From the November 2006 issue of Boomer Market Advisor • Subscribe!

November 1, 2006

Compare the Traditional 401(k) to the Roth 401(k)

The Pension Protection Act of 2006 gives permanent status to pension and IRA provisions established by EGTRRA that were due to expire at the end of 2010. Now your clients need your advice on whether they are better off contributing to a traditional 401(k) plan or to a new Roth 401(k). It depends, but in most circumstances, the Roth 401(k) will be the better choice.

Please note that the tax treatment of the employer's contribution to an employee's 401(k) has not changed. The question for employees at companies that offer a Roth 401(k) is whether they want their deferral contribution treated as a Roth 401(k), a traditional 401(k) or a combination of the two.

Broadly speaking, the variables that factor into the decision to contribute to a traditional 401(k) versus a Roth 401(k) are similar to the variables you would evaluate if your client were trying to decide whether to contribute to a fully deductible traditional IRA or a Roth IRA. A key variable is the taxpayer's current marginal income tax rate versus the taxpayer's expected marginal tax rate when distributions are being taken.

If your tax bracket in retirement stays the same as when you contributed to the plan, you will be better with the Roth 401(k), as shown in the graph above.

The graph reflects the greatest benefit, i.e., when maximum allowable contributions are made. If, for example, your client is 50 years old or more and can afford it, he can make a $20,000 401(k) contribution. If he contributes that $20,000 to a Roth 401(k), he is actually making a $20,000 retirement plan contribution. If he makes a $20,000 contribution to a traditional 401(k), he is really only saving $20,000 minus the tax savings on his contribution.

If your tax bracket in retirement is higher than when you contributed to the plan, you will be much better off with a Roth 401(k).

If your tax bracket in retirement is lower than your tax bracket during your working years the picture is not as clear.

Surprisingly, if the long-term plan is to keep the money in the tax-free Roth environment, possibly leaving it to heirs, the Roth is the preferred vehicle.

Effects of slightly lower tax rates in retirement

How can Roth become better with lower taxes in retirement, when someone drops from the 35 percent tax bracket to the 25 percent tax bracket, for example? The answer is yes, it still proves advantageous in the long run. The extra 10-percent tax savings you forego on the traditional 401(k) is eventually overcome.

Effects of extremely lower tax brackets in retirement

The picture of the Roth is not all golden. When there is a significant drop in an individual's post-working marginal tax rate (say, for example, dropping from the 35 percent bracket to the 15 percent bracket) the traditional 401(k) plan is significantly better. If we extended a projection through age 96, the Roth would become better, so it could conceivably benefit your heirs -- but that assumes no funds are spent. Spending would diminish the possibility of breaking even.

The bottom line is that in order to get the tax advantages from the Roth, you should be sure that you will have a tax rate in retirement that is not too much less than while working. Otherwise, the tax deduction from traditional 401(k) contributions may be too good to pass up. My rule of thumb: use the Roth 401(k) unless you expect to have at least a 15-percent drop in your income tax rate or your investment time horizon is quite short.

Also, note that the analysis of this article applies to the question of using the traditional 403(b) versus the Roth 403(b).

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