Roth 401(k) brings tax-free retirement closer

Play with your future

Why on earth, then, would you choose a Roth 401(k)?

Running the numbers might convince you. A 40-year-old contributing 15% of her $90,000 salary would save about $1 million by age 65, assuming an 8% return. With the traditional 410(k), she'd have paid $711,500 in taxes and have retirement income of $5,500. But with the Roth 401(k), she'd have paid $562,500 in taxes and have income of more than $6,450.

Using this comparison calculator, keep in mind that certain keep-it-simple assumptions have been made:

• That you're in a dead-end job and will never get a raise. But hey, you won't get laid off, either.

• Despite widespread advice urging you to periodically increase your 401(k) withholding percentage, you will not do so.

• The length of your retirement will be 20 years.

• It doesn't factor in any matching dollars from your employer. Remember that matching dollars automatically go to the traditional 401(k), meaning they're taxable when you withdraw them in retirement.

• In real life, you can split your 401(k) contribution between traditional and Roth. In this calculator, it's all one or the other.

However, some of the assumptions can be adjusted to your circumstances:

• Your current age, salary and tax bracket.

2008 tax rates

Joint return	Single taxpayer	Rate
$0-$16,050	$0-8,025	10%
16,051-65,100	8,026-32,550	15%
65,101-131,450	32,551-78,850	25%
131,451-200,300	78,851-164,550	28%
200,301-357,700	164,551-357,700	33%
357,701 and up	357,701 and up	35%

• The age at which you plan to retire.

• The percentage you contribute to your 401(k). Although it doesn't factor in any salary increases, you can test countless scenarios.

• Expected return on investments, both while you're working and after you retire.

• The tax bracket you think you'll be in when you retire.

There's another scenario that pays off well for most people: Choose a traditional 401(k) and invest the tax dollars you save. It assumes tax savings will be invested in a regular, taxable account.

What the experts say

I spoke with two financial planners. Scott Jensen works at Hardy and Hardy Co. in Lima, Ohio. Scott Neal is president of D. Scott Neal, Inc. in Lexington, Ky. Both of them agree that while the tax savings from a traditional 401(k) should be invested in some way, "it just doesn't happen," Neal said.

Here's where they think a traditional 401(k) is best:

• If you're in the highest federal income tax bracket (35%) and believe you'll be in a significantly lower bracket when you retire, the opportunity to lower your taxable income now through a traditional 401(k) might be more appealing.

• If you're a very conservative investor or if retirement is near (meaning less potential for growth), the prospect of tax-free redemptions from a Roth 401(k) might be less attractive.

Here's where they think a Roth 401(k) is better:

• If you don't plan to spend all of your money in retirement, your Roth 401(k) can be rolled into a Roth IRA and avoid minimum distribution requirements. The tax-free growth can pass to your heirs. (Neal suggests his wealthy clients pay as much attention to distributions from their nest eggs as to the building of them.)

• If you're a younger worker currently in one of the lower tax brackets, Jensen said, the Roth 401(k) is nearly irresistible. "The future tax-free growth benefit of a Roth 401(k) far outweighs the current tax reduction of a traditional 401(k)," Jensen said. "I would build up assets in the Roth 401(k) as much as possible."

No matter which 401(k) you wind up choosing:

• Always, always contribute enough to your 401(k) to get your employer's matching dollars. As Neal points out, this is "free" money that should never be left on the table.

• Every time you get a raise, bump up your 401(k) deduction percentage.

My plan

If Roth 401(k)s aren't on your company's radar, now is the time to put a bug in the ear of your benefits department.

I used to max out my Roth IRA and put 14% of my salary in a traditional 401(k). Early on in my research, I figured I'd evenly split the 14% between the two 401(k) options, softening the tax hit on the full 14%. In subsequent years I'd tilt more toward the Roth 401(k).

After crunching the numbers, though, I decided to ante up faster, putting 10% into the Roth 401(k) until Congress made the plan permanent -- which happened in the Pension Protection Act of 2006. Then I eliminated contributions to my traditional 401(k).

Updated Jan. 3, 2008

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