Considerations for switching a traditional 401(k) to a Roth 401(k)

ByKenneth W. Rudzinski, CFP, CLU, ChFC, CRPC, CASL, CAP

As a saver and investor, you have more than likely heard of the concept “asset allocation” whereby you diversify your investment pool among various asset classes, such as domestic stocks, foreign stocks, corporate bonds, growth and value stocks, mid-caps, etc. While asset allocation does not remove risk from a portfolio, it can reduce volatility by spreading out your money into more than just a couple asset baskets.

What is also more than likely is that you are putting aside dollars regularly in a 401(k) plan, 403(b) plan, SIMPLE-IRA, or other qualified plan offered by your employer. In fact, many people reach retirement with little assets accumulated elsewhere. If you are one of those, you may have a sizable retirement plan balance after many years of saving through payroll deduction, but you may lack the income equivalent of asset allocation, commonly called “income allocation.” Income allocation is the diversity of income sources at retirement, some fully taxable, like distributions from your traditional 401(k) or 403(b), some untaxed (for federal taxes), like interest from municipal bonds or structured withdrawals from a cash value life insurance policy or qualified withdrawals from a Roth IRA, and some partially taxable, such as stock dividends categorized as “tax-preferred.” Income allocation gives you income tax choices among the various assets you own, a much better way of funding your retirement standard of living. But, if the majority of your retirement savings resides within a pre-tax 401(k) account, then you are forced to pay taxes on any and all withdrawals from that source. Not a good result.

Roth employer retirement plan

Enter the Roth 401(k)/403(b) option, passed by Congress several years ago and now available in many employer plans (each employer plan must decide whether to allow the Roth after-tax option). Accumulating retirement dollars in an after-tax Roth retirement plan option permits significant tax-free dollars to become available at retirement, assuming you satisfy the IRS rules for doing do. Withdrawals from an employer-sponsored Roth 401(k)/403(b) plan, like a pre-tax 401(k)/403(b) plan (unless you are still working), require mandatory withdrawals at age 70.5 years. However, it is possible to roll over your employer Roth 401(k)/403(b) account to an Individual Roth IRA thus allowing you to push back any or all withdrawals at and beyond your age 70.5 years

The basic difference between a pre-tax 401(k) and a Roth 401(k) option is when you pay the taxes due. With the former, you pay income taxes upon taking withdrawals (penalty of 10% for pre-age 59.5 years withdrawals); with the latter, you pay taxes up front, i.e., contributions are made with after-tax dollars. Both permit accumulations to grow without current taxation.

If you are in a lower tax bracket now due to lower taxable earnings, the tax deduction for a pre-tax 401(k) contribution may not mean much by way of tax savings so after-tax Roth contributions may be better. Also, if you expect to be in the same or higher tax bracket at retirement, tax-free withdrawals from a Roth 401(k) account may be more suitable. On the other hand, if you are currently in a high tax bracket, and/or you expect to be in a lower bracket at retirement, the pre-tax 401(k) option may be better for you.

Here is an example. You and your friend Bob are young physicians and right now are both in lower income brackets. Let’s use 25%. Bob chooses to make pre-tax salary deferrals (most plans allow any combination to either or both as long as you remain within the $18,000 contribution limit — $24,000 for 50-year-olds and up). You choose to make after-tax Roth contributions. Each of you is contributing $5,000. Note that you should deduct the taxes paid prior to calculating for an equivalent investment comparison (in other words, you have to earn $6,667 in order to net a $5,000 after-tax contribution to your Roth 401(k) account. You are both 35 years old, with 30 years of investment before you retire (age 65 years). At retirement you both expect to live for 25 years (age 90 years). You both expect to remain in the same current 25% tax bracket at retirement and project a 7% rate of return (ROR) until retirement, then 6% thereafter.

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At age 65 years, both of you will have accumulated the same amount of money — $511,287, which would produce $38,275 of annual income assuming a $0 balance at age 90 years. But Bob, who opted for the pre-tax contributions would have to pay income taxes on those withdrawals, or about $9,569 annually, reducing his after-tax income to only $28,706.

Disciplined tax planning

In my 2009 book, “A Physician’s Guide to Avoiding Financial Blunders,” I made this point. Unless Bob or anyone investing in a pre-tax retirement plan also invests the tax savings attributable to the pre-tax deduction, the Roth after-tax option may be better. In fact, in Bob’s case, even if he invests the $1,250 annual tax savings in a taxable account yielding the same ROR, he only creates $5,956 of additional annual income, or a total of $34,662, much less than your $38,275. The difference would be magnified even more if Bob’s retirement tax bracket was higher than 25% whereby the taxes upon withdrawals would eat away even more at the pre-tax accumulation. By paying taxes before you make your after-tax Roth contributions, you force yourself into a disciplined tax planning scenario. Most people do not save the tax savings from their pre-tax contributions, they spend it. That can make the Roth after-tax option a valuable one.

I invite you to go to the American Funds website (www.americanfunds.com), click the next to last link entitled, “Planning,” then click “Traditional vs. Roth 401(k)/403(b) Analyzer” to help you figure out for yourself whether the pre-tax or after-tax (Roth) option suits you better. This is not an endorsement of the American Funds; I simply find their analyzer easy to use.

Most employers allow for either option in whatever percentage you wish. However, matching contributions, if any, usually go to the pre-tax account. To obtain the ability to make tax-free withdrawals from the Roth account, you cannot make withdrawals within the first 5 years of contributions.

Finally, the projections produced above (using the American Funds website analyzer) assume the same tax bracket throughout your working years. That may not and probably will not be the case. Your earnings are probably going to be higher later in your working years as will your tax bracket, and marriage creating two-income families may accelerate your income quickly to higher tax brackets. While an after-tax Roth may be better in your early years, the pre-tax Roth may be better later on. You be the judge. The nice thing is where you make your contributions is flexible and you can mix and match as needed.

This article does not attempt an exhaustive treatment of the after-tax Roth option for employer retirement plans. You need to check with your plan sponsor by requesting a summary plan description for details about what your plan provides by way of a Roth option.

For more information:
Kenneth W. Rudzinski, CFP, CLU, ChFC, CRPC, CASL, CAP, is a registered representative of Lincoln Financial Advisors Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Heritage Financial Consultants is not an affiliate of Lincoln Financial Advisors. Lincoln Financial Advisors does not provide legal or tax advice.CRN-2277655-101218. He can be reached at email: kenneth.rudzinski@lfg.com.