bracket, which tops out at $148,500 for married couples filing jointly. T. Rowe Price estimates that even if they pay a tax rate in retirement just 3 percentage points lower, the Roth 401(k) will leave them with 8% more spendable income in retirement than a traditional 401(k).

Only if the future tax rate is more than 10 percentage points lower than the initial tax rate does the traditional 401(k) becomes a better deal for the 45-year-old couple. That would be a large lifestyle haircut even if federal tax rates merely stay steady.

TAX RATE TESTS

For 55-year-olds the traditional 401(k) becomes the smarter choice when the future tax rate is at least 8 percentage points lower. A married couple in the 35% federal tax bracket today (so income between $405,101 and $457,600) would need to get by on income of no more than $226,850 (the top of the 28% federal tax bracket) to pull that off.

Higher-income earners need to carefully navigate potential short-term tradeoffs. For example, two fifty-somethings can each defer up to $23,000 this year in a traditional 401(k). That's a lovely $46,000 reduction in taxable income. Put that in the Roth 401(k) and you lose that upfront tax break, which could wreak alternative minimum tax havoc.

And remember, if you opt for the traditional 401(k), the IRS will come knocking at age 70 ˝, expecting you to start taking annual required minimum distribution (RMDs) -- forced taxable withdrawals -- from your savings. RMDs are taxable income and make it harder to generate a steeply lower tax rate.

If you don't think you'll rely heavily on your 401(k) savings in retirement, a Roth 401(k) looks even better. Roll it into a Roth IRA before age 70 ˝ and you won't suffer forced withdrawals. That can help manage taxable income in retirement and give you the latitude to keep more of your retirement funds growing tax-free for heirs.

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