Entrust Learning Center > Retirement Plans > Are Roth 401(k) Plans a Good Idea?

Are Roth 401(k) Plans a Good Idea?

By: By: Jack Kiley, CPA, PFS

IRA Insights

Beginning on January 1, 2006, businesses have had the option to add a Roth deferral element to their 401(k) plans. What this means is that, assuming an employer added this option, the employees would be able to designate money deferred from their pay as they do currently (on a pretax basis) or on a new after tax basis. This after tax method is referred to as a Roth deferral because the earnings on these funds would not be taxed.

Since the inception of the Roth 401(k) plan, there has been a running debate as to whether it makes sense (tax wise) to utilize the Roth feature or to continue to defer from pay using the traditional deferral feature. The answer to this question depends on several factors. Some of these include the time to retirement, other potential sources of retirement income, and your tax rate outlook.

If you cut through all the numbers, really what you’re looking at is the earnings you made on the deferrals. You will pay tax on the deferrals themselves (with Roth you pay in the year of deferral and with traditional you pay when you pull the money out). The question becomes, what is the potential tax savings on the earnings if the Roth deferral is made.

The first factor is the length of time until you retire. If you retire in five years, the maximum amount you can defer will be $75,000 (using the 2006 max deferral amount-this amount will increase in future years). Your potential earnings assuming a 10% average rate of return would be about $12,000 making your potential tax savings about $4,000 (assuming 30% tax rate). This may not be worthwhile.

If, however, you had twenty years to retirement, your total amount deferred would be $300,000 with the potential earnings at 10% being approximately $220,000. The tax savings on the amount would be about $66,000. The tax savings on $220K may be worth forgoing the current year tax deductions. Other sources of retirement income are a potential consideration.

If you plan to have other streams of income at this time of your life, Roth is more appealing. One of the great advantages of Roth is the fact that you are not required to take distributions beginning at age 70 1/2. This allows for a longer period of time for your retirement funds to grow. Roth also allows you to ‘supplement’ your retirement income without impacting your tax situation. If you needed to buy a new car, for instance, and took $30,000 out of your Roth, there would not be any tax impact (Roth funds come back to you tax free).

Your outlook on tax rates also has a bearing on whether to utilize Roth deferral or not. If you think tax rates are going to increase, you may want to pay the tax now (presumably at a lower rate).
These are but a few considerations you should take into account when deciding the utilized the Roth 401 (k). As with any tax and financial planning, you should seek the advice of trained, certified professionals.

Jack Kiley, CPA - Partner, Entrust MidAtlantic, LLC.  Serving the states of Maryland, Virginia, DC, and the Western Counties of West Virginia.

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