Monday, May 12, 2008

Roth 401(k)s!

Back (temporarily) to financial stuff, retirement stuff.

There have been questions about getting a "Roth" option built into the TAG 401(k) Plan, and as requested, I've gone to the Plan advisor and will shortly bring the subject up to Plan trustees. In the meantime, I'm throwing up this post to provide an overview of the subject.

To start, a Roth 401(k) is like a a Roth IRA: You tuck money on which you've already paid income taxes into a pension savings plan, and any earnings on that money will be tax free when you pull the loot out to live on during retirement.

With a traditional 401(k) Plan or traditional IRA, you pay no income taxes on your initial contributions, but pay income taxes on withdrawals when you reach retirement age ...

The thinking is that you will be in a lower tax bracket in retirement than during your peak earning years, when the tax deduction you don't get with a Roth could be really useful.

Obviously, this may or may not be true. Tax brackets can always change. You might have a lot of income during retirement. But here's the thinking of one of the Plan's outside financial advisors (one of the gurus at 401(k) Advisors) that I share with you now:

Vendors now have a bit more experience, systemwise, with the Roth 401(k), and the concept has picked up a bit more traction with some plans. My concerns are the same as initially. This product is often misunderstood. Roth does not present an opportunity for any greater savings by virtue of the Roth, only re characterizing contributions from pre-tax to post-tax.

Any gains ultimately depend on tax bracket increases at retirement. Many people will say...."taxes will go up". While that may be true, most (99%) 401(k) participants will not be retiring at 100% of their pre-retirement income, so tax rates would have to go up sufficiently to exceed the inherent disparity created based on actual retirement income vs. tax rates then in place.

What our advisor is saying here is that the tax break you get up front with a regular 401(k) could well be larger than the one you get on the back end with a Roth 401(k). He continues:

This is often down-played in the press by assuming either a gross up in the contributions or (in many cases) faulty math.

Basically, you would need a crystal ball to know into what tax bracket a 35-year-old will be retiring to know if that 35-year-old would benefit from Roth.

Roth typically makes the most sense for either 1) a very high net-worth person, who can generate a significant Roth account balance or 2) a young worker who is in a low tax bracket now, and who will escalate signficantly in salary over time. (This person would also need to know when his tax bracket will reward him/her for moving back into a traditional 401(k).)

The long and short of it? Sometimes being in a traditional 401(k) is a better move than being in a Roth, and sometimes the reverse is true. According to Mass Mutual, 22% of surveyed plans now offer a Roth option.

What muddies any calculation is that nobody can know what tax rates and brackets will be in the future (Congress is funny that way). As a manager at Mass Mutual said to me last week: "When I got into the business, top tax rates were 70%, and back then I thought those rates would be going up. Shows what I know!" Back to the advisor:

The Roth 401(k) requires separate payroll tracking and the requirement to educate all employees in the Roth option. If these issues are not significant concerns perhaps, Roth should be considered.

A couple of final points: A) TAG's 401(k) Plan administrator has said that individual participants who roll their traditional 401(k) money out of the Plan can convert it into a Roth IRA (obviously, income taxes would have to be paid during the conversion). B) For any 401(k) Plan with a Roth option, participants would have to choose between doing Roth-style contributions (income taxes paid), and a traditional 401(k) (income taxes deferred). They couldn't do both at once.

This will be a topic of conversation with 401(k) Plan trustees going forward. I don't believe the union trustees have any issues with doing a Roth, but I don't know what the company trustees think about it. When I know more, I will tell you.


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