Reed Rinderknecht, CFP®

A physician called last week to say he had decided to direct all of his 401k contribution for 2013 into the new Roth 401k that his practice had recently begun offering to participants. He even emailed his colleagues, urging them to do likewise!

“If I pay the taxes on my contribution now with a Roth 401k, then later when it’s time to withdraw my money, I’ll have no further taxes to pay, either on my contributions or the earnings.”

If the physician was a young professional in the early stages of his career, that Roth 401k option might be a good choice, due to the fact that he would likely be earning less in a lower tax bracket now, as opposed to later years.

On the other hand, if the participant is in his peak earning years—40s, 50s or later—his contribution to the Roth would be taxable at higher tax rates. The consequences could be that he would have to pay the highest amount in taxes, roughly one third of the total of his annual contribution (assume he is contributing the maximum amount allowed, currently $17,500 annually, or $23,500 if age 50 or above).

All of which points to the key difference between a traditional 401k and a Roth 401k: With a traditional 401k, you contribute income pre-tax and then pay taxes on the funds when you withdraw them, during your retirement years. With the Roth 401k, you write a check for taxes upfront so you can make withdrawals tax-free during retirement. With a Roth 401k, neither the amount of your contributions nor your earnings are taxable at withdrawal.

By paying taxes now on the money going into the Roth 401k, particularly if he’s in a higher tax bracket, the participant would have a reduced opportunity for his invested assets to grow. The opportunity cost of paying the taxes, rather than allocating that money into further investments, would likely mean a smaller “number” (that is, fewer dollars) available to him at retirement.

If you’d like to get a good idea of the differences between contributing to a traditional 401K or a Roth for your individual circumstances, Charles Schwab offers an online calculator at https://www.schwabplan.com/Download/RothCalc/RothCalculator.htm. It lets you plug in your own specific information and income assumptions—to determine your estimated annual retirement income from a traditional 401k vs. a Roth 401k, or even some combination of the two.

What about a Roth IRA? Investing in a Roth IRA is an additional way to save post-tax. But high-income folks may bump into earnings caps. Married couples filing jointly begin to lose the ability to fully fund a Roth IRA once their income exceeds $173,000. And Uncle Sam limits IRA contributions by individuals to $5,500 in 2013—$6,500 if age 50 or over. But there is an entirely legal, two-step “work-around” for folks who bump into these earnings caps but still want to have a Roth IRA. Assuming your income exceeds the threshold for making Roth IRA contributions, you’re an active participant in an employer-sponsored retirement plan and you receive taxable compensation of at least these amounts, Step 1 is to make non-deductible contributions to a traditional IRA up to $5,500 annually ($6,500 if you’re age 50 or over).
Step 2, which you need to follow without fail each year after making your non-deductible IRA contributions, is what allows all future IRA distributions to be non-taxable. Immediately after making your non-deductible contributions to your traditional IRA account, you need to convert the entire contribution to a Roth IRA. Once your traditional IRA funds are transferred to your Roth IRA, none of the future distributions from your Roth IRA, including earnings, will be taxable, provided you don’t take any distributions for at least five years after you make your first Roth IRA contribution and you are age 59-1/2 or older.
One more factor to consider: Roths appeal to those who want to pass money on to their heirs, because there are no required minimum distributions (RMDs) starting at age 70 1/2 on a Roth IRA. One point to remember is heirs will be subject to a tax free required minimum distribution.

With all the technicalities and regulations governing Roth investments, you’ll want to confer with your tax accountant or financial advisor to help determine which 401k is right for you. The bottom line, of course, is be aware of any circumstances that enable you to take advantage of tax-benefitting savings and investment opportunities available to you.

PLEASE NOTE LIMITATIONS: Please see Important Educational Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com\disclosures. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.