Why Your 401(k) Should Have a Roth 401(k) Option

Sofi

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[Editor’s Note: This guest post is from John Lim, MD. He sent me this email:

“I’m a radiologist practicing in Newport Beach, California in a group of about 30 radiologists.  I had no prior financial background and basically taught myself finance since beginning in private practice in 2002.  I love finance and sometimes wonder if it was my true calling.  I have no websites or books to sell or advertise.  I serve as a trustee on our groups retirement plans (401k, Roth 401k, profit sharing plan, and Cash balance plan) and was a former CFO for our group. I recently lobbied to add a Roth 401k option for our group.  I succeeded but met fairly stiff resistance.  I wrote this to explain to our members why they might consider a Roth 401k option.”

I found it kind of sad that he met any resistance at all. There is literally no downside to adding a Roth 401(k) option to a plan, whether you use it or not. At any rate, I thought many readers would find the post useful, especially his “trick” for those who have a cash balance plan but aren’t maxing it out. We have no financial relationship.]

WHY ROTH 401K?

Tax diversify your retirement savings. “Multiple buckets”

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Nobody knows what income tax rates will be in the future (upon retirement). By diversifying retirement savings into both pretax accounts (401k, IRA, Cash Balance plan) and posttax accounts (Roth 401k, Roth IRA, Health Savings accounts), you have greater flexibility at retirement to draw income in a way that is most tax efficient. For example, if income tax rates are very high for a few years, you could draw income from the Roth 401k account without paying any income taxes (or conversely if tax rates are low, draw on pretax accounts).

This issue is particularly applicable to us because we are able to put away so much money in pretax accounts. Not only does this open you up to tax rate risk, but the larger your total pretax balance, the larger your mandatory distributions will be (starting at age 70.5). This alone could raise your income tax bracket at retirement.

Here is a chart of income tax rates that might give you pause:

Highest-Marginal-Tax-Rates-1913-2013You are saving more for retirement in a Roth 401k. “Forced savings”

The annual contribution limits for a Roth 401k and traditional 401k are the same ($18,000 in 2015). However, $18,000 in a Roth 401k is more “valuable” than $18,000 in a 401k. Why? Because the 401k will get taxed when it comes out and the Roth 401k does not. “Wait”, you say, “but I’ve saved on my taxes by contributing to the 401k!”

That is true. But, you haven’t saved more for retirement unless you take that tax savings and set it aside and invest it for retirement. Instead you might take the taxes you’ve saved and go on a vacation, nothing wrong with that, but you just haven’t used the tax savings for retirement

Junior members benefit most from a Roth 401k. “Time is on your side”

Two reasons. First, you may be in a lower tax bracket during your early years prior to reaching full partner. So, although contributions to a Roth 401k are still taxable, you are paying lower tax rates then you will later on in your career. Second, the longer your time horizon, the longer your investments have time to grow tax deferred. And when you withdraw money from the Roth 401k, it will be tax free.

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You can bequeath Roth IRA accounts to your family. “Be a Rockefeller”

Unlike traditional 401k and IRA plans, the IRS does not mandate that you withdraw
money from Roth IRA accounts. Therefore, for those so inclined, there is an easy way
to bequeath money to your children or family. Simply rollover the Roth 401k into a Roth
IRA upon retirement and then it will not be subject to required minimum distributions
(RMD). On the other hand, the IRS mandates withdrawals from IRA and 401k accounts
beginning at age 70.5.

Roth 401k tax strategy for those contributing to the Cash Balance Plan “Have your cake and eat it too”

I believe this is a compelling strategy for those who want to contribute to a Roth 401k but are not willing to give up the immediate gratification of the tax deduction they have been receiving. Two prerequisites to this strategy are:

  1. You are contributing to the CBP but not maxing it out (many of us are in this boat)
  2. You can save & invest at least $18,000 per year in regular after-tax accounts.

So, let’s say you plan on doing the following in 2015:

  • Traditional 401k contributions: $18,000 (maximum) Roth 401k contributions: zero
  • Profit sharing contributions: $34,500 (maximum)
  • Cash Balance plan contributions: $60,000 (your maximum is $80,000)
  • After tax income that is saved: $25,000 (but outside of retirement accounts)
  • Total Pretax savings (tax-sheltered income): $112,500 ($18,000+$34,500+$60,000)

Instead, why not do this?

  • Traditional 401k contributions: zero
  • Roth 401k contributions: $18,000 (maximum)
  • Profit sharing contributions: $34,500 (maximum)
  • Cash Balance plan contributions: $78,000 (your maximum is $80,000)
  • After tax income that is saved: $7,000 (but outside of retirement accounts)
  • Pretax savings (tax-sheltered income) $112,500 ($34,500+$78,000)

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What have you really done? You’ve taken $18,000 of savings that you’ve already paid taxes on and simply put it into a Roth 401k instead. But, in order to do this, you could no longer contribute anything to your traditional 401k. To offset the loss of tax-sheltered income of $18,000, you simply increase your CBP contribution by an equal amount of $18,000. Voila! You still save the same amount of taxes and you now have $18,000 in a Roth 401k (instead of a regular taxable brokerage account). That $18,000 contribution alone in a Roth 401k can grow tax deferred over decades (e.g. into ~$123,000 in 25 years assuming an 8% annualized return), and when you take the money out, you owe Uncle Sam exactly zilch!

Of course, you could simply invest the $18,000 in a regular after-tax brokerage account or mutual fund, but every year you would pay taxes on dividends & capital gains. And at the end of 25 years, you would have less than $123,000 (because of taxes on dividends and capital gains, as would happen with any mutual fund). Let’s say because of this tax drag your annual return is only 7.5% (instead of 8%). That translates into just less than $110,000 at the end of 25 years. Not bad, until you realize you owe taxes on the capital gains of $92,000 ($110,000 – $18,000). Today that means you would owe about $18,400 in taxes. After paying Uncle Sam, you have a grand total of $91,600.

That’s a far cry from $123,000 in the Roth 401k. And that is based on a one time $18,000 contribution! (you will likely be making annual contributions for many years) Besides boring you all to tears, I hope this exercise also illustrates why the Roth 401k benefits younger partners the most. The longer the money is in the Roth 401k, the greater is the tax-advantaged
tailwind.

Please note that nothing in this article constitutes specific financial advice. You should always consult with your financial planner and tax accountant with regard to your personal circumstances.

What do you think? Do you have a Roth 401(k) option in your plan? Why or why not? What can you do to have one added? Would you use it if it were there? Comment below!