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Roth 401(k) or Not?

Contributed by mm | March 7, 2006 1:15 PM PST

Roth 401(k) is picking up steam lately. According to WSJ and USA Today, at least four companies (General Motors, Delphi, Vanguard and A.G. Edwards) have been providing Roth 401(k) since January. Microsoft, usual a leader in adapting benefit plans (think about SOTP and Stock Award), also announced that it will make Roth 401(k) available to U.S. workers starting in April.

It probably helps to give a brief primer of Roth 401(k):

• It allows an employee to make after-tax contribution up to $15,000 every year to the Roth 401(k) account (and this limit is shared with regular 401(k) contribution).

• Unlike Roth IRA, Roth 401(k) has no income limitations. Anyone with job income covered by a ligitimate Roth 401(k) plan can participate.

• The money will grow tax free in the account and can be withdrawn tax free at age 59 1/2 provided you have money invested in Roth 401(k) for at least five years (and mandatory withdrawal by age of 70). (However, unlike Roth IRA, you cannot make tax-free withdrawal before 59 1/2.)

• Employer match will be still made on a pre-tax basis (to the regular 401(k) account).

• Roth 401(k) is a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 that is set to expire in 2010.

• Roth 401(k) can be rolled over to a Roth IRA if one leaves a job.

Roth 401(k) is great to many people because it allows more assets to grow in a tax-advantaged fashion. For people in the 25% tax bracket, making the full annual contribution of $15,000 to Roth 401(k) equals to a pre-tax contribution of $20,000 to regular 401(k). Therefore, those savers who can shelf more than $15,000 in pre-tax dollars a year have a reason to celebrate now that they have a channel to put more money to work more efficiently.

But is maximal contribution to Roth 401(k) a no-brainer if you can afford it? At least not for me. I am no longer covered by Microsoft's U.S. benefit plan, so I will not have the immediate choice when Roth 401(k) is rolled out in Microsoft in April, but should Fidelity enables Roth 401(k) in its self-employed 401(k) plan, I will have the choice by deciding how to split my business profit to the pre-tax bucket or after-tax bucket. Truth be told, I don't think I will be eager to taste Roth 401(k).


Discussion of whether Roth 401(k) has an edge over traditional 401(k) will all boil down to one question: will the applicable tax rate be higher or lower than that of today? As of today, I believe there is more chance my tax bracket will be lower when I need to make a withdrawal. Here is what's in my line of thinking:

• I'm currently in the high-end of the income range of the 28% federal tax bracket (my residence is in the State of Washington where there is no state tax). Roth 401(k) contribution does not give me any dollar-for-dollar deduction of my taxable income, and will likely push my tax bracket to the 33% level.

• Now that I reset my goal to financial indepence by 36, what it means is I might seek a lower-pay but more meaningful job 5-10 years down the road. It surely means less income (and more time). Why is that important for the Roth 401(k) decision? Because as long as my modified AGI is below $100,000, I can convert any pre-tax traditional 401(k) or traditional IRA balance to Roth IRA and enjoy the same tax-free growth of Roth 401(k) and Roth IRA. (And having modified AGI below $100,000 surely means I will be taxed at a much lower rate than 28% or 33%.)

• A more interesting question is whether we should believe in the government promise of not taxing Roth 401(k) (and Roth IRA) withdrawals. In the past, I have blogged about some doubts expressed by tax professionals. Our politicians do not have a good track record when they deal with taxation on social security benefits.

• Another area that is worth special attention is how the tax reform will go. In the last round of tax reform, proposals like flat nation-wide sales tax and value-added tax attracted some attention. Such consumption-type tax, if indeed passed (yes, I do realize how difficult it is to move the needle to simplify our tax system), may render all the tax pre-paid on Roth 401(k) and Roth IRA balances meaningless.

When you face a difficult decision, and you have the option to safely delay the decision to the future without adverse consequences, the better decision is probably not to make one. This is all in my mind right now when I think of the Roth 401(k). Of course, I admit my situation is atypical, but Roth 401(k) is not designed to benefit everyone either.

This Post Has Received 56 Comments. Share Your Opinions Too.

RS Commented on March 7, 2006

I am very suprised that I hav enot heard anything about this at my company (IBM). They are usually pretty good about giving us options (especially since they canned the pension...a good thing for most in my opinion). Hopefully soon we will at least have the option.

Mark Commented on March 7, 2006

I like your comments about conversion to a Roth. I have thought about the benefits of taking a couple years off to convert my traditional IRA/401K's over to Roths. From my clacs it makes sense to pay for my year off (18k/year) and the tax on the conversion. Just a thought.

Jerry Maguire Commented on March 7, 2006

The reason you haven't heard about it is that many companies are holding out and waiting for others to try it out first. Offering an alternative 401(k) option can be expensive for a company, particularly because the arrangements need to be made for what investment products will be available in the 401(k). I think 401(k)s are great, but the one negative thing is that you are limited in your investment options. You can only buy whatever is available. Don't think that the mutual fund firms aren't making a killing on management fees because they are licking their chops whenever they get awarded a new contract to provide funds for 401(k)s. I personally like the SEP IRA if you have any self employment because it has a higher contribution limit and very flexible investment options. If the 401(k) is your only option, then I would look at your age and estimated retirement tax bracket to see if it is worth it.

Jerry Maguire Commented on March 8, 2006

I understand the excitement over the Roth 401(k). The prospect of not paying taxes on a lot of gains is certainly tempting. Don't let the "uncertainty" of future taxes scare you into the Roth. Both MM and 2million are going to end up with a lot more than a few million dollars down the road. You guys are both in your late 20s and early 30s with a good chunk of change already in net worth. You will find that as you reach your goal you will look for more "sophisticated" investments. You won't want to be locked into any type of 401(k) because by that time you will want more flexibility in your investments. You guys don't strike me as the type of guys that are going to sit on your laurels and let yourselves go to waste without working to some extent once you get your riches.

By the time you retire, you will both be so rich that it won't matter to you that you have to pay taxes. All of us have a duty to support the system that enabled us to make this money through paying taxes. I trust that both of you will have passive income coming in and that you won't be relying on "paper assets" such as your brokerage account of income.

Secondly, there are lots of other ways to shelter your money from taxes. If you look at most of the wealthy people in the US, their wealth is not sitting in tax-free accounts. All of the bigwigs want control over their wealth and your retirement account with limited investment products is not control.

I am just giving you guys another point of view. I am in no way suggesting that you should not go for a 401(k) or Roth 401(k). Everyone should maximize their tax-free zones if they are available. You guys are both kicking butt and I applaud your efforts.

Guest Commented on March 13, 2006

The good news is that you won't have to wait too long to see the tax laws change. I've read that Medicare will be broke by 2016 and Social Security by 2020 (depending on whom you believe). Given those two scenarios, you can expect the tax laws to change right AFTER the 2012 election.

I suspect it will unfold as follows:
Politician A will say we need to save Medicare, so let's tax all those hefty Roth 401k's with $500,000 or more at a paltry 5% tax.

Politician B will say no, no, no we promised tax free withdrawls from those accounts and we will BUT we'll cut off their Social Security and they can pay for their own medical needs.
[see the magic trick - no new taxes but less benefits! Presto!]

Jennifer Hershey Commented on April 16, 2006

I do think that Roth is another bad idea - your tax is being paid now, and nobody knows what income tax will be when you withdraw money. Makes sense if you beleive income tax will nott be lower than now.

francis Commented on April 26, 2006

I totally agree with you. But I think Roth 401(k)has emerged as a golden opportunity for some people. Lets hope to see some more benefits from it.

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