Roth 401(k)s?

Some participants in the TAG 401(k) have asked,

"Why don't we have a ROTH 401(k) option? You think we can get one?"

To which I always say, "The trustees of the Plan will look into it."

(Kindly note that regular 401(k) deductions are pre-tax -- meaning no state or federal income taxes are paid on the money when it's placed into your 401(k) account, but only when it does the other way. Roth 401(k) deductions are after tax -- taxes are paid on the up-front contributions but not on the withdrawals.)

So which is better, a Roth 401(k) or standard-issue 401(k)? Today Michael Viljak of 401(k) Advisors presented me with this:

... A mistake that people make when comparing regular [401(k)] deferrals to Roth deferrals is that they assume that the retirement benefits of participants will be distributed and taxed as a lump sum at retirement. However, most retirees roll over to IRAs. So, the real question is: How much will participants take out—and be taxed on—each year?

... [F]or the typical husband and wife filing a joint return, they can earn about $20,000 a year without paying any taxes. In other words, the first $20,000 that they receive from a taxable IRA will be tax-free.

For a withdrawal rate of 5%, a partic­ipant should have at least $400,000 in a non-Roth, taxable account—to take advantage of the tax-free $20,000; it is better than Roth—tax deductible when deferred and tax-free when distributed. Furthermore, the first dollars over that amount will be taxed at the lowest tax rates, lower than the top marginal tax rates the participant paid while employed—and, therefore, lower than the taxes the participant would have paid if he had made a Roth contribution. ...

Of course, the tarantula in the ointment is: Nobody knows where tax rates will be twenty ... thirty ... or forty years hence.

I have a simple rule of thumb. If you can avoid paying a tax today, by all means do so. Somebody in the top income tax brackets (state and federal) can shelter $16,500 per year from Uncle and Arnold by enrolling in TAG's 401(k) Plan. As of January 1st, when income tax cuts expire (as mandated by the 2001 legislation), total state and federal taxes for the top rate in California will be around 50%. If you were to deduct $400 per week into the 401(k), your take-home would drop by a mere $200, since you're not paying tax on the deductions.

Unless you want to leave the money tax-free to heirs, or plan to stay in the top bracket in retirement (good luck with that), you're likely better off taking the tax deferral up front instead of the back end. (But if you're hell-bent on leaving a large stack of tax-free loot to little Timmy and Becky Sue, you can still fund a ROTH IRA outside the 401(k).)

My advice is to take the deduction while you're making a higher salary, and worry about what kind of taxes you'll pay in retirement when you're kicking back in your rocking chair. Decades from now, there will still be ways to minimize your tax bite.

As for that Roth 401(k) option, we'll take it up at the next trustee meeting.