As featured in The Wall Street Journal, Money Magazine, and more!

Roth 401(k) Not For Everyone

by Flexo on February 1, 2006

in Uncategorized

There’s a new retirement investing option being rolled out across the United States, the Roth 401(k). The new option allows you to take your after-tax income, invest in mutual funds or stocks, defer taxes on earnings, and begin untaxed withdrawals upon retirement.

Since the limit in all 401(k) accounts per individual doesn’t change, if your employer offers and you decide to take advantage of the new investment account, you’ll have to split the same $15,000 limit ($20,000 for those over 50) between the traditional and Roth 401(k).

The law that has brought the account into existence is scheduled to expire in 2010 unless congress extends the law.

This article from the Associated Press highlights the positive about the account:while an article from the Philadelphia Inquirer outlines the negative.

Why aren’t Roth 401(k)s as good as they sound?

Mainly because they lack the traditional 401(k)’s up-front tax deduction on contributions. A worker in the 25 percent tax bracket could save $2,500 in income tax by putting $10,000 into a traditional 401(k), allowing him to save more, supercharging investment results.

Having those extra funds in the traditional 401(k) accelerate the compounding of returns.

My company will be offering the Roth 401(k) later this year — they’re still developing the programming and promotional materials. I don’t think I’ll be taking advantage at the moment. I’m investing in the traditional 401(k) and my personal Roth IRA — and I’m just about evenly split between the two.

VN:F [1.7.4_987]
Rating: 0.0/5 (0 votes cast)


Email this article Email this article Print this article Print this article
Share this article: Twitter | Tip'd | Facebook | Delicious | Reddit | Digg
About the Author

Flexo, the owner and creator of Consumerism Commentary, has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow him on Twitter.

If you enjoyed this article, get the free RSS feed or get daily emails.

Join the free Consumerism Commentary newsletter. Enter your email address here to receive weekly emails with behind-the-scenes information, exclusive giveaways, and money tips.



Related Entries on Consumerism Commentary

  • They will "supercharge" their investments with money that will be taxed, but everything will be taxed once they withdraw. Too bad no one knows what the tax rates will be when they retire.
  • Anon
    "A worker in the 25 percent tax bracket could save $2,500 in income tax by putting $10,000 into a traditional 401(k), allowing him to save more, supercharging investment results."

    This is false. It does not matter if taxes are taken out before or after an investment, the result is the same (given the same tax rate). For example (assume 200% return):

    (10000 * 2) * .75 = 15000
    (10000 * .75) * 2 = 15000
  • evin
    The Philadelphia article is inaccurate. Assuming your current tax rate is the same as your tax rate during retirement and you're not maxing out your 401(k), both options are equivalent. Suppose I have $5000 pre-tax money to invest, and my marginal tax rate is 25%. Suppose that over 35 years, my investment will grow 7-fold.

    Traditional 401(k): $5000 * 7 = $35000, minus 25% tax is $26250.

    Roth 401(k): $5000 minus 25% tax is $3750. Times 7 is the same $26250.

    If my tax rate will be lower when I retire, the traditional 401(k) makes more sense. If it will be higher, the Roth 401(k) makes more sense. In any case, I should put some money in the traditional 401(k) because when I retire, I will still have tax deductions and the first few dollars of my income will be taxed at a lower rate.

    However, if you are currently maxing out your 401(k) and Roth IRA and want to save even more, then the Roth 401(k) makes much more sense. Your limit is still $15000, but these are after-tax dollars, so they are worth more. You end up being able to to significantly increase your tax-advantaged savings.
  • I agree with Loi, the Philly article doesn't do a good job pointing out that bigger amount put away just gets taxed later instead of now. In my calculations, even if I keep the same tax bracket as now, I'm ahead with a Roth. Of course these are based on assumptions, but so are theirs.

    I think one main difference is just pyschological. You FEEL like you have more money saved up with a regular 401k.
  • jim
    I'd do the Roth 401k if my company offered it but unfortunately they don't.
  • Paul
    "allowing him to save more, supercharging investment results"

    I agree that the math is wrong. But I would also like to point out that this article, like many others, implies that your rate of return will be higher if you save more money -- thus classically confusing nominal dollar return and real percentage return. $1,000 at 5% is no better than $100 at 5%. Except that it is more money -- but that doesn't have anything to do with the "investment results."
  • Um, you're missing a major point (more than one, actually, but I'll stick with main issue)

    Both a traditional 401k and a Roth are tax deferred.

    However, you contribute pre-tax dollars to traditional, and when withdrawn, it is taxed, together with any and all earnings at full rate.

    Roth is after tax money, so it is leveraged right from the beginning. If you put the same numerical number of dollars in, you have more effective dollars in the account. But even if you put a lessened number of dollars in to reflect the money you would otherwise spend in taxes, not just the contribution but every penny in earnings is tax exempt when withdrawn. This means that the earnings in the account (as opposed to contributions) are never taxed.

    Under current tax code, this has all kinds of implications. For instance, it means that the income withdrawn from Roth accounts doesn't bump you up in marginal bracket, it doesn't cause you to hit income limits, and it doesn't cause your social security to be taxable or more taxable if that is still a factor when you retire.

    It is still possible for traditional 401s to come out ahead, but the necessary assumptions verge upon torturing the data.
  • Another thing to consider is if you actually end up losing money in it like so many people in 2000, its better if you didn't pay taxes on it to begin with!!
  • Anon
    "Under current tax code, this has all kinds of implications. For instance, it means that the income withdrawn from Roth accounts doesn’t bump you up in marginal bracket, it doesn’t cause you to hit income limits, and it doesn’t cause your social security to be taxable or more taxable if that is still a factor when you retire."

    But, it can have exactly that effect today. Depending on your income, removing a $15k above-the-line deduction (by switching from traditional to Roth) could eliminate your ability to fund a Roth IRA and take any number of other deductions and credits.

    It is unfortunate that you cannot characterize the contributions at the end of the year, rather than the beginning, so that such calculations can be made.
  • The "superchargin returns" argument is precisely wrong. You actually get to contribute more in after tax terms to a ROTH than to a traditional 401k/IRA. The $15,000 after tax you contribute is equivalent to contributing about $19,500 to a traditional plan (at 33% tax).

    It is scary that a large newspaper wouldn't run the numbers on something like that before printing them. It takes about 20 minutes in excel.
  • Rather, I meant to say, you have a higher maximum in ROTH. If you aren't contributing the max, then it doesn't really matter either way.
blog comments powered by Disqus

Previous post: Citibank Check Received

Next post: First Impression: The Automatic Millionaire Homeowner by David Bach