July Focus: Is a Roth 401(k)
Right for You?
The
Roth
401(k) has piqued the interest of many individuals because
it provides an opportunity for tax-free earnings. But even the
savviest investors are sometimes unsure of how to determine if
a Roth 401(k) is better than a traditional 401(k).
In this issue, we focus on two of the key factors which can be
used to determine if a Roth 401(k) is more suitable for you
than a traditional 401(k) account.
1.
Pre-tax
Contributions Reduce Your Income Tax – But Roth Contributions
do Not!
Pre-tax
salary
deferral contributions to your traditional 401(k) reduce
the amount of income tax withheld from your paycheck. As a
result, a portion of the cost of funding your retirement
account is offset by the reduction in the income tax that you
would owe.
Example:
Assume
you earn $5,000 per month. Depending on your tax withholding
rate, a pre-tax salary deferral contribution of 10% ($500) to
your 401(k) would reduce your take home pay by about $344,
instead of the full $500. This is because when you defer $500
on a pre-tax basis, $4,500 ($5,000 less $500) would be subject
to income tax, instead of $5,000, resulting in your income tax
withholding being reduced by about $155.
As
a result, it would cost you only $344 to make the contribution
of $500. Let’s compare a sample paycheck of $5,000 for a New
Jersey resident, where a pre-tax salary deferral contribution
(labeled as “Voluntary retirement plan contribs.” below) of
$500 was made in one instance and where no contribution is
made in another.
|
|
|
|
|
|
|
|
Current
(for 2009) |
|
Alternative
(for 2009) |
|
|
Gross
pay for one pay period |
|
5,000.00 |
|
5,000.00 |
|
|
|
|
|
Federal
income tax |
|
720.17 |
|
845.17 |
|
|
State
and local income taxes
(NJ) |
|
137.42 |
|
167.92 |
|
|
Social
Security and Medicare taxes |
|
382.50 |
|
382.50 |
|
|
Voluntary
retirement plan contribs. |
|
500.00
|
|
0.00 |
|
|
Mandatory
retirement plan contribs. |
|
0.00 |
|
0.00 |
|
|
Other
pre-tax reductions |
|
0.00 |
|
0.00 |
|
|
Other
after-tax reductions |
|
0.00 |
|
0.00 |
|
|
|
|
Take-home
pay |
|
3,259.92 |
|
3,604.42 |
|
|
|
|
Net
cost (reduction in paycheck) |
|
0.00 |
|
-344.50 |
|
Paycheck
Comparison Calculator available here.
As
you can see, making the contribution of $500 reduces the take
home pay by only $344.
Contributions
to your Roth 401(k) do not reduce your income tax because they
are made on an after-tax basis. As such, when choosing between
funding your traditional pre-tax 401(k) and your Roth 401(k),
your options would be:
(a)
reduce
your contributions from $500 to $344 so as not to affect your
take-home pay, or
(b)
contribute
$500 and reduce your take home pay by
$155.
If
you are working with a tight budget, option 1 may be the
better choice.
1.
Roth
401(k) Distributions Can be Tax-Free, Traditional 401(k)
Distributions are Taxable
Distributions
from your Roth 401(k), including earnings, are tax-free if
distributions are qualified;
on the other hand, distributions from your traditional 401(k)
generally would be fully taxable. If we compare $500 being
added to a Roth 401(k) with $500 being added to a traditional
401(k) on a monthly basis over a twenty year period, the total
account balance would be $183,998.59 for each
(assuming a 4% rate of return); but a complete analysis looks
beyond this basic comparison and requires your financial
advisor to take other factors into consideration, such
as:
- If
you choose to contribute $500 to a Roth 401(k), the true
cost would be $500 vs. the cost of $344.50 to fund your
traditional 401(k). As such, funding your traditional 401(k)
leaves an additional $155.50 to invest, which could offset
the income taxes that would be owed on future distributions
from these funds.
- Other
sources of income you may receive during retirement and how
the taxable income from your retirement assets would impact
the amount of income tax you pay on those
amounts.
- Whether
your legacy planning objectives include leaving tax-free or
taxable retirement assets to your beneficiaries.
There
are other factors that should be considered when conducting a
Roth vs. traditional 401(k) analysis, and it should be noted
that the outcome will vary for each individual based on his
specific circumstances.
Conclusion
Comparing
the features and benefits of both types of 401(k)s can assist
in making the determination of which plan is more suitable for
you based on your individual circumstances. However, in order
to make an informed decision, you will need to work with a
financial advisor who understands how your 401(k)
contributions impact your retirement savings, as well as how
each option affects your specific set of retirement needs and
financial profile. If you are unsure of whether a Roth 401(k)
fits your financial profile, you may want to contact an Ed Slott Elite
IRA Advisor.
