Understanding Roth 401k And Its Benefits

By Pinyo, on February 15, 2009

In this Ask The Expert With Larry Swedroe article, Erin from Working for Financial Freedom wants to learn more about contribution limit for Roth 401k.  She also wants to know if and how she should split her investment between traditional 401k and Roth 401k.  Here’s the question from Erin:

Is there a limit to how much you can contribute to a Roth 401k? And is it wise to split your investment contributions between a traditional and a Roth 401k?

Answer From Larry Swedroe

The Real Difference Between Roth versus Traditional

There is a limit which is set by the IRS every year for both Roth and Traditional IRA accounts. The current IRA contribution limits for those under 50 is $5,000 and for those over 50 it is $6,000. This allows for what is called a catch up. What is important in making the decision between the two is mainly one thing: What is your current tax rate and what tax rate you expect to pay in when you withdraw the money. If the tax rate is higher now you should contribute to the Traditional IRA. If the tax rate is expected to be higher when you withdraw you should contribute to the Roth IRA.

There is another consideration, which is a bit complex. Most people do not understand that both Roth and Traditional IRAs allow you to invest tax free. Most people think that a traditional IRA allows you to invest tax deferred. But that is wrong. The right way to think about it is that with a traditional IRA the government owns a share of your investment. The percentage they own is the tax rate you will pay on withdrawal. They own that percentage plus any earnings on that percentage. You own the remainder. There is no tax on your withdrawal.

Consider two investors, John and Mary. Currently, both are in the 25% tax bracket. In addition, they both expect to be in that same 25% bracket when they retire. They also have the same income and spending needs. And they both invest on the same day in the same mutual fund. Each has just received a $1,000 bonus.

• John decides that he will invest his bonus in a Roth IRA. Given that he has to set aside 25% of his bonus to pay federal income taxes, John makes a $750 contribution to his Roth IRA. John invests that amount in a mutual fund that invests in equities. John’s investments increase in value by 33-1/3%. He now has $1,000. Assuming that there was no penalty for early withdrawal, he would be able to withdraw $1,000 and no taxes would be owed.
• Mary decides to use her bonus to contribute $1,000 to her traditional IRA. Despite being in the same situation as John, Mary can invest $250 more than John because she doesn’t have to pay the current income tax on the $1,000 invested. Mary now invests her $1,000 in the same mutual fund that John invested in. Thus, she earns the same 33-1/3% return. The result is that she ends up with $1,333. When she withdraws the funds from her traditional IRA (again assuming no penalty for early withdrawal) she will pay a tax of 25%. After paying taxes of $333, she ends up with exactly the same $1,000 that John did. Note that the tax of $333 is equal to the original tax that was deferred of $250 plus $83 dollars. The $83 presents the 33-1/3% gain on the $250. In other words, Mary was investing funds on behalf of the government. She actually owned only 75% of her IRA. The government owned the other 25%.

There is another advantage of a Roth IRA. While traditional IRAs require minimum withdrawals (Required Minimum Distribution, or RMD), Roths do not. Roths do not have this requirement because the government has already collected its toll (taxes on the income have already been paid). The result is that if an individual believes that they will not need the RMD to pay for living expenses, the choice of the Roth could be better even if the tax rate was expected to be lower upon withdrawal than at the time of contribution. In addition, it is important to remember when estimating future tax rates to consider the impact of an RMD on the marginal tax rate.

Roth And Tax Free Investing

There is another consideration: The contribution to the Roth actually allows you to invest more of your assets in a tax free environment. Let’s assume your tax bracket is currently 25% and it is expected to be 25% on withdrawal. That would make the two investment vehicles identical, with one exception. If you invest in a Traditional IRA and you invest the maximum of $5,000, you will really have an investment of not $5,000 but $3,750 as the government owns 25% of the asset (which it will claim when you withdraw the funds — plus its share of any future earnings). If you invest in a Roth instead you get to invest the full $5,000 in a tax free environment, paying the taxes ($1,250) out of other funds.

Just to be clear: If you invest in the Roth you invested $5,000 and paid a tax of $1,250. That is a total of $6,250. Now let’s look at what happens to your $6,250 if you invest in the Traditional IRA: you invest $3,750, the government is investing with you $1,250 (total $5,000) and then you can invest the remaining $1,250 in a taxable account (you saved that amount in taxes because the $5,000 in contributions was not subject to current income taxes). That is the same total of $6,250. The difference is with the Roth you get to invest $5,000 in a tax free environment. With the Traditional IRA you get to invest just $3,750 in a tax free environment and then another $1,250 in a taxable account. The same $5,000 is invested but in the Roth case it is all free of taxes.

Making The Most Of Your Roth 401k

It is important to note that the issues related to the ability to maximize contributions also relates to a Roth 401(k). The difference is that the Roth 401(k) is not constrained by the same income limitations or contribution rules that constrain a Roth IRA. As we discussed, for 2009, individuals under the age of fifty are limited to contributing no more than $5,000 to a Roth IRA. Those fifty or above can contribute $6,000. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income (MAGI) of more than $120,000. The limit is $176,000 for those that are married and file jointly.

However, with the Roth 401(k), employees can decide to contribute funds on a post-tax basis, in addition to, or instead of, pre-tax deferrals under their traditional 401(k) plans. An employee under the age of fifty can defer (whether to a traditional 401(k), a Roth 401(k), or to both) up to $16,500 for tax year 2009. If they are over fifty, they may contribute an additional $5,500, or a total of $22,000. Note that employer contributions (employer match, profit sharing contribution, etc.) are always pre-tax; the Roth option is only available for employee contributions.

Since individuals should always try to maximize their contributions to tax-advantaged accounts, the Roth 401(k) is a valuable tool. Note the same issues apply to 403(b) accounts.

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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