Roth 401(k) Knowledgebase

Reasons to Consider the Roth 401(k)

Reason #1: Your Tax Rate During Retirement will be Higher than Today

Low Income Taxpayers  Many individuals are in lower tax brackets today since they are in entry level positions due to age or inexperience. Hopefully, as these individuals mature, their income will as well. Contributing to the Roth feature today while in a lower bracket could be very advantageous to these individuals assuming they can afford to save any money at all and the lower equivalent Roth contribution qualifies for the maximum employer match.

Example: Roth May Not Qualify for Highest Available Match

Case Study: Low Income Taxpayer: Age 25, Single, Earning $20,000

Middle and High Income Taxpayers For many individuals, it is sensible to think that you will be in a lower bracket during retirement. Is it also sensible to think that the government will increase tax rates?  Perhaps rates will rise in the future and you are in a lower bracket. However, even though you may be in a lower bracket, this does not necessarily mean that your tax rate will be lower.

For example, if you are in the highest bracket today, your federal tax rate is 35%. If the three highest tax brackets in the future are 45%, 42% and 38% respectively, even if you are in the third highest bracket, your tax rate will be higher.

Example: Lower Future Bracket May Not Mean Lower Rate

Reason #2: Roth 401(k) Diversifies Future Tax Risk

Prudent investing dictates that one should diversify investments in accounts or investment vehicles that are taxed differently (taxable, tax-deferred, tax-free). The Roth 401(k) provides a very attractive alternative to tax-free investing as compared to traditional tax-free investments such as tax-free bonds.

Reason #3: Roth IRAs are Not Subject to Required Minimum Distributions

This may have the greatest appeal to business owners and other individuals who have substantial savings. If an individual plans to leave substantial assets to his heirs other than a spouse, it is generally recommended that these individuals defer commencement of distributions until minimum distributions are required. The participant may designate a younger spouse or nonspousal beneficiaries to “stretch” the tax-deferred payments over a longer period to mitigate the impact of taxation. The Roth IRA provides an opportunity to “super stretch” payments since no minimum distributions are required.

Example: Postpone Minimum Distributions

Case Study: "Super-Stretch" Distributions to Multiple Nonspouse Beneficiaries

Reason #4: Roth 401(k) is Advantageous for HCEs Limited by 401(k) Test

HCE contributions are oftentimes limited if a plan is in danger of failing the 401(k) nondiscrimination test (the “ADP Test”). Affected HCEs can get more “bang for the buck” by contributing the maximum dollar amount permitted under the test to a Roth account on an after-tax basis instead of to the pre-tax. The Roth contribution effectively equates to a higher pre-tax contribution.

Case Study: High Income Income Taxpayer: Age 51, Married, Earning $150,000

Reason #5: Roth 401(k) Contributions Maximize Retirement Benefits

If the participant desires and has the ability to maximize contributions to a qualified retirement plan, the Roth permits the participant to accumulate a greater retirement benefit.

Example: Pre-tax 401(k) Limit for 2008 Equates to $31,538

Case Study: Maximize Retirement Benefits: Pre-tax Limit Equates to $31,538

Reason #6: Roth Facilitates Prepayment of Income Tax for Estate Planning

By paying income tax now on the Roth 401(k) contributions, the participant effectively prepays federal income tax on money that passes to heirs without impacting gift or estate tax exemptions.

Reason #7: The Roth Option Promotes Saving More for Retirement

Contributing the same dollar amount to an after-tax Roth account as you would to a pre-tax account increases the amount you save.  We all like to save taxes but very few of us save the dollars resulting from the tax deduction. 

The Roth option provides the “psychological push" most of us need to help us save more for retirement.

Article: "Behavioral Finance" Provides Another Reason to Consider the Roth 401(k)

Others Reasons for considering the Roth option may include...

A desire to receive tax-free income during retirement to mitigate the possibility of taxing Social Security payments;

The belief that future tax rates will be higher for all; and lastly (for no objective reason whatsoever)...

A desire to receive tax-free income during retirement.

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