January 1, 2006, a new opportunity for retirement savings came to town. Known as the post tax ROTH 401k – this is the classier sister to the traditional 401k plan. In one corner is the post tax Roth 401k, with a fuller bodied contribution as taxes are included on the front end. There’s also a five year wait to end the relationship and take a tax free withdrawal. In the other corner is the pre-tax traditional 401k, a tax stripped model with no wait on distributions. But you pay the taxman for both the 401k contribution and the 401k earnings on premature withdrawal and retirement.
Now comes the trouble— which 401k sister to choose?
Ready to roll the dice? You’re going to have to consider the following:
The tax code structure-will the tax structure be more difficult when you are ready to retire?
The marginal tax rates-will they be higher or lower at your retirement?
The inflation rates-will they be too low or too high for you to benefit?
So which sister will it be? –The pre-tax traditional 401k or the post tax Roth 401k–
If you are among the highly compensated, (those earning $95,000+ in 2005), or a business owner, you may find yourself better off with the post tax Roth 401k.
Although contributions are counted dollar for dollar, Roth 401k contributions are worth more to the highly compensated than the pre-tax dollars. As an example, in a company, that fails the non-discrimination ADP test or limits the deferrals of the highly compensated to avoid failing the ADP, and assuming an individual’s tax rate remains the same, making a Roth deferral is economically equivalent to increasing a pre-tax deferral by the amount of the tax savings.
Company B maintains a 401(k) plan. James, age 49, earns $220,000/year and would like to defer the maximum each year. Unfortunately, the average deferral rate of the Non Highly Compensated Employees (NHCE) is 3%, thus limiting James’ deferral rate to 5% ($11,000). The same limitation would apply if the plan added a Roth feature. However, assuming a 35% combined (total fed & state) marginal tax rate, the $11,000 Roth post tax contribution would be the same as making a traditional 401k $14,850 pre-tax contribution.
With the Roth 401k, James will not only make a larger deferral but one that is the same as the pretax deferral in excess of the dollar limit, and more than the ADP test limit. While it is true that James can only defer $11,000 either way, his deferral dollars go farther with a Roth. And if James was a business owner in a Solo 401k Plan, there would be no non-discrimination ADP limit at all.