Roth 401(k) Plans: The Numbers Don't Lie.

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date : 27-Feb-2007

Dear Subscriber:

The New Roth 401(k) Plan

A new retirement account was signed into law on August 17, 2006. It is a component of a “regular” 401(k) plan; however, the funding of a “Roth” 401(k) plan is funded with AFTER-TAX dollars. This is similar to the Roth IRA but with higher funding limits and no limit on earnings to contribute. Money contributed to a Roth 401(k) plan grows without tax and is distributed without tax. (In 2007, the funding limit is $15,500 ($20,500 if over the age of 50)).

Who should use a Roth 401(k) Plan?

-Anyone who will be retiring with the same or higher tax-bracket.

-Anyone who will be retiring with a tax-bracket within 10% of their current tax-bracket.

For example, if you are in the 40% tax bracket and retire in the 30% tax bracket, using a Roth 401(k) is still a better financial tool. An example is really the best way to crystallize the benefits of a Roth 401(k) plan and when it is appropriate to use one.

For this example, assume the client (age 40) contributes $15,000 to a Roth 401(k) plan each year for 25 years and takes distributions from the plan from age 66-85.

Because the contribution is non-deductible to the plan, the client will have to pay the following taxes on his/her contribution:

-40% tax bracket = $6,000 tax
-30% tax bracket = $4,500 tax
-15% tax bracket = $2,250 tax

Assume a 7% investment returns over the life of the plan.

For a comparison example, the client will invest an amount of money equal to the taxes he/she would have saved in taxes had a "regular" non-Roth 401(k) been implemented (a side account).

-$6,000 for the client in the 40% tax bracket
-$4,500 for the client in the 30% tax bracket
-$2,250 for the client in the 15% tax bracket

When clients actively invest money in the stock market after tax, in order to have a real world example, the numbers must reflect a capital gains/dividend taxes on the post-tax brokerage. The following are the assumed annual taxes on the growth in the account.

-25% for the client in the 40% tax bracket
-20% for the client in the 30% tax bracket
-15% for the client in the 15% tax bracket

How much can this client receive in retirement from his Roth 401(k) plan?

$60,831 from the plan income-tax free every year for 20 years (66-85).

If the client instead funded a regular taxable 401(k) the following is how much the client could receive from ages 66-85 after-tax?

-$36,498 in the 40% tax bracket
-$42,581 in the 30% tax bracket
-$51,706 in the 15% tax bracket

The above numbers must be added to the side account the client would have funded with the extra dollars he would have had from funding a deductible 401(k) plan. From the side account, the client could receive the following amounts after tax from ages 66-85.

-$18,063 in the 40% tax bracket
-$14,510 in the 30% tax bracket
-$7,769 in the 15% tax bracket

Totaling the numbers

From a regular 401(k) plus side account after-tax the client would receive the following from ages 66-85:

-$54,562 in the 40% tax bracket
-$57,092 in the 30% tax bracket
-$59,475 in the 15% tax bracket

Who wins? Since the client could receive $60,831 from a Roth each year; the client who funds a Roth 401(k) wins.

Manipulating the numbers

What if the same client starts in 40% income-tax bracket and then drops down to 30% in retirement? He/she could take out $60,645 over the same time period.

What if 30% and then 15%? $66,216.78

What if 30% and then up to 40%? $51,008

What if 40% and then 15%? $69,770

Summary

Simply put, Roth 401(k) plans are financially beneficial for nearly every client.

Do you use a Roth 401(k) plan? If not, why not? Probably because your current advisors are not familiar with them and/or proactive with their advice.

For help determining if a Roth 401(k) plan can help you in your business, please contact our office for help at info@trustmakers.com.

Roccy M. DeFrancesco, JD, CWPP™, CAPP™

ABOUT THIS EDITOR:

Roccy DeFrancesco, JD, CWPP, CAPP, MMB - Author and lecturer, Roccy specializes in advanced estate and asset protection planning. Roccy's passion is to teach advisors how to implement lawful strategies that will hold up for the test of time.

Full Bio - Email Roccy