Sizing Up Traditional 401(k) With New Roth

Millions of workers may have a new retirement plan choice next year: the Roth 401(k).

Created in the 2001 tax law but first available in 2006, the Roth 401(k) may be offered by about 30% of employers as an alternative to a traditional 401(k), according to a survey by Hewitt Associates.

Both Roth 401(k)s and traditional 401(k)s allow accumulated earnings to build in the account without facing current taxation. However, there are key differences involving other tax considerations.

Contributions to a traditional 401(k) come out of employee paychecks before tax and thus reduce a worker’s taxable income in the year the contributions are made. That makes it relatively cheap to contribute because each $100 contributed to the plan reduces the participant’s taxable income by only $70, assuming that 30% of the participant’s income goes to pay federal and state taxes.

The downside: Every dollar that is withdrawn from a traditional 401(k) is taxable at ordinary income tax rates at retirement.

Roth contributions are made with after-tax dollars. That costs comparatively more upfront: The $100 contribution costs $100 when it’s made. But the accounts promise tax-free withdrawals at retirement.

For workers that raises a simple question: Should you deduct now or enjoy tax-free income later?

“There really isn’t a good rule of thumb,” said Chad Parks, a certified financial planner and president of Online 401(k). “Everyone should ask which is better for them.”

Parks did suggest one rule to consider, although he cautioned that it was not perfect because it made certain assumptions. If you are in a lower tax bracket today than you expect to be at retirement, contribute to the Roth. If you are in a higher tax bracket now than you expect to be later, the traditional 401(k) is a better deal. If you think your tax bracket won’t change, flip a coin.

This rule of thumb assumes that someone contributing to a Roth today probably couldn’t afford to make as large a contribution as he could to a regular 401(k) because of the difference in the upfront tax cost. Under this scenario, a worker who could contribute $200 monthly to a traditional 401(k) would put only $140 a month into a Roth. Assuming that this worker earns 8% on average on his savings, he would have $488,741 at retirement versus $698,201 if he had contributed the $200 a month to a traditional 401(k) -- a $209,460 advantage.

But multiply $698,201 by 30% -- the presumed tax hit at retirement -- and you get $209,460. Advantage eliminated. So there would be a difference between the choices only if the participant’s tax rate changed between now and retirement.

Or not.

Hubert Bromma, chief executive of Entrust Group, a 401(k) advisory firm in Oakland, disputes the assumption that people would save less each month in a Roth because of the tax burden. He speculates that most people would save the same amount and pay more upfront taxes, simply living on a little less today to have a lot more tomorrow.

Bromma thinks that anyone under the age of 60 ought to contribute to the Roth 401(k), regardless of his or her tax rate. Why? He thinks that tax rates may well rise in the future, which means that even if you think you’ll earn less in retirement, you might still be paying more tax.

“I think paying 30% now is a lot better than possibly 40% years from now,” he said.

Rande Spiegelman, vice president of financial planning for the Schwab Center for Investment Research, agrees that today’s budget deficits may spell higher tax rates in the future. But he also worries that giving up today’s tax write-off might be shortsighted at a time when a presidential panel is studying the U.S. tax system with an eye to overhaul.

One of the many alternative tax ideas is a flat tax, which would eliminate all credits, deductions and other write-offs and simply impose tax on all income -- no matter the source -- at one relatively low rate. Anyone expecting a flat tax would be encouraged to take a tax break now and hope for a lower overall rate later.

His solution: Play both sides. Put half of your annual 401(k) contribution in a Roth and half in the traditional deductible kind.

There’s another current-day tax twist. Because many tax deductions and credits phase out once taxpayers exceed a certain income threshold, switching to a Roth 401(k) boosts the family’s taxable income enough to make them ineligible for lucrative credits.

Consider, for example, the Child Tax Credit, a $1,000-per-child break that reduces the parent’s tax on a dollar-for-dollar basis. But parents lose $50 of this credit for each $1,000 that their joint income exceeds $110,000.

That means that a couple with $120,000 in income and one child would lose $500 of the tax credit if they contributed $10,000 to the nondeductible Roth. If they made the same contribution to the traditional 401(k) instead, the deduction would knock their adjusted gross income back to the $110,000 threshold, and they could get the full $1,000 child tax credit.

In cases like these, future tax rates would have to be significantly higher before the math would work in the Roth’s favor.

Lori Lucas, director of participant research at Hewitt Associates, says focusing on whether the Roth or the traditional is the better choice obscures the bigger question: whether participants are saving enough.

Hewitt research indicates that 22% of those who are eligible for 401(k) plans don’t even contribute enough to take full advantage of company matching programs, which generally kick in 50 cents for every dollar contributed by the participant. “They’re just leaving money on the table,” she said.

About 31% contribute only enough to get the match, even though the amount they’re saving may be inadequate, she said. And 30% don’t save through the plans at all.

The non-savers are most likely to be people in their 20s who simply refuse to think about retirement, she said. And yet they’re the ones who could reap the biggest benefits for the smallest amount of cash, thanks to the power of compound interest.

For example, a 25-year-old who saves $500 a month until age 65 would have $1.74 million at retirement, assuming an 8% average annual return, according to the National Assn. of Securities Dealers savings calculator (on the Web at www.nasd.com). A startling $1.5 million of that amount would have come from investment earnings on the account; the investor would have put in only $240,000 of his own money.

But suppose this individual waited 10 years to start saving, at age 35. Even if he saved twice as much per month, he would still end up with less -- $1.5 million--and would have had to contribute $360,000 of his own money.

The bottom line, Lucas said, is that whether you save through the Roth or the traditional is much less important than saving as much as you can as early as possible.

“Contribute early and contribute often,” she said.

Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com. For previous columns, visit latimes.com/kristof.

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Every penny counts

Whether you choose a Roth or a traditional 401(k) is less significant than contributing as much -- and as early -- as you can, some experts say. The numbers show why: Here’s a look at the final retirement nestegg for people who started saving at 25, 35, 45 and 55, assuming that each investor contributed a set monthly amount until age 65 and earned an average of 8% per year on the savings.

*--* Start at $200 month $250 month $350 month $500 month Age 25 $695,201 $872,751 $1,221,853 $1,745,503 Age 35 $298,071 $372,590 $521,626 $745,179 Age 45 $117,804 $147,255 $206,157 $294,510 Age 55 $36,589 $45,736 $64,031 $80,039

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Source: Times research