Should taxpayers invest in the new Roth 401(k)?

• Author: Koppel, Michael D.

The basics of Roth 401(k)s were discussed elsewhere (see Oleasz, Tax Clinic, "New for 2006: Roth 401(k)s," p. 723, this issue). This item discusses the type of taxpayer that will benefit from investing in a Roth 401(k).

Limited Resources

The first kind of investor is one with only limited resources. These investors have only a certain amount that they can contribute to a Sec. 401(k) plan. If they contribute to a Roth 401(k) instead, the contribution is made on a post-tax basis.

Example 1: Employee Z has determined that he can invest $10,000 in a traditional Sec. 401(k) plan. His marginal tax rate is 25%; thus, the amount actually available to contribute to a Roth 401(k) instead is $7,500. Z makes contributions for 20 years, with 8% growth per year.

At the end of 20 years, Z's traditional Sec. 401(k) would have accumulated approximately $476,000, while the Roth 401(k) balance would be only approximately $357,000. However, this does not provide an accurate picture of the accounts' real values. If Z takes distributions over 20 years, with a continuing 8% return, his annual pre-tax distribution will be approximately $46,610 from a traditional 401(k). A Roth 401(k) will provide an annual tax-flee distribution of approximately $34,960; see Sec. 402A(d)(1).The exhibit below indicates the net amount received from a traditional Sec. 401(k) at various tax rates.

The exhibit demonstrates that when the marginal tax rate during retirement is less than the rate when the contributions were made, a traditional Sec. 401(k) is the preferred choice. Conversely, when the marginal tax rate is higher during retirement, the Roth 401(k) provides more cash annually.

Other considerations: The complexity for Z continues, however; there are situations in which Z may want to invest in a Roth 401(k), even when the calculation indicates that this is not beneficial:

* While Roth 401(k)s have the same minimum distribution requirements as do traditional Sec. 401(k)s, the former can be rolled over into a Roth IRA (see Sec. 402A(c)(3)(A) (ii)), which has no such requirement. Thus, the account can continue to accumulate tax free, even for a period after the investor's death. This alternative provides for interesting estate planning opportunities.

* For an investor who, because of the availability of other resources, will not need required Sec. 401(k) distributions, the ability to roll over a Roth 401(k) into a Roth IRA may be beneficial.

Maximum Contribution

The second type of...