Roth 401k: Retirement Pan Option a Saving Technique for Owners, Employees

Since 2006, businesses offering 401(k) plans have had the opportunity to implement a potentially powerful new “tax-free” option to their retirement plans,  called a “Roth 401(k).”

Web-4357-101413-gs4357.jpgRoth 401ks allow employees (including business owners working in their business) to put money into a retirement account that grows tax-free. Unlike traditional 401(k) profit sharing and other tax-deferred retirement accounts, a Roth 401(k) can therefore produce retirement income that will not owe any federal income taxes.

For people paying the highest rate of federal income taxes, this tax-free retirement income feature could boost the value of distributions coming out of 401(k) savings by a remarkable 50 percent.

For example, consider a highly successful retired business owner who has saved money in her company’s traditional tax-deferred 401(k), which she rolls into an IRA when she retires in the future.  Since she will have substantial investment income from other sources, distributions from her IRA will be taxed at the highest federal rate (now 35 percent).  At today’s tax rates, she might pay as much as $35,000 in federal taxes out of every $100,000 she withdraws from her tax-deferred retirement account.

If, however, in the future she makes contributions into the new tax-free Roth 401(k) rather than the traditional tax-deferred plan, she would not owe any federal taxes when distributions are made from that account.  She would take home $100,000 of every $100,000 distributed from her future Roth 401(k) retirement savings – 53 percent more than the $65,000 she would receive after taxes reduced the value of distributions from a traditional tax-deferred 401(k) plan.

There is, however, a significant short-term cost to this future tax benefit, because contributions to a Roth 401(k) are not tax deductible, unlike contributions to a traditional 401(k).  As a result, people who put money into a Roth 401(k) rather than a traditional 401(k) are choosing to pay taxes now instead of paying them later.

For this reason, people who expect to be in a much lower tax bracket after retirement than they are now may reasonably be disinclined to use the Roth 401(k) option.  However, even a person who anticipates being in a lower tax bracket in retirement than now might want to consider contributing to a Roth 401(k).

The reason I suggest this has less to do with math, and more to do with how people behave in the real world.

Research demonstrates that most of us, even those who are highly paid, spend approximately what we take home in our paychecks – that is, after taxes and retirement plan contributions are removed.

There are certainly exceptions to this rule, including many of my clients.  However, even the most rigorous savers understand this phenomenon and fuel their retirement savings by arranging for additional retirement savings to be taken automatically out of the checking accounts soon after their paychecks are deposited.

In other words, the main reason that most of us save money out of our paychecks is that we never get our hands on it in the first place.  And this is why I think Roth 401(k)s have such potential power to help people of all income levels save for retirement.

When earnings are contributed to a Roth 401(k), taxes are paid on those earnings along with all other earnings in that pay period.  Thus, Roth 401(k)s produce two types of savings – the cash that goes into the account, and the taxes that do not have to be paid later.

This dual-powered savings not only can result in much lower taxes in future years.  It can also mean that people need less in retirement to maintain their standard of living, because they have gotten used to spending less due to paying more in taxes while they were working.

Here’s why: People who contribute earnings to a Roth 401(k) who would have otherwise saved money in a traditional 401(k) will take home a little less money because they will pay taxes on the value of those savings.

Some people making Roth 401(k) contributions may suffer as a result of the added taxes paid when their retirement plan contributions are no longer deducted from their income.  I speculate that most, however, will simply adjust to the slightly smaller paycheck and end up spending less than they would have otherwise.

The net result could be quite powerful.  First, people contributing to Roth 401(k)s will end up with far more after-tax retirement dollars for the same amount saved since distributions will not be taxed at all.  Second, they will have gotten used to spending less due to the “out-of-sight, out-of-mind” effect of paying their taxes in advance.

There are still unanswered technical questions about Roth 401(k)s, which will likely be worked out in the months ahead and could make the option even more attractive for business owners.  What is clear, however, is that Roth 401(k)s are something that all business owners ought to be looking into – for the sake of their employees, and for themselves.