Twenty-two percent of employers now offer Roth 401ks and another 60% are either planning to or considering it. Several fund families (TR Price, Scudder) are now offering “solo” Roth 401ks for self-employed taxpayers. Should investors take advantage of these plans if they’re available?
As investors, we diversify our portfolio to minimize investment risk. We also purchase insurance to protect against the economic risks associated with death, disability and poor health. Investors should be equally concerned with the risk of higher taxes. True, higher taxes are not a random risk but are still one that can be mitigated by use of Roth IRAs and Roth 401ks when available.
Contributions to Roth accounts are made with after-tax dollars. These contributions are then allowed to grow and be withdrawn in retirement, free from taxation. The conventional strategy is to defer taxes as far into the future as possible by making pretax contributions to tax-deferred plans, such as a 401(k). However, this strategy will have an adverse outcome if the investor finds him or herself in a higher tax bracket when the money is later withdrawn.
At 35%, the current top marginal tax bracket is the lowest it’s been in almost 30 years.
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Will these rates stay low? Medicare and Social Security shortfalls are growing. According to the 2007 Social Security Trustees report, projected Medicare Part A tax income will begin to fall short of outlays in 2013 and OASDI tax income will begin to fall short of outlays in 2017. Further, the expensive concept of universal health care never seems to lose political traction.
Higher rates could have a detrimental effect on tax deferred retirement plans. Consider that a retiree with taxable income of $100,000 would be in the 25% marginal tax bracket today and for each additional dollar withdrawn from his tax deferred account he’d be left with 75 cents. The following chart answers the question of how much one would have to have withdrawn under historical tax rates to be left with the same 75 cents adjusted for inflation.
Note that in 1986 a retiree would have had to withdrawn 21% more than she would today in order to have the same after tax income. However, if equipped with a Roth account, she could employ a simple tax saving strategy by drawing money from her tax deferred account until the upper limit of a low tax bracket is reached. Additional dollars would then be withdrawn tax-free from the Roth account.
While it’s impossible to predict future tax rates it’s very possible to be ready for them.
1 According to the Profit Sharing Council of America.
Posted February 15, 2008 by Charles Ryan
Our research has shown that although there are seldom any black/white answers. We did find that the following factors are relevant for the Roth vs. conventional IRA/401k decision. The younger the saver, the more attractive a Roth. Roth is also more attractive if a higher income in retirement is anticipated. As Charley noted, Roth becomes more attractive if you expect marginal tax rates to increase. Finally, higher expected returns favor the Roth over deductible retirement plans.