Q: Your column on back-door Roth conversions made we wonder if I should use the Roth account in my 401(k) plan. My husband has been trying to get me to switch to the Roth for a long time, but I don’t know. He says we would be better off because we would never have to pay taxes on it. What do you think?
A: To answer your question, we need to review how Roth accounts work. When you choose a traditional 401(k) account, you get an immediate tax deduction—a dollar-for-dollar reduction in your taxable income for every dollar you contribute to your account. When you choose the Roth option, on the other hand, you get no deduction. You pay tax on every dollar you contribute to your Roth account.
In both types of accounts your savings grow tax-free. However, when you take withdrawals from a traditional 401(k), you pay tax on all withdrawals as if they are current income. Qualified withdrawals from a Roth are tax-free.
Many people choose the Roth option simply because they hate the idea of paying taxes on the growth in their account. Quite honestly, they confuse themselves. By paying taxes today and never having to pay them again in the future, they think they are minimizing their overall tax burden. But this is only true if their future tax rate is higher than the rate they pay today. A simple example will illustrate my point.
Let’s suppose you currently face a 20 percent marginal tax rate and that you earn $10,000 that you wish to invest in a retirement account with a compound annual return of 8 percent per year. If you put it in a traditional account, you can put all $10,000 to work. However, if you put it in a Roth account, you only have $8,000 to invest because you have to pay $2,000 in taxes.
Now, fast forward 30 years into the future. At this point, after earning 8 percent per year, your Roth account would be worth $80,501 while your traditional account would be worth $100,626. But the traditional account is taxable. To put the Roth and traditional accounts on equal terms, let’s see what the after-tax value of the traditional account would be at various marginal tax rates.
- If your future marginal tax rate is still 20 percent, the after-tax value of the traditional retirement account will be $80,501—exactly the same as your Roth.
- If your future marginal tax rate is 10 percent, the after-tax value of your traditional retirement account will be $90,563—more than $10,062 greater than the Roth.
- If your future marginal tax rate is 30 percent, the after-tax value of your traditional retirement account will be $70,438—$10,063 less than the Roth.
As our example illustrates, the decision between a Roth or a traditional account is really a judgment about where you think your future tax rate will be compared to your current tax rate. If the future tax rate is lower, you are better off paying the taxes in the future (i.e., choosing the traditional 401(k) option.) However, if you believe your future tax rate will be higher, you should pay your taxes today (i.e., choose the Roth.)
While tax rates are the primary consideration, there are some other things you probably want to keep in mind as you consider the choice between a Roth and a traditional account. The first is the situation where the investor earns plenty of income to cover her living expenses, including all income taxes, and is still able to max out her 401(k) contributions. In this case, by choosing the Roth account, the investor effectively increases the amount of retirement savings she puts away each year by the amount of taxes that would be due on the contribution. In our earlier example, using other money to pay the taxes on Roth contribution would have increased your retirement savings by the $2,000.
Another benefit to Roth accounts, is the ability to control your annual distributions. A Roth 401(k) has required minimum distributions just like a traditional 401(k) account, though Roth RMDs are tax-free. However, upon retirement you can roll the Roth 401(k) balance into a Roth IRA and thereby avoid RMDs altogether. This added control can be a valuable benefit.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have about investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.