Roth 401(k)

My wife’s employer started to offer Roth 401(k) plan through Fidelity this year. While it’s good to know that there’s a new saving vehicle available, we decided not to participate after examining the pros and cons of the plan at that time. The main reason was that it doesn’t offer more benefits than the traditional pre-tax 401(k) plan that she is maxing out. Our decision could change next year though, depending on our tax situations.

Looking at the plan itself, the way it works is quite similar to Roth IRA plan, i.e., contributions are made from after-tax dollars, earnings can grow tax-free, and withdrawals at retirement (59.5 years or older) are exempted from income taxes. However, the annual contributions are subject to IRS limit. For 2007, the combined contributions from both pre- and after-tax accounts cannot exceed $15,500. Thus, from the point of view of maximizing savings, adding a Roth 401(k) plan won’t help us save more. In addition, as an employer administrated plan, the investment choices Roth 401(k) offers are limited. At this point, it’s not very attractive to us.

Then what’s the benefit of this new plan? The key selling point seems to be the tax-free withdrawal at retirement. Compared to traditional 401(k) plan, the difference between these two is whether to pay taxes now (Roth) or later (traditional). The decision on which plan to use thus depends on what is going to happen with tax rate. If the tax rates declines in the future, pre-tax 401(k) account makes more sense since withdrawals at retirement will be taxed at a lower rate. If things are going in the opposite direction, one will be better off making after-tax contributions now to take advantage of the current rate. The problem is, of course, nobody knows for sure what tax rates will be 10, 20, or 30 years from now.

Besides the tax issue, Roth 401(k) does give high-income earners who are not eligible to contribute to Roth IRA a way to save for retirement as there’s no income restrictions on Roth 401(k) participants. Roth IRA, on the other hand, starts to phase out for joint filers with incomes between $156K and $166K.

Last April after we filed our taxes, we had to withdraw all but $200 of our 2006 Roth IRA contributions as we were in the phase out range. For 2007, the phase out range is a little higher than that of 2006 and there are several weeks that I was unemployed. Therefore, our income this year may not exceed the threshold. We will need to wait till next January after the income data is in to see if my wife should participate in the plan or not next year.

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7 Responses to “Roth 401(k)”

  1. Brip Blap |  Jul 25, 2007 at 9:25 pm

    I would definitely participate if you’re able to. There’s a lot of variables that play into the “Roth vs. regular” debate (for 401ks or IRAs) but to me the risk that the US is going to be raising taxes to pay for the Baby Boomers makes anything that will be tax-free in the future a good bet. If it’s matched by the employers, all the more so. I’m still stuck with a regular 401K but I would switch in a heartbeat, based on my pessimism.

  2. Jeremy |  Jul 26, 2007 at 2:02 pm

    My employer just began to offer this and I’ve yet to enroll. I have to get off my butt and adjust the contributions between the standard 401 and the roth. Tax diversity is where it will be at come retirement time!

  3. 401k Rollover IRA |  Jul 26, 2007 at 4:30 pm

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  4. Irving |  Jul 26, 2007 at 6:32 pm

    Another factor that needs to be considered – and I rarely see discussed – is the effect of taxation of social security benefits. I spoke to a friend who contributed to his regular 401k while working, is now retired, and taking 401k distributions. Because the 401k distributions increase his income, more of his social security income is taxable. He did the numbers, and determined that the rate of tax of his 401k distributions is MORE than the tax break he received from contributing, once the effect of increased taxation of his social security income is figured in. Needless to say, he is not a happy camper. Contributions to a Roth 401k would avoid this problem, because Roth 401k distributions would not be added to his income, and therefore would not increase the amount of his social security income subject to taxation.

  5. Sun |  Jul 26, 2007 at 9:48 pm

    Brip Blap: Yes, the tax-free withdrawal in the future is indeed quite attractive, though we don’t know exactly what the tax rates will be. There are chances that the government will need more tax revenue to fund social security and medicare. However, it’s also possible that the current deficit will be gone in the near future without increasing tax burdens.

    Even though Roth 401(k) doesn’t offer immediate tax benefit, it seems to be more flexible by the time we need to withdraw the money. Next year we could use a mix of regular and Roth 401(k).

    Irving: That’s an excellent point that I have never thought about. All I have read on Roth 401(k) are about the tax effect that the plan itself will have, not the impact on other distributions as you mentioned. I can imagine that at some point the taxes paid in the future will outweigh the benefit received in the past.

    I have to think my strategy again :).

  6. Harry |  Jul 30, 2007 at 2:31 am

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  7. kitty |  Jul 30, 2007 at 11:07 am

    I think a lot depends on income. While withdrawals from 401K are added to income and may increase tax on social security, the total income in retirement are still likely to be smaller, so it may result in lower tax rate. In some cases, 401K contribution may be the only thing that is keeping someone from getting hit by the alternative minimum tax or getting limits on deductions, etc. In other cases, choosing Roth 401K vs Roth IRA would put someone in a higher tax rate.

    For example, 401K contribution is the only thing right now that allows me to contribute to Roth IRA as well. Adding the money I currently contribute to 401K will immediately put my income above max Roth IRA limit (this year I will be in phaseout range, but without my max 401K contribution, I would definitely be above). If I sell stock I may get into the AMT situation (given that I live in NY State)