A study by the Vanguard Center for Retirement Research suggests that many types of workers would greatly benefit from investing in a Roth 401(k) if they only got the chance.
Unlike a regular 401(k), the money diverted into a workplace Roth will be taxed up front. But the cash grows tax-free in the account. When you pull money out during retirement, no taxes are owed. In contrast, the cash deposited into a traditional 401(k) isn?t initially slammed with taxes. A participant won?t pay the tab until he or she starts drawing down the account. At that point, an investor will owe income tax on the withdrawals. This year, you?ll be able to sink up to $15,000 into either a Roth 401(k) or the traditional kind if your workplace offers both. You could also split the money between the two types of 401(k)s in any way you want, as long as you don?t exceed the contribution ceiling. Workers who are 50 or older can sink an additional $5,000 into either of the plans or divide that money between them.
The Roth 401(k) can be a great move for anybody who shares the hoarding habits of the lowly squirrel. Squirrels spend a lot of their time gathering nuts for the winter, which isn?t much different from hard-core savers hoarding cash for their retirement years. The retirees with the most nuts stored up are more likely to get stuck with higher tax bills because they must begin withdrawing a percentage of their retirement assets shortly after reaching the age of 70 1/2. Withdrawals from a Roth 401(k), however, aren?t taxed. And if you eventually transfer the cash in a Roth 401(k) into a Roth IRA, you can also sidestep mandatory withdrawals. Other workers likely to benefit from a Roth 401(k) are lower- and middle-class workers who are currently in a low federal tax bracket.
Those who should probably stick with a regular 401(k) include low-income workers who pay no federal tax because they qualify for earned income and additional child tax credits. Plenty of financial experts have suggested that the Roth 401(k) won?t be appropriate for those who retire into a lower tax bracket. Of course, many people expect a less-punitive tax bite after they quit work, but this can actually be a dangerous assumption. To understand why, you have to look back over the changes to the tax structure during the past two decades.
Since 1980, Vanguard researchers note, the top marginal federal tax rate has dropped from 70 percent to 35 percent. At the same time, tax brackets have broadened, the use of tax credits has spread, and the tax treatment on retirees? Social Security checks has changed. These tax changes, the study suggests, have actually weakened the case for pretax savings because an increasing number of individuals now face the possibility of remaining in the same tax bracket in retirement or actually getting shoved into a higher one. If you pull out a sizable withdrawal from your 401(k) or traditional IRA, for instance, you could get hurled into a higher bracket. Plenty of affluent retirees are also horrified when they find their Social Security benefits getting taxed. Because the thresholds for taxing these benefits aren?t indexed to inflation, more retirees will get dinged in the future.
Vanguard provides an example of how retirees can get trapped in a higher tax bracket. Researchers used the example of a married couple, making $80,000, who raised two children while working. The couple, who fell into the marginal 15 percent tax bracket during their careers, retired with 75 percent of their working income. They?d expect to stay in the 15 percent bracket, but thanks to the tax treatment on their Social Security checks, their effective tax rate jumps to 28 percent in retirement. Ultimately, Vanguard suggests that many workers should invest in both types of 401(k)s for the tax diversification.
A free copy of Vanguard?s research paper, titled ?Tax Diversification and the Roth 401(k),? is available at www.vanguardretirementresearch.com.