From The Portsmouth Herald, March 3, 2011

Money Talk: Building a 401(k) with tax advantages

By David T. Mayes, MA, EA, CRPC(R), CFP(R)

Our large budget deficits and burgeoning national debt continue to raise concerns about the potential for much higher future tax rates. For retirement savers, this prospect has many looking more closely at the Roth 401(k) option as a way to build a source of tax-free retirement income.

Roth accounts are a fairly recent addition to 401(k) plans and are only offered by about 29 percent of employers, according to data from Hewitt Associates. Like its IRA counterpart, a Roth 401(k) allows savers to make after-tax contributions to a retirement account, foregoing a current-year tax deduction in exchange for tax-free withdrawals of earnings in the future. As long as earnings are left in the account for five years from the year of the first contribution and attainment of age 59½, no tax is due on distributions.

The Roth 401(k), however, has a couple of advantages over a Roth IRA. While Roth IRA contributions are limited to $5,000 annually ($6,000 if age 50 or older), 401(k) investors can defer up to $16,500 ($22,000 if 50 or older) to their Roth account. Roth 401(k) contributions are also eligible for employer matching, but these matching funds must go into a traditional, pre-tax 401(k). In addition, the ability to make Roth 401(k) contributions is not subject to income limits like the Roth IRA, thus allowing even high wage-earners to build a tax-free retirement nest egg.

When the Roth option is added to 401(k) plans, participants must decide how to divide their contributions between the traditional (pre-tax) and Roth (after-tax) accounts, along with choices about their contribution rate and investment options. In evaluating how the Roth option may help you meet your retirement goals, the first thing to understand is that Roth and traditional 401(k) contributions will result in the same amount of after-tax income as long as your tax rate stays the same before and after retirement.

For example, consider a 401(k) participant in the 25 percent tax bracket who contributes the maximum of $16,500 to her traditional 401(k) account for 2011. Ten years later, assuming an average annual return of 7 percent, her 401(k) account would be worth $32,458. After paying taxes due on withdrawing this amount, she is left with $24,344 to spend. If she, instead, contributes the maximum to a Roth 401(k), she would pay tax on the $16,500 contribution amount up front, leaving only $12,375 in after-tax dollars to invest. Again assuming a 7 percent annual return, her Roth account would be worth $24,344 after 10 years, the same after-tax amount as in her traditional 401(k).

Given this after-tax equivalence, the decision regarding whether a Roth 401(k) makes sense hinges on what your tax rate will be during retirement, a key aspect to consider as part of your overall retirement plan. This future tax rate will depend not only on what Congress chooses to do with rates, but also your other sources of retirement income. If you will rely largely on Social Security (which is only partly taxable) for a large part of your retirement income, or you will continue to have significant itemized deductions, you may find yourself in a much lower tax bracket in retirement. This tips the scales toward the traditional 401(k), even if Congress raises rates across the board.

Generally, Roth contributions make more sense for younger workers currently in low tax brackets but who expect their earnings to increase substantially before retirement. For these 401(k) participants, the tax savings provided by traditional 401(k) contributions is relatively small compared to future tax savings offered by the Roth option. Still, Roth contributions can make sense for higher-income earners, particularly if they have been locked out of contributing to a Roth IRA due to income limits. If these workers expect their income needs to keep them in the same tax bracket during retirement, or they anticipate rising rates, having a Roth 401(k) to draw upon, tax-free, can significantly improve their after-tax retirement income. With both traditional and Roth 401(k) balances, they can better manage their tax bracket in retirement.

David T. Mayes is a certified financial planner professional and IRS enrolled agent at Mackensen & Co. Inc., a fee-only advisory firm in Hampton. He can be reached at 926-1775, david.mayes@mackensen.com or by visiting www.mackensen.com.