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• The money will grow tax free in the account and can be withdrawn tax free at age 59 1/2 provided you have money invested in Roth 401(k) for at least five years (and mandatory withdrawal by age of 70).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.