One of the big perks of a Roth IRA is that you’re not forced to take a distribution unless you want to. Does the Roth 401k offer the same benefit? I honestly don’t know.

The reason I ask is because a lot of retirees had to take forced distributions from their standard 401ks in 2008 when everything hit rock bottom and lost a big chunk of their portfolio’s principle. A lot of them had emergency funds saved up for such a bad time that they could have used while waiting for the worst to pass.

That said I’m mostly with the people who say try to do part Roth and part traditional and tax diversify. If a Roth 401k helps someone do that, more power to them. I know I’d sure take advantage of it.

It’s hard to make predictions, especially about the future. Obviously there are no plans to change it, but there are two forces at work 1) forces to keep income taxes low and 2) libertarian forces for pay-per-use.

Combine these two and you may very well have the current low (or lower) income tax rates along with more toll roads, a federal sales tax, a federal networking tax, a very high federal gas tax, and so on. These would make the Roth IRA and 401k a poor choice.

On the other hand, my crystal ball is cloudy. Diversification is good.

I have been saving money in a 401k and a Roth IRA. I only recently, two years ago, found out about the Roth IRA. I think that it is an incredible tool.

Does any one know if the IRS will be able to change the tax free status of the Roth IRA in the future, or is it always going to be tax free for payouts?

Since my previous comment I did learn that I was mistaken about the final point (no 10% penalty for non-qualified withdrawals). Apparently, just like the traditional 401K, there would be a 10% penalty assessed for non-qualified withdrawals of earnings, in addition to taxes on the earnings.

I’d still contribute to a Roth 401K if I had the opportunity for 2 reasons:
1) I could put more future purchasing power into tax-deferred accounts.
2) I prefer to evenly tax-diversify my retirement funds.

I believe that employer contributions cannot be applied to the Roth 401K, so if you have both 401K plans, be certain to use the traditional 401K to the point of your company match.

I like your column but you’re really confused on the 401K plans. You’re comparing apples to oranges. In the regular 401K scenario Joe is using $10,000 of his income towards retirement. In the Roth 401K case he is using $12,800 of his income towards retirement; $2,800 goes to the government in taxes, the other $10,000 into the Roth IRA.

As a few people have already pointed out, if you are in the same tax bracket before and after retirement then your choice of Roth vs regular 401K plans DOES NOT MATTER as long as you save the same amount. You will have exactly the same amount of money.

“the more complicated you make a scenario, the less comprehensible it is, so I chose to make it as simple as possible”. You want simple, here’s simple. Joe makes his first and only contribution to his 401K on January 1, 2007 and retires 2 years later on January 1. Joe earns 10% annually on his investment. Which is better, Roth or traditional?

Let’s suppose Joe is willing to save $1,000 of his income that cold January day. In the traditional 401K, all $1,000 goes into the plan and 5 years later he has $1,000 * (1.1 * 1.1) or $1,210. He takes a lump-sum distribution and pays 28% in taxes ($339), leaving him with $871.

In the Roth 401K $280 of the amount Joe earmarked for saving goes to taxes, so he invests $720. It grows after 2 years to $871, which he can withdraw tax-free. Surprise, surprise! It’s the exact same amount as he had with the traditional 401K.

Trent, if the Roth is better why doesn’t it show up in this simple case? You can pile on complexity, talking about taking distributions over multiple years and making contributions over many years instead of just one, but it doesn’t change the fundamentals. If you’re tax rate will be the same before and after retirement, it simply doesn’t matter which way you choose.

Furthermore, applying your argument about taxes to this example you’d be claiming Joe is “better off” paying $280 in taxes today to save $339 in taxes 2 years in the future. You’re missing the idea of present value here; the amounts are exactly the same in present value!

Highly Compensated Employees (HCEs) in 2007 are those who made $100,000 or more in 2006–with the exception that a company where more than 20% of its employees make more than $100,000 can specify that only the top 20% count as HCEs. This definition is used for Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests to make sure that an employer’s non-Safe Harbor 401K complies with government regulations; if they don’t, some HCEs end up having to have some of their deferred contributions paid back out to them.

The Roth IRA eligibility limit for a full contribution is $99,000 for single filers and $156,000 for joint filers; you can make partial contributions if you’re a single filer with income from $99,000 to $114,000 or a joint filer with income from $156,000 to $166,000.

some Roth 401K advantages over Trad 401K:

1) *If* you’re maxing out your Trad 401K and (if eligible) a Roth IRA, it allows you to put away more tax-advantaged dollars (because $15500 post-tax is worth more than $15500 pre-tax).

