Roth 401(k) and 403(b) plans, available since January of 2006, offer substantial benefits for employees who are looking for ways to shelter income from taxes on a permanent basis. However, it can be difficult for employees to know whether they will come out ahead by selecting the Roth option in their plans instead of the traditional pretax contribution features. Let's take a look at some of the benefits of the Roth feature and compare them to traditional retirement plans. (For background reading, see Introducing The Roth 401(k).)
How Does the Roth Feature Work Inside a 401(k) or 403(b) Plan?
Plans that offer the Roth alternative work much the same as traditional plans, except that the Roth portion of the plans are taxed similar to Roth IRAs, and only after-tax contributions are allowed in the Roth account. Similar to Roth IRAs, employees can withdraw their balances tax free, provided distributions are qualified. For this purpose, a qualified distribution is one that is taken after five years, with the five-year period beginning the first year that the Roth plan receives a contribution. The employee must also be either at least 59.5 years old and disabled or deceased.
The maximum contribution that can be made for 2013 is $17,500, plus the additional $5,500 catch-up contribution for employees who are at least age 50 by the end of the year. However, only the employee's salary deferral contributions can be allocated to the Roth account; any matching contributions by the employer must be done as traditional pretax contributions.
Benefits of the Roth Plan Feature
One of the main advantages that Roth 401(k) and 403(b) plans offer is the freedom from income limitations on contributions that apply to Roth IRAs. These plans effectively provide a tax-free shelter for high income earners that cannot be matched. In 2013, a corporate executive making $300,000 per year can shelter up to $17,500 in a Roth 401(k) or 403(b), but he or she would not be eligible to make any kind of contribution to a Roth IRA with such a high income level.
A $17,500 Roth contribution made annually for 20 years with a growth rate of 5% comes to more than $607,000. This is likely the largest tax-free pool of cash that the employee could accumulate under any circumstances. But the benefits of the Roth plan are not limited to high income earners. Lower-salaried employees can also contribute to their Roth plans and still make contributions to a Roth IRA as long as their incomes do not exceed the threshold amount. For example, a rank-and-file employee earning $70,000 annually could contribute $17,500 to a Roth IRA and still put another $5,500 per year into a Roth IRA. Given the same time horizon and return on capital as the executive, this employee would have more than $1 million tax-free to spend! There are few other types of investments or savings plan that can even come close to offering this kind of tax-free accumulation.
A real drawback to Roth 401(k) and Roth 403(b) plans is that they are only available for employees of companies that offer them. Self-employed individuals can use these plans too, although they are likewise limited to a maximum Roth contribution of $51,000 for 2013, plus an additional catch-up contribution of $5,500. Of course, Roth plans also have the same disadvantage as Roth IRAs, in that their contributions are made on an after-tax basis. However, the flip side to this is that employees can then take a distribution of any size from their Roth balances in retirement and not have to worry about it impacting the taxability of their Social Security benefits or the rate at which any of their other income is taxed. Furthermore, any employee who rolls over their plan balance into a Roth IRA will not have to worry about taking any kind of required minimum distribution (RMD). This simplicity is worth something in and of itself, especially for retirees who are not financially savvy and may struggle with understanding how their plan distributions impact their taxes in other areas.
Beyond these issues, Roth accounts provide a deeper assurance that the employee has a future hedge against taxes, which becomes even more valuable if taxes increase. Roth accounts are quickly coming to represent the promised land for many retirement savers - a haven where the tax man cannot reach them, a place where government bureaucracy is shut out, an area of their lives that they alone control. (For related reading, see The Simple Tax Math Of Roth Conversions.)
So Which Is Better, Roth or Traditional Accounts?
Some pundits would say that it is important to know whether you will be in a higher or lower tax bracket at retirement before you choose between a Roth or a Traditional plan, but in many cases, this may not matter.
For example, Sally Saver is in the 28% tax bracket and works for an employer that offers a Roth 401(k). She dutifully saves $15,000 a year in her account for 30 years. But because she is making after-tax contributions, her contributions are actually costing her $19,200 a year ($15,000 plus $4,200 in taxes because the amount is not tax deferred). Therefore, at the end of 30 years, she will have paid a total of $126,000 in taxes on her Roth contributions.
Meanwhile, her friend, Nancy Now, makes contributions to a Traditional 401(k). Nancy is also in the 28% tax bracket and enjoys an annual tax reduction of $4,200 on her contributions, because they are made on a pretax basis. Therefore, she reduces her taxes by a total of $126,000 over 30 years. Assuming that both women earn an average of 9% on their investments, they will each have slightly more than $2 million in their plans by the time they retire.
Now assume that both Sally and Nancy begin drawing money from their plans at the end of the 30-year period, that they both drop down to the 15% tax bracket in retirement and draw $50,000 per year from their plans. Nancy must pay $7,500 per year on her distributions, while Sally pays nothing. If both women live for another 30 years, Nancy will have paid a total of $225,000 in taxes on her 401(k) distributions alone. Of course, these distributions will also likely trigger at least a partial tax on her Social Security benefits and may raise the rate at which any other income she receives is taxed. And if Nancy manages to stay in the 28% tax bracket, then her taxes will soar to $420,000. Of course, we cannot forget the $4,200 that she received in tax reductions. If she saved that amount every year, she would have about $600,000 in after-tax savings after 30 years, assuming the same 9% rate of return.
This scenario is a telling example of the benefit that can be reaped by biting the bullet and paying taxes now instead of later. Although such variables as changes in tax brackets, longevity and investment performance must also be taken into account, the Roth account tends to beat the traditional plan in most scenarios. Other factors must be taken into consideration, such as what is done with the tax savings received as a result of making pretax contributions. If you are trying to decide which is better for you, consult your financial advisor.