401(k) or Roth 401(k)?

[roth401k]

I am interested to find out which Retirement option you think is better, 401(k) or the new Roth 401(k), and why.

I have already decided that the Roth 401(k) will be better for me because it will allow me to put more money away for retirement than a traditional 401(k). All this talk about comparing your tax rate at retirement to your current tax rate and then deciding which plan is better seems meaningless to me since you can effectively put more money away for retirement in a Roth 401(k).

If you can afford to maximize your Roth 401(k) I dont understand why you would not want to do that. Putting $15,000 in after tax money into a Roth 401(k) equals roughly 19,500 pretax assuming a 30% tax rate. This effectively increases the amount of money that can be saved for retirement compared to a Traditional 401(k), not to mention the fact that your money will grow tax-free!! Can you put $19,500 into a Traditional 401(k)? I dont think so.

Seems like a "no brainer" to me.

I'd like to hear what you think and which one you plan on using and why.

[Nate]

I agree that the Roth is mostly a no-brainer, primarily because of its higher effective savings rates.

However, putting all funds into a tax-free vehicle is a mistake. If you assume future tax code will be even remotely similar to the current tax code, a two-member household can realize nearly $30,000 dollars before they start to get taxed at all (because of deductions, exemptions and credits). So, in an ideal world, a household should have enough tax-deferred accounts to realize income that stays "under the radar" due to deductions, exemptions and credits. Then any income needs beyond that threshhold would come from the tax-free accounts.

Using assets in this fashion allows a household to NEVER pay taxes on tax-deferred accounts (not on the contribution, and not on the withdrawal). That's the smart move.

[clightle]

I agree with both of you. I see the roth401k as an effective way to save more money in a tax advantaged vehicle. Since I already have a tax deferred plan (401k) and taxable accounts, my plan is to use the roth(both IRA and 401k) to supplement my income above the non-taxable income that I will withdrawl from my tax deferred/taxable accounts. The only flaw that I may run into is that I have to take manditory withdrawls from my tax deferred accounts greater than the lowest(none) tax bracket. I guess this could be viewed as a good thing though because it is basically saying I would have too much money. Of course when I get closer to retirement (current age = 31) I may attempt to pay the tax on some of my deferred accounts and convert these funds to Roth funds(similar to the traditional to roth conversian) if allowable.

[roth401k]

There are five reasons why the Roth 401(k) is the preferred choice of 401(k) options for highly compensated employees. Four are listed below but you'll have to wait until September 15 to learn number five, the one that makes this a very easy decision for most high paid savers.

ENTIRE ARTICLE HERE


Reason 5

In determining if the new Roth 401(k)/403(b) option is preferable when compared to the traditional pre-tax option, the key factor for participants to consider is the tax rate they pay today versus their future tax rate on distributions following retirement. However, participants who wish to maximize their retirement savings (and can afford to) have another factor to consider, one that mitigates the need for predicting future tax rates and simplifies this very complex decision.......


ENTIRE ARTICLE HERE

[roth401k]

THE TAX ADVISOR: A New Era in Retirement Planning

The Roth 401(k) is a very sharp tool, especially for business-owning clients

By Christopher G. Laucks

There were more than 400 new tax rules in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and most went into effect years ago. But the time is finally arriving for one provision that will substantially alter the retirement plan market. It’s the Roth 401(k), and after a sustained period in which Americans have accumulated trillions of dollars in retirement assets through traditional 401(k) plans that will inevitably be taxed, the Roth option, which will be available January 1, 2006, opens the door to tax-free retirement income.


While the Roth 401(k) will hold appeal for millions of investors, perhaps no group will be more interested than high-income earners and proprietors of owner-only businesses. In addition.........



ENTIRE ARTICLE HERE

[Beverly]

Los Angeles, CA 90017 March 15 2006

Effective January 1, 2006, a Roth 401(k) option is available. This Roth 401(k) option does not have the income limitations that have previously prevented use of Roth IRAs by affluent persons. Employers with an affluent work force (such as law firms) should definitely be offering this option.

Roth contributions, unlike pre-tax deferrals, are included in one’s current taxable income. In exchange for this current taxable treatment, Roth 401(k) earnings are tax-free when distributed so long as:

The distribution occurs at least five years after the participant’s first Roth contribution, and

The participant is at least 59 ½ years old, becomes disabled, or has died.

The Roth 401(k) option will require a simple Plan amendment and some additional recordkeeping obligations. Compared to the benefits to your work force, this additional effort by the employer is definitely worthwhile.

