An Article by Neal Templin in Barron’s, featuring Susan Elser.
“For 40 years, Americans have used their 401(k) retirement accounts to delay paying taxes.
However, many financial experts say most people would be better off paying taxes now and saving their retirement money in a Roth 401(k), where future withdrawals will be tax-free. This is particularly true in a period of growing federal budget deficits that are likely to force tax rates up in the future, they say. There are other benefits to making a Roth 401(k) your main workplace retirement account. By paying taxes now instead of in the future, you are putting aside more money for retirement.
“A $10,000 Roth contribution is a larger contribution than $10,000 in a traditional 401(k),” says William Reichenstein, a retired Baylor University finance professor who researched retirement benefits taxation. “It’s $10,000 of your after-tax dollars as opposed to $10,000 of your pre-tax contribution.”
Reichenstein offers this example. Suppose that $10,000 doubles inside your 401(k) and you withdraw it during retirement while in the 24% tax bracket. If it’s in a traditional 401(k), you’ll have $15,200 to spend after paying taxes. If it’s in a Roth 401(k), you will have $20,000.
There’s more. After you turn age 73, required minimum distributions (RMDs) from your traditional 401(k) may increase the portion of your Social Security benefits that are taxed. You may pay higher Medicare premiums, which are based on income. All this means that your true marginal tax rate could be well above 40%, Reichenstein says.
By contrast, there are no RMDS from a Roth account while the account owner is alive. And all withdrawals from a Roth are tax-free provided the account has been open at least five years and you are at least 59 1/2.
While tax-deferred 401(k)s had been the only game in town for many years, 93% of 401(k) plans now give workers a Roth 401(k) option, according to trade group Plan Sponsor Council of America.
Participation is still light. Only 21% of eligible workers invest in a Roth 401(k), and the average worker contributes just 1.6% of his salary to the accounts. By comparison, 74% of workers invest in traditional 401(k)s with average workers deferring 6.1% of their salaries.
Susan Elser, a financial advisor in Indianapolis, says she advises nearly all her clients to save through Roth 401(k)s instead of traditional 401(k)s. Elser frets that looming federal deficits will force the federal government to lift its tax rates in the future.
“It’s very disconcerting,” she says. “We’ve had Democrats and Republicans blow
through deficit spending like it’s someone else’s money.”
Certified public accountant Ed Slott, who specializes in retirement account strategies, echoes that view. He says tax rates remain historically low for now, and says workers should be putting as much money as possible in Roth 401(k)s.
“Most people would be better off with a tax-free retirement account,” he says. “And you get it now on sale because tax rates are low.”
Although there is wide agreement that tax rates are headed up, nobody knows when that day will come. “Though it may seem inevitable, it may not affect every taxpayer,” says David Frisch, a certified public accountant and wealth advisor in Melville, N.Y.
Contributing to a Roth 401(k) doesn’t make sense for everybody. If you intend to give away your retirement savings to charity, you are better off contributing to a traditional tax-deferred 401(k), Frisch says. The charity won’t pay any taxes on the gift.
However, if you plan to leave your retirement account to your children, a Roth 401(k) does them a big favor, Frisch notes. They will inherit the account tax-free, and the money inside it can grow tax-free for a decade after your death. If instead your children inherit a traditional 401(k), all their withdrawals will be treated as ordinary income. For high-earning children in high-tax jurisdictions like New York City, as much as 50% of these withdrawals could go to taxes, Frisch calculates.
“If somebody dies when they are 85 years old, and their children are 55 or 60, they’re at their peak earnings years,” Frisch says.
Roth 401(k)s are particularly compelling for young workers who aren’t earning a lot and are still in low tax brackets, Slott says. Even many highly paid workers should contribute to Roths because they will still be in a high bracket in retirement.
If you instead contribute to a traditional 401(k), “All you’re doing is taking a loan from the government that has to be paid back in the future at the very worst time when you don’t know how high taxes will be at that point,” Slott says.”
