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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™

 

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