For High Savers, the Popular Press is Wrong.

Non-affluent investors have to decide whether to reduce taxes currently, or accept the long-term advantage of not ever paying taxes on earnings in a Roth 401(k). The affluent really don’t have such difficult tradeoffs. Consequently, the popular press on the Roth vs. regular 401(k) debate focuses on whether one’s income tax rate is less in retirement than when the 401(k) contribution is made. This leads one to the correct but overly simplistic conclusion that the benefit of a Roth vs. regular 401(k) depends on a comparison of the tax rates that exist now versus what will exist in retirement.

One problem with this comparison is that, when the Roth account has a long enough time to earn large returns, the ability to entirely escape taxes on earnings with a Roth account overcomes the fact that a smaller amount may initially be available to invest.

But a second problem occurs. Most affluent professionals and business owners want to save far more for retirement than can be placed annually into a 401(k) account. For these people, there is not a need to reduce one’s 401(k) investment by the additional taxes that need to be paid currently if a Roth option is made. For these affluent investors, additional retirement savings occur outside of the 401(k).

For anyone who is maxing out on their 401(k) contributions and/or has additional retirement savings outside the 401(k), then the answer proposed by the popular press is probably wrong, even if tax rates turn out to be lower during retirement. Those who can afford to both save the annual 401(k) maximum and pay taxes now effectively get a near doubling (assuming a 50% marginal tax rate) of the annual limitations. Stated otherwise, a Roth 401(k) effectively doubles the contribution limits that otherwise exist under IRC sections 402(g) or 415.

The Roth account is always better than the ordinary savings that are outside any 401(k). This occurs because the same rate of return, when non-taxed, is always better than giving some of your earnings to the government. Since the money earned inside a Roth account is tax free, the after-tax return of the Roth savings will always beat the alternative of having some of your retirement savings in a currently taxable account.

This conclusion may not be true for savers who are not maxing out on their 401(k) contributions, especially if the employer is matching employee contributions. If one reduces the amount contributed to a Roth 401(k) to pay for current income taxes, the “free” money provided by the employer’s matching contribution might also be reduced. In this circumstance (which rarely applies to affluent professionals and business owners anyhow), the regular 401(k) account may be best.

Other Reasons Why Affluent Benefit Extra from the Roth 401(k)

As explained above, the Roth account effectively increases one’s tax-advantaged investments. In addition, affluent professionals, executives and business owners should generally be using a Roth 401(k) for the following reasons:

More affluent people are more likely to remain in the higher tax brackets during their retirement, thus favoring the Roth account under the traditional, simplistic analysis. Moreover, because of America’s growing social welfare obligations for Medicare and Social Security, combined with the already high federal deficits, it is unlikely that there will be lower taxes in the future for the affluent. A real possibility exists for higher marginal tax rates in the future, creating an advantage for paying taxes on retirement funds now.

Because 401(k) plans are exempt from creditor claims, a 401(k) plan is the best and least expensive asset protection device available. In the unfortunate situation that lawsuits or other tragedies cause such planning to be applicable, a Roth 401(k) effectively doubles the after-tax monies that are safe from creditors.

If you are classified as a “highly compensated employee”, or HCE and your contributions are limited because the Plan otherwise fails the anti-discrimination tests, a Roth contribution effectively gets the HCE the same after-tax result within the smaller limits that are allowed.

Because regular 401(k) distributions are part of the income base used to determine whether Social Security benefits are taxed, the Roth account does not worsen the challenge of keeping Social Security benefits from being taxed.

A Roth 401(k) can be rolled over to a Roth IRA, which does not have minimum distribution requirements during the life of the IRA holder. By using the Roth 401(k) and making this rollover, those with substantial retirement savings can avoid the requirement to take 401(k) withdrawals at age 70 ½. This is important to anyone interested in leaving tax-advantaged money to the next generation.

The IRS has now published its Roth 401(k) regulations, so there is no good reason for employers to delay this sound choice. The additional recordkeeping and administrative costs are small compared to the benefits described above. The deadline to adopt an amendment implementing Roth provisions is the end of the plan year in which the Roth amendment is effective.

Fulcrum Financial Inquiry is a Registered Investment Advisor and a licensed CPA firm. We help law firms with a broad range of financial services that help lawyers serve their clients, such as damages analysis, financial investigations, and appraisals of business interests.

David Nolte (dnolte@fulcruminquiry.com)
Fulcrum Financial Inquiry LLP
1000 Wilshire Blvd
Los Angeles, CA 90017
Phone : 213.787.4111
Fax : 213.787.4141