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Roth 401(k) Knowledgebase

Participant Information

To answer the question: “Pay Uncle Sam now or pay him later,” participants and their advisors should focus on a number of key factors including the:

  • Participant’s tax rate today versus his or her future rate
  • Extent of participant’s need for income at retirement
  • Participant’s desire to maximize retirement savings

Marginal Tax Rate The Roth option is financially beneficial to participants whose marginal tax rate (MTR) is lower when contributions are made versus their MTR when distributions occur following retirement, since taxes were paid at the lower rate when contributed.  Conversely, the pre-tax option is more beneficial to participants whose MTR is higher when contributing versus when distributions commence following retirement, since taxes are paid at a lower rate when receiving distributions in retirement.

If the participant chooses to contribute to the Roth option instead of the pre-tax option, and the participant wants the same net take home pay as the pre-tax option, the Roth contribution is lower than the pre-tax contribution because the participant pays tax on the salary reduction before it is deposited to the Roth account. 

Example: Same Net Pay means Lower Roth Contribution

Example: Same Roth Contribution means Higher Salary Reduction  

Employer Match Participants who contribute the lower Roth contribution (that corresponds to the same gross salary reduction as a pre-tax contribution) instead of their current pre-tax amount must be mindful that the lower after-tax Roth contribution may not qualify for the highest available employer match.

Example: Roth May Not Qualify for Highest Available Match

Change in State of Residence at Retirement  Participants should take into account the possibility of a change in their permanent state of residence that would cause a swing in the MTR while contributing vs. the MTR at the time of distribution (a decrease would favor the pre-tax option, whereas an increase would favor the Roth).  In addition, reciprocal agreements between states to collect taxes on pension distributions may become more prevalent in the future.

Roth Impact on MTR  The participant’s election to contribute to the after-tax Roth rather than to the pre-tax 401(k) may result in an increased MTR and/or may cause the alternative minimum tax to apply due to the increased taxable income.

Maximize Contributions  If the participant has the desire and ability to contribute the highest permissible contribution to a qualified retirement plan, a maximum after-tax Roth 401(k) contribution effectively raises the maximum individual contribution limit. 

ExampleMaximize Contributions - Same Net Pay means Lower Roth Contribution

ExampleMaximize Contributions - Same Roth Contribution means Higher Salary Reduction

Case Study: Pre-tax 401(k) Limit for 2010 Equates to $33,846

Predicting the Future The factors listed above cannot be predicted with certainty.  Therefore, advisors and plan participants should explore various outcomes based on different contingencies as shown in the case studies. 

Access: Case Studies

Also see: Reasons to Consider the Roth 401(k) Option

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