Financial Planning > Tax Planning

How To Determine When The Roth Vehicle Is Best

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There are several considerations when determining whether a Roth IRA, 401(k) or 403(b) is better than a traditional retirement vehicle, such as the traditional IRA.

The first is based on income tax rates when the contributions are made as compared to the rates upon distribution. If the income tax rates are the same at contribution and distribution, then the Roth and non-Roth products are economic equivalents.

If, however, the applicable income tax rates are higher at the time of contribution, when the contributed amount is subject to income tax for a Roth, then the traditional retirement vehicle is economically superior.

Alternatively, if the applicable income tax rates are lower at the time of contribution, then the Roth retirement vehicle is economically superior.

As an example, say that $15,500 is contributed to a traditional 401(k) and grows at 5% for 10 years, producing a value of $25,248. If that amount is distributed to the participant and tax is triggered at 35%, the participant will be left with $16,411 after-tax.

By comparison, if the participant allocates the same $15,500 to a Roth 401(k), tax will be paid up front and, assuming the same 35% tax rate, the participant will have $10,075 left in the account. If the $10,075 earns the same 5% as assumed for the traditional 401(k), the account will grow to $16,411 after 10 years.

The result, then, for both the traditional and Roth 401(k) is the same: $16,411 of after-tax funds after 10 years.

But what if tax rates are higher when the distribution is made from the traditional 401(k)?

Assuming the above facts are the same but that the marginal tax rate applicable to the 401(k) distribution has increased to 45%, then the $25,248 of pre-tax 401(k) dollars is only worth $13,886 after 10 years. That is significantly less than the $16,411 the Roth 401(k) provides on an after-tax basis.

The above income tax rate analysis leads to a question: Will income tax rates likely be lower or higher in the future? While it is difficult to make any prediction about future legislation, federal income tax rates appear to be at a historic low. (The top marginal federal income tax rates have fluctuated over time, but were in the 50-92% range from 1946-1986. From 1986-2002, the top marginal income tax rates have ranged from 28-39.6%. The current top marginal rate, as of early 2007, is 35%.)

When viewed from the prism of historically low income tax rates, coupled with existing budgetary constraints, it may be necessary to increase income tax rates in the future. (Note: During the last several years, the nation’s long-term budget posture has turned from surplus to deficit. Also, the cost of U.S. entitlement programs, such as Social Security, Medicare and Medicaid, now consumes 8% of Gross Domestic Product, and they are projected to increase to 17% by 2030 and 28% by 2050.)

In any event, a further reduction in federal income tax rates seems unlikely in the near term. And, if one believes that income tax rates will be going up, it may make sense to make Roth contributions and subject income to tax while the rates are lower.

The above example also demonstrates how a Roth 401(k) can provide an additional savings benefit for a participant. In the example, we compared a participant who saves $15,500 in a traditional 401(k) with another participant who allocates the same amount, after taxes, to a Roth 401(k) to show that, assuming constant investment return and tax rates, these are economic equivalents. However, since a Roth 401(k) allows for the same amount to be saved on an after-tax basis, the participant can choose to pay the up-front taxes from other funds and reap the benefit of saving on a tax-favored basis by fully utilizing the Roth.

Returning to our example, under a traditional 401(k), the participant may contribute $15,500 in 2007 and will need to earn at least $15,500 to make that contribution amount. Alternatively, one can contribute $15,500 after-tax to a Roth 401(k), which will require earnings of at least $25,834 (assuming a combined 40% federal and state income tax rate). The traditional and Roth 401(k) savings amounts are the same, but since the Roth is an after-tax amount, it allows for an individual to keep more.

The additional savings amount correlates to the tax rate applicable to the individual. In this case, the additional savings opportunity is assumed to be 40% (or $10,334 of additional pre-tax money that can be put away on a tax favored basis).

There are some additional income tax considerations when deciding whether to use a Roth product. First, since Social Security benefits are subject to income tax based on one’s annual taxable income, taking distributions from a Roth avoids increasing one’s taxable income and creating an additional tax liability. Similarly, in light of recent Medicare changes that increase one’s Part B premium at certain income levels, the use of a Roth might reduce one’s Part B Medicare premium costs.

Perhaps the most compelling reason to use a Roth product is to gain the flexibility to control the timing of distributions. The Required Minimum Distribution (RMD) rules do not apply to Roth IRAs, so one is not compelled to distribute any amount from a Roth during one’s lifetime. In this respect, the Roth IRA is the optimal vehicle to ensure that one can maintain one’s target retirement income, since the Roth may be hoarded on a tax preferred basis without limit.

In the case of a Roth 401(k) or 403(b), the flexibility is less direct since the RMD rules do apply. However, under current law an individual may roll a Roth 401(k) or 403(b) to a Roth IRA and enjoy the same planning flexibility described above.

Advisors will find that the ability to control the timing of distributions creates wealth and income planning opportunities for clients.

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