2) Even if you expect to earn less in retirement in real purchasing power, there is still uncertainty as to whether you’ll pay more or less in taxes in the future. Historically, tax levels have gone up over time. Thus, it makes sense to tax diversify your retirement dollars — some pretax, some posttax.

3) Highly Compensated Employees (somewhere around $100K) are not eligible for a Roth IRA, but may contribute to a Roth 401K.

4) At age 70-1/2, a Roth 401K can be rolled into a Roth IRA to avoid required minimum distributions.

5) When you make a non-qualified withdrawal before age 59-1/2 from a Roth 401K, you will have to pay taxes on the earnings, but not on the contributions. The earnings portion of your withdrawal is considered to be proportional to the percent earnings on the full account. With the traditional 401K, there would be a 10% penalty on the full amount of the withdrawal. Thus, it functions as a second-tier emergency fund.

Assuming that tax rates stay the same, then they are exactly the same from a tax point of view, except if you can afford the maximum after tax, in which case you are allowed to contribute more to the Roth.

If your marginal tax rate is 15% and you can only afford $100 before tax, you can only afford $85 after tax.

And I’m glad someone used the word ‘commutative’ :)

So, is there just a simple example that spells out which one is better without getting into taxology 40-years from now and a ton of what-if scenarios?

At the max, the Roth is only better by the small amount of additional money you can put into the Roth. If you invest the difference in a tax efficient fund (eg Vanguard Capital Appreciation), then the difference is a VERY SMALL advantage for the Roth.

BUT WAIT

There are two more things to consider. 1) You are paying taxes to the government currently in charge, not the government running the show in 30 years. Not everyone will care about this, but some might. 2) If you are in a lower tax bracket when you retire, the ROTH IS ACTUALLY WORSE. You paid taxes at the higher rate. It’s likely that this dwarfs the small Roth advantage mentioned earlier.

It’s not possible to forecast tax rates, so you might want to hedge your bets. We use a Roth IRA and a trad 401k, but at a 1:5 ratio.

1. Legally, choosing between a Roth and normal 401k is not an all or nothing decision. If your employer lets you, you can contribute a bit to both (combined contributions still cannot exceed the maximum for any given year).

2. Tax rates are not terribly stable (see the graph at the bottom of the Top US Marginal Income Tax Rates, 1913–2003 page). Your tax rate, regardless of your bracket, may be much higher than it is now or it may be lower.

Combining these two points, deciding which 401k plan to contribute too depends on how you want to manage risk. If you contribute to a normal 401k, you are banking on the belief that you will pay less in taxes when you retire. If you contribute to a Roth 401k, you are banking on the belief that you will pay higher taxes when you retire.

Trying to minimize your total payed taxes is a risky business that involves predicting the future. My opinion is that you should diversify. If you contribute to both types of 401k, you will not end up paying the minimal amount of taxes, but, by paying some now and some later, you will amortize your tax burden across both your working years and your retirement years, and you will reduce the risk of your prediction of the future being wrong.

Traditional: earn 10K, contribute 10K. 30 years of growth at 10% = 174.5K. Take 25% tax off and you are left with 130.8K.

Roth: earn 10K, pay 2500 in tax, contribute 7500. 30 years of growth at 10% = 130.8K

Sure if you look at it from at tax point of view, it sounds crazy that paying 43.7K of taxes 30 years from now is the same as paying 2500 in taxes now as the size of the number makes you want to cringe. But if you ignore tax paid and just look at how much money you have left over, it’s all a matter of the tax rate now versus what you think the tax rate will be in the future.

But how can you guess what your taxes will be in the future? Who knows what the future government will do? Or what your expenses and withdrawal rates will be? Or how much social security you will get? The best advice you can get is to tax-diversify. Have some in traditional, have some in Roth, have some in taxable. Cover all bases.

What if at retirement, there were NO federal income tax? a la the Fair Tax (www.fairtax.org)

If you haven’t read the book already, the Fair Tax proposes to do away with the federal income tax and go to a federal sales tax.

The point is, assuming the gov’t were to pass this and doesn’t cover everyone that might get screwed, wouldn’t there be a large risk in paying tax now on something that might not be taxed in the future?

I’m in agreement that either this scenario or the scenario where the gov’t does not honor the tax-free status of a Roth IRA put in the hands of people an arguable 50/50 gamble. Thoughts?

As I said in the article, the more complicated you make a scenario, the less comprehensible it is, so I chose to make it as simple as possible and make the message clear – by putting into a Roth 401(k) instead of a regular one, you’re functionally prepaying your tax bill on the earnings for that money. In the scenario, you’re paying $2,800 a year now in taxes to save yourself a $14,000 tax bill